Three mutual fund managers thrive by betting on growth

Tim Gray

The managers of three of the third quarter’s better-performing mutual funds thrived by betting on growth: They all favored companies that have been increasing their earnings at faster-than-average rates.

They also hold far fewer stocks than the typical actively managed mutual fund.

Cindy J. Starke, manager of the Value Line Larger Companies Focused Fund, said she invested with high conviction, meaning she holds about 40 stocks and piles nearly half her fund’s assets into the top 10 names.

Managers sometimes load up on stocks — the average actively managed stock fund tracked by Morningstar holds 164 — to diversify their holdings, preventing a few bad bets from sapping the overall return. Some research has shown, Starke said, that “you get rid of much of that risk by the time you hit 20 stocks.” She said she tried to own what she called “core growth names,” like Facebook and Amazon, and would then “pepper in some interesting emerging companies.” When managers hoard too many stocks, she said, their funds can end up performing like the overall market.

Starke leans toward the information technology and health care sectors. “That’s where you find the most innovation and differentiation,” she said. Her largest holding at midyear was Alexion Pharmaceuticals, a maker of drugs for rare diseases.

Alexion has been restructuring, with layoffs and a planned move of its headquarters from New Haven, Connecticut, to Boston. An internal investigation uncovered improper sales practices, but Starke said she viewed the company’s troubles as transitory. “They have a growing drug pipeline,” she said, “and the bad news didn’t affect the longer-term fundamentals.”

The distinctive nature of biotechnology companies’ product pipelines is a draw for Starke. “The companies are typically not competing against each other — they can all be addressing different diseases,” she said. The health care sector, which includes biotechnology, recently accounted for about a third of her fund’s assets — around twice as much as her average Morningstar peer.

Starke’s fund, which has a retail expense ratio of 1.15 percent, returned 8.1 percent for the third quarter, compared with the 4.48 percent returned by the Standard & Poor’s 500.

The managers of the Akre Focus Fund share Starke’s highly focused approach to investing but take it even further. Their fund recently held only 23 stocks.

John H. Neff, one of the three portfolio managers, said he and his two colleagues, Charles T. Akre Jr. and Thomas Saberhagen, liken their investment process to a three-legged stool. They seek businesses with strong competitive advantages, skilled and honest management and promising opportunities for reinvestment.

“Our job is to be as discriminating as we can in identifying these three-legged-stool businesses and to be discriminating in what we pay for them,” Neff said. If stocks do not meet those criteria, the fund will sometimes let cash build up.

A theme in the portfolio is what Neff called “bottleneck” or “toll-bridge” businesses, which operate at a choke point in the economy and profit from their position.

Consider MasterCard, a top recent holding. The volume of electronic transactions, which MasterCard processes, continues to grow, but cash and checks still prevail worldwide, Neff said. That represents a hefty opportunity for handlers of electronic payments. “Whatever you buy and wherever you buy it in the world, we own a business that has improving odds of being involved,” he said.

Neff said that another of the fund’s top holdings, Moody’s, likewise stood athwart a toll bridge: Its ratings are critical in the issuance of bonds and other debt securities. The biggest raters — Standard & Poor’s is the other — came under fire after the financial crisis because some of the subprime mortgage bonds they classified as investment-worthy ended up collapsing, and some policymakers have called for greater competition in the industry. So far, though, Moody’s and Standard & Poor’s continue to dominate, and Neff said he and his colleagues do not foresee that changing soon.

The Akre fund, which has a retail expense ratio of 1.34 percent, returned 9.99 percent in the third quarter.

Stephen M. DuFour, manager of Fidelity Focused Stock Fund, also restricts his fund’s total holdings. Officially, the fund can own as many as 80 stocks, but DuFour said he aimed for half that number. “With 40, you have enough names to diversify,” he said, “but you also get bang for your buck.”

DuFour has lately heard that bang coming from technology stocks, which accounted for 40 percent of the fund at September’s end. In picking stocks, he said, he does not heed sector classifications. “I’m sector agnostic,” he said. “My overweights change based on where I find good investments, and I see great stuff in tech now.”

He added he did not see his technology investments as bets solely on computers and the web. PayPal, for example, was a top recent holding, and the company is an innovator in the technology for handling online payments. “But they also do loans and credit cards,” he said.

The growth in electronic payments is one of the three themes that unify the fund, he said. The others are the internet, especially the emergence of artificial intelligence, and exchange-traded funds.

DuFour said that working for Fidelity, one of the country’s largest asset managers, had given him insight into the upsurge in ETF investment. Fidelity, like its industry counterparts, has had money flow out of its actively managed funds and into its passively managed ones, including ETFs, he said. (An ETF, like a traditional index mutual fund, often tracks an index.)

“As I look for ways to play that, it turns out that people who own the indexes are in a very advantageous position,” he said. “So in my top 10, one of the names that shows up is Standard & Poor’s,” which is also a leading creator of indexes. Every ETF built around, say, the S&P 500 must pay Standard & Poor’s for the right to use the index.

DuFour’s fund, which has a retail expense ratio of 0.62 percent, returned 7.75 percent in the third quarter. DuFour has managed the fund since 2007. Over that time, it has returned an annualized average of 8.41 percent.