Investing--Q&A, The Post: "Putting All the Eggs in a Few Baskets"
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>>>Putting All the Eggs in a Few Baskets
Sunday , October 8, 2000 ; Page H03
The Merrill Lynch Focus Twenty Fund took a drubbing in the two months following its launch in March, but it sizzled in the summer.
According to Lipper Inc., the aggressive growth fund was the best-performing general equity fund in the third quarter, with a 23.21 percent return. That compares with a 0.97 percent decline in the Standard & Poor's 500-stock index and 7.39 percent drop in the Nasdaq composite.
Merrill Lynch Focus Twenty concentrates on a small portfolio of companies that its managers feel have potential for strong earnings growth. James McCall, the lead manager, and Michael Hahn, his associate, joined Merrill Lynch & Co. last year from Pilgrim, Baxter & Associates, where they managed a similar fund.
Following are edited excerpts from an interview in which the two discussed with Washington Post staff writer Kathleen Day the strategy that enabled them to beat the market.
Q: What did you know that the rest of the market didn't?
McCALL: In a market like the third quarter that was trading in a very narrow range, the only way to consistently do well is to just stay focused on a handful of companies. If you're able to concentrate on just a handful of really great companies, then you at least position yourself to do better than the market. If you own a lot of companies, a portfolio with 150 to 200 stocks, there's no way.
HAHN: We try to select stocks on the basis of their business fundamentals. It's strictly a bottom-up approach. We're sort of the anti-index fund because we just pick what we think are the best companies. It doesn't matter to us whether we've got all our eggs in the technology sector, because we're going for the best companies.
Q: But in theory everyone has the same information you have. So what did you add up in a smarter way than other fund managers?
McCALL: The concentrated nature of the portfolio helped us a lot because, if we're picking the right stocks, the fact that we only own 20 of them means that we have a substantial investment in each, and if those stocks work then the impact on the overall portfolio is going to be substantial.
And if they don't work then the fund would suffer in the other direction, the way it did when it was first formed?
McCALL: Right.
Q: What is your trading strategy?
McCALL: We invest in these stocks with a long-term perspective. We want to continue to own these stocks as long as the fundamentals remain as strong as they were when we first invested. We don't sell a stock because it reaches a certain price target or a certain price-to-earnings ratio. The only time we sell is if we get a sense the fundamentals are breaking down or if we come up with an even better idea.
Q: What's the average turnover time for the stocks you hold?
McCALL: We're averaging about a 12-month turnover.
Q: What is the sector breakdown of the stocks you own?
HAHN: We've got about 85 percent to 90 percent of the portfolio in technology right now. We've got some health-care investment and then a little bit in the consumer sector, in a Hispanic TV broadcaster called Univision.
Q: If your strategy is to buy and hold based on fundamental value, then doesn't a 12-month turnover rate undermine that?
HAHN: A lot of our investments are in the technology sector, and we're in a market where things change more quickly these days. Information flow is higher than it was five or 10 years ago and companies' fortunes can change on a dime. That's why we think this is the type of portfolio where it pays to have someone at the wheel watching all the time.
And things have changed in the last six months. You went from an environment where companies like semiconductor companies were quite strong to one where the economy is slowing down and some of those companies aren't doing quite as well.
Q: What are some of the technology stocks that you haven't turned over?
McCALL: That would be names like Extreme Networks, Juniper Networks, Corning, Nortel Networks. We try to find areas where the market is under-appreciating these names and take advantage when that happens. We also own stock in Ciena Corp. [based in Linthicum, Md.], a company on the cutting edge of using optical networks to move data around.
Q: Have you had a wild ride, being so heavily invested in the technology sector?
McCALL: We got hit hard in March, April and the early part of May. It was the psychology of the market that was going against aggressive growth equities. Versus our peer group of funds we were down about the middle of the pack. As the psychology became more positive we've moved to the front of the pack.
Q: Tell me about your health-care holdings.
McCALL: The only thing we own in there right now is PE Corp.-PE Biosystems. They supply a lot of the equipment that is used in biotechnology research, the genome stuff.
Q: Is that the kind of health-care company you like?
McCALL: It's a more conservative way to play biotech. You don't have to try to identify the companies with the drugs that are ultimately going to be blockbusters in the market. All of these companies are buying the same equipment, and they're buying it from PE Biosystems or their competitors. PE also is the majority owner of Celera Genomics [based in Rockville], which is one of the high-profile genome companies.
Q: Are you wedded to the idea of keeping that much of your portfolio in technology?
McCALL: We're not wedded to any sector. We're looking for the 20 best investment ideas, and we don't care where we find them. It just so happens the vast majority of the best ideas come from the technology space right now. We're looking for very high-growth companies right now. In financial stocks, for example, we have no exposure because they don't meet the growth characteristics we're looking for.
Q: What are the characteristics of the companies you'll buy?
McCALL: We have a rule where we don't look at companies that aren't growing their revenues at least 15 percent and their earnings at least 20 percent. We have $5 billion in market capitalization as the minimum size of a company we'll buy. That's a mid-sized to large-sized company. The average actual market capitalization of companies in the fund's portfolio is $55 billion.
Q: Even though your investment strategy in, say, biotech, is conservative, the fund itself is not meant for a conservative investor with a low tolerance for risk, is it?
HAHN: No. It's definitely a volatile product. When you go after companies that are growing this quickly, the expectations are high, and they move around a lot. It's a product for people that are comfortable putting their money there and leaving it for a long time.
Q: What's the fourth quarter look like, given the recent spate of disappointing earnings at some prominent technology firms such as Xerox and Intel?
HAHN: Things should improve for both the economy and the technology sector. Tech companies have a lot of sales internationally, and we've gone through a period where the euro's been getting hit quite hard, so U.S. products have become more expensive for overseas buyers. We do really well in that environment.
McCALL: You won't see us owning the Dell computers of the world, or the Apple computers or the Xeroxes. We invest in companies that are in markets that are growing rapidly, and the companies we own within those markets have some competitive advantage. They are taking market share in a market that is growing fast.
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