Last week, savvy investors picked up strategies and tips for choosing mutual funds from AmSouth’s leading portfolio managers during a special breakfast, lunch and dinner series for business leaders in metro Jackson.
“You can do all the research in the world, but this is a game of percentages, a game of portfolio construction,” said Dean McQuiddy, manager of Sawgrass Asset Management and AmSouth’s small cap fund, which represents small cap stocks with a total market capitalization of less than $2 million. “The market is the collective judgment of thousands of investors. You’re not going to be right 100% of the time or anywhere near that. You have to hope that, over time, you’ll be right more than half the time and that you put those stocks together into a portfolio that performs well.”
Two of the most common mistakes investors make is being impatient and buying on emotion, said Ron Lindquist, who was recently named as one of Standard & Poor’s top large cap growth money managers in the nation, and manager of AmSouth’s large cap fund since its inception in 1992. The mutual fund portfolio includes 63 companies ranging from $1 billion to more than $500 billion in equity market capitalization. “The average Jack or Jill must know what they intend to accomplish and stick to that doggedly.”
McQuiddy, who managed Barnett Banks’ small cap fund from 1987 to 1997 and has outperformed the Russell 2000 Growth Index on one-, three-, five-, seven- and 10-year comparisons, said every stock picked has specific attributes: above market sales and earnings growth, positive changes in analysts’ estimates through a quantitatively driven series of models and reasonable value in relation to that level of earnings growth.
“We call it the sweet spot,” he said. “We don’t have a lot of pure Internet stocks in our portfolio, for instance, because a lot of those companies have not yet reached the stage where they are profitable. You’re seeing a lot of dot coms turn into dot bombs, with some stocks down 50% to 70%. We’re going through an extreme correction in technology. The NASDAQ was off over 40%, so a lot of companies that led the market last year that didn’t have earnings are really correcting rather hard. We’ve had some of our best performance this last year, especially in the last three or four months, because we do have an element of risk control and insist on companies in our portfolio that have profitability.”
Like a roller coaster ride, there’s been tremendous change and excitement in the small cap arena because of a strong economy and strong earnings, McQuiddy said.
“Earnings for the market for the first quarter of 2000 are in excess of 20%, the strongest we’ve seen since the first quarter of 1993 when we were coming out of a little recession,” he said. “Earnings are good, and that’s part of the story why we think the market as a whole is very attractive. The companies we’re talking about are moving in very fast parts of the economy. There’s a heavy emphasis in technology, the semiconductor industry, the networking industry, communications and software. We’ve been looking at companies that can grow their earnings at an above-market rate. When you say the market is growing its earnings at 20% plus, it makes it a little more difficult to find companies that are growing 30%, 40% and 50% on an annual basis range, and we’re able to find those in today’s economy. Actually, the average stock in our portfolio over the last 12 months has increased its earnings over 100%, with special factors that account for that.”
In the last six years, small cap funds have under performed the overall market, McQuiddy said.
“We’ve got a very optimistic outlook for the market as a whole, particularly the small cap sector because they are selling at a discount to the overall market,” he said. “We’ve gone through a cycle in the last six years that small caps have gone up, with absolute returns of about half the level of the overall market. If the S&P has been up 25% in the last six years, these smaller stocks have only been up about 13%. The focus has been away from the pond we fish in. It’s turning a little bit, with the focus coming back to the smaller stocks. Typically, these stocks sell at a premium over the history of the capital markets in this country.”
In the last seven years or so, small cap stocks have sold at an average of 30% to 40% premiums to extremes of optimism, trading at twice the overall market level, McQuiddy said.
“The last time that happened was in 1983 when their PE ratio was about 45 times earnings and the overall market was about 20 times earnings,” he said.
Red flags to look for when picking stocks
• When revenues, earnings or margins do not continue the trend that is the reason the stocks were picked in the first place.
“Listen to what the company is saying about its future prospects, goals and strategies,” McQuiddy said. “You can pick up a lot of information from management discussions. It’s very vital to thoroughly read the annual reports.”
• When there is an underlying change in the fundamentals of the company, such as not producing the kind of sales and earning gauge that investors had become accustomed to.
“That’s usually when we seek to exit,” McQuiddy said.
• When there is a significant overvaluation on a relative basis.
“An overvaluation to us would be a relative PE multiple well in excess of its historical average over the very long run on an individual company unless that significant increase is accompanied with a ‘ramping-up’ of the expected earnings per share growth rate of that company,” Lindquist said. “Unless it’s accompanied by that, we believe there’s reason for concern and the possibility of that particular issue being even long-term overvalued if it persists. That individual investor is likely to become very excited with what appears to be a tremendous and well-earned success and he may ride that racing horse far too long, even if he ended up as a long-term holder. That would be a concern that I think the average investor, trying to do it on his own, would fall prey to.”
• Companies that are victims of their own success.
“What typically happens is that they find themselves in industries and segments growing so rapidly that their growth outstrips the level of management talent, or the level of their technology system,” McQuiddy said. “Typically, these companies are started by entrepreneurs who invented a better mouse trap and are very early in their growth curve. Many haven’t had time to prove themselves as mature businesses.”
Advice to business investors
• A long-term horizon is a must. “With technology and access to trade on a daily basis, a ‘trading’ mentality is very dangerous,” said McQuiddy.
“The people we talk to are investing retirement money they’re counting on in 20 or 30 years. Stock prices as a whole will follow earnings and our economy is growing very strongly and will continue to do that over time. None of us can predict what the short-term wiggles are going to be, but we can make a fairly strong case that the stock market is going to be higher than it is today.”
• Find an investment discipline that works for you and stick with it. “Stick with a plan and do not let emotions of the market sway you,” said Ron Lindquist, manager of AmSouth’s large cap fund.
• Stay the course despite peaks and valleys.
“The simple passage of time has served our investors well,” said Lindquist.
• Don’t hold on to stock that is declining in va
“The price originally paid for an investment has a benefit in terms of informational content only to the tax man,” Lindquist said. “Whether it’s lower or higher, there is no informational content in that number. Investors tend to reason, ‘if I loved it at 10, it must be twice as good at five.’ Ignore the original number. Investors ask, ‘