Look out, index huggers! The stock market is shifting in a direction that favors active managers and stock pickers, says T. Rowe Price fund manager Ann Holcomb. That should boost prospects for the stock mutual funds she helps run, whose portfolio holdings include leading stocks like Intuitive Surgical (ISRG), Red Hat (RHT) and Mastercard (MA). Two of her funds have already done well in a variety of past markets, having outperformed the S&P 500 in calendar 2017 as well as over the three, five and 10 years ended Dec. 31.
Only 10% of U.S. diversified stock funds with at least $100 million in assets pulled off that four-for-four feat, which makes them winners of the 2018 IBD Best Mutual Funds Award winner.
The market is rotating to the benefit of active managers and stock pickers because of heightened volatility, says Holcomb, one of three managers of $635 million T. Rowe Price Capital Opportunity (PRCOX) and its institutional clone, $654 million Institutional U.S. Structured Research (TRISX).
Holcomb’s funds bear an additional distinction. While Holcomb and her co-managers Jason Polun and Tom Watson oversee the portfolios and keep their eyes on the big picture, T. Rowe Price lets a team of some 30 analysts make buy and sell decisions for the fund. Each analyst runs his or her own sleeve, or segment, of the portfolio. It’s like a professional sports team. Coaches oversee the team, but it’s the players who score and play defense. Delegating that much responsibility to analysts is rare in the stock mutual fund world.
Holcomb, who is 46 years old, discussed the funds’ investment approach with IBD from her office in Baltimore, Md.
Warmer Outlook For Active Managers
IBD: How does the market environment impact Capital Opportunity?
Holcomb: We’ve had years of low volatility, high correlations (among stock performances) and compressed dispersion. That’s challenging for stock pickers. There’s no extra reward for good stock picking if all stocks move together.
But now, volatility is increasing and correlations are going down. That should continue as interest rates rise. That helps active managers in addition to stock pickers. They’re the ones who can take advantage of mispricing vs. underlying stock values that our analysts discover.
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IBD: Why do rising rates cause that dispersion?
Holcomb: They’re not necessarily the cause, but they help. Companies that have been supported by free or low-cost money now get (somewhat) taken out of the market. High quality companies take market share.
T. Rowe Price’s Unusual Move
IBD: Your two funds are the only T. Rowe Price portfolios that let analysts make buy-sell decisions. Why use that approach? Is it because 30 minds are better than three?
Holcomb: It was the idea of our current CEO, Bill Stromberg, when he became director of research in the late 1990s. Our analysts are experts. Bill wanted to showcase their stock picking by having them manage a portfolio within a risk-controlled framework. We limit how much their industry and sector weights deviate from the S&P 500.
IBD: What’s left for you portfolio managers to do?
Holcomb: We have what we call an oversight committee. It consists of the named PMs and portfolio specialist Jennifer Martin. We decide which analysts join the team. We also look at how much of the S&P each analyst covers.
We monitor the overall profile of the portfolio daily. This comes in the form of risk monitoring, looking at components of active risk, any tilts that develop in terms of looking more growthy or valuey. We’re also analyzing the analysts’ performance.
We’re also ensuring that there is consistency between their positioning in this portfolio and what they advocate (for other funds). We engage with our large, institutional clients as well.
Also, we manage a monthly rebalancing process in which any positions that are outside our risk limits are brought back in line.
Intuitive Surgical Uptrend
IBD: Intuitive Surgical has been volatile since November. But it’s in a long uptrend. What’s driving that?
Holcomb: Its fundamentals continue to improve. Analysts have raised their estimates. When companies deliver like that, sometimes it takes time for the market to catch up.
We’ve had a big position for some time. Our analyst Jon Wood has a very favorable view. It’s a bet on computer assisted robotic surgery, a bet that it becomes more mainstream. It’s been adopted in urology and gynecology. Our analyst sees it being used more in general surgery.
IBD’S TAKE: Learn why Intuitive Surgical hit a record high after reporting first-quarter results.
IBD: The fund has trimmed its exposure to Red Hat. Do you still like it?
Holcomb: Red Hat is the prime beneficiary of the increased use of open source software, driven by cloud computing. They have leadership in Linux. So Red Hat has a strong core, which is successfully expanding into cloud software.
Analysts change their positioning for many reasons…. (In trimming the position in) Red Hat, which remains overweight in the fund relative to its weight in the S&P 500, analyst Ken Allen used it as a source of funds to reduce his underweight in Oracle (ORCL) (due to) the analyst’s view that its prospects are improving.
Holcomb: They are largely doing the same thing. Looking at Mastercard, our analyst Jon Friar sees it as a sustainable mid- to high-teens earnings per share grower. Both companies benefit from the movement of payments from cash and checks to electronic. They have high incremental margins, pricing power and strong free cash flow conversion.
With regard to Mastercard, they have a willingness to invest in next generation products, such as their acquisition (last year) of (U.K.-based payments technology company) Vocalink.
Mastercard has a very attractive business model, with high barriers to entry.
More Stock-Pickers’ Picks
IBD: Why has the fund trimmed its stake in PayPal (PYPL)?
Holcomb: Our analysts prioritize within their own sleeves. Our PayPal thesis has been that it can materially outperform due to monetizing their Venmo asset, or using their balance sheet to buy back shares or for some accretive M&A or if they have some core business surprises.
Our trim in PayPal was because its valuation was not as attractive as some other names. We used it as a source of funds for those more attractive names. But, long-term, we see some PayPal characteristics that can still be in play, so it’s still in the portfolio.
Holcomb: Generally, SVB does well heading into a Federal Reserve (money) tightening cycle like the one we’re in, and the market has not fully valued its deposits strength. We’re looking at the potential for it paying a dividend. Usually, paying a dividend opens your investor base. So we started a position in March.
IBD: Which do you prefer with S&P Global — its index business or its ratings business?
Holcomb: It does have a lot of businesses. It is a compounder. It should grow earnings per share at a double-digit pace. It should improve its margins through cost cutting and price increases.
Its ratings business has a market-leading share. And it is returning capital to shareholders.
Also, its tax rate fell with implementation of tax reform.
After the financial crisis, regulation of its space increased, but that just made it more difficult for competitors to get into their business, deepening the moat around their business.
Like PayPal, Red Hat and Mastercard, S&P Global is a leader that is pulling further ahead of rivals.
They’re also shifting to a recurring revenue model, which makes their financials less lumpy and can lift their valuation. About 75% of their revenue is recurring vs. less than 60% five years ago.
IBD: What’s your thesis for Salesforce.com (CRM)?
Holcomb: It pioneered SaaS (software as a service) applications. It remains by far the biggest company in that market. It benefits from a large ecosystem of software, hardware and IT services partners to make its products more valuable and make its market position even larger. And they’re another company with a recurring revenues model.
IBD: How does Diamondback Energy (FANG) fit into a growth portfolio?
Holcomb: Well, we’re a core portfolio with exposure to all S&P 500 sectors, including energy. Diamondback is one of the leading operations in the Permian Basin, where they’ve got a lot of low-cost acreage and can grow production faster with better results than a lot of competitors.
They have low financial leverage, and their execution over the last several quarters has been excellent.
IBD: Give me an example please of a play that is not part of the S&P 500.
Holcomb: Worldpay (WP) is one. They’re a combination of merchant acquirer and payments processor. This was Vantiv (until its takeover of Worldpay early this year). It has the best collection of assets among public merchant acquirers, and should grow earnings per share at a mid-double-digit pace for an extended time.
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