Top Mutual Funds: AB Large Cap Growth's Performance Excels With 'Idiosyncratic Opportunities'

AB Large Cap Growth (APGAX) is in an elite group of top mutual funds. It is a 2018 IBD Best Mutual Funds Award winner. Each of those top mutual funds beat its benchmark in 2017 and over the past three, five and 10 years as of Dec. 31. That takes extraordinary consistency. For $6.3 billion Large Cap Growth and other U.S. stock mutual funds, the bogey they’ve beaten is the S&P 500. Across all categories, only 22% of eligible funds managed the four-time feat.


More impressively, AB Large Cap Growth outperformed in all four time periods in three categories: U.S. diversified equity funds, growth funds and large-cap funds. How hard is it to gain entry to the winners’ circle? Only 10.4% of eligible U.S. diversified stock funds made the Best Mutual Funds Award list.

To become a top mutual fund like this, lead manager Frank Caruso, co-manager John Fogarty and senior research analyst Vinay Thapar have assembled a diversified portfolio that includes leading stocks in auto parts, health care, financials and technology such as Copart (CPRT), Edwards Lifesciences (EW), Zoetis (ZTS), S&P Global (SPGI) and Nvidia (NVDA).

Holding periods vary, but the stocks in the past 12 months have risen from 48% for Edwards to 49% for S&P Global, 55% for Zoetis, 63% for Copart and 116% for Nvidia.

Still, Caruso and his team have been trimming one of those leading stocks because of a growing competitive threat. Below, Caruso describes which of those stocks he has reservations about and why.

Meanwhile, overall finding stocks that persistently outperform the market depends, Caruso says, on finding “idiosyncratic opportunities to invest.”

Sixty-one-year-old Caruso and his colleagues — Fogarty, 48, and Thapar, 39 — discussed that and other aspects of the team’s investment approach with IBD from their offices in Manhattan.

IBD: This portfolio is a 2018 IBD Best Mutual Funds Award winner. What does it take to outperform so consistently over periods as short as 12 months to 10 years?

Frank Caruso: We focus on looking at businesses, not stocks. We are attracted to businesses with differentiated competitive positions, companies that produce higher than average levels of profitability, profitability that exceeds the fair cost of capital.

Here’s our secret sauce: we start by looking for good businesses, then we obsess over each company’s idiosyncratic opportunities to invest and to earn high returns on capital.

IBD: What exactly do you mean by ‘idiosyncratic opportunities to invest’?

Caruso: It is an investment opportunity that is company specific. It occurs when a company takes action that can put upward pressure on profitability. Take Nike (NKE). They’ve been chasing low-cost labor since the 1960s. We noticed patent filings that looked like new manufacturing technology. If they could build shoes with robotized machines, they could build plants closer to consumers, saving on tariffs, duties and shipping.

IBD: The fund is fairly concentrated, with just 47 stocks as of Jan. 31. Why do you prefer a concentrated approach?

Caruso: First, we think we’re good at researching companies. And we want to get paid for research.

Second, having around 50 names allows us to get exposure to some larger-cap companies and also seed the portfolio with sometimes younger and more exciting companies.

Forty-seven is near the small end of our portfolio size range. We may have been in the low to mid sixties when we first took over this portfolio in 2012. We were still shaping the portfolio to our vision.

IBD: Auto auctioneer Copart is one of your smaller names with a market cap under $12 billion. It has posted three straight quarters of earnings per share growth acceleration. What’s the driver?

Caruso: They’re probably not the type of business in a lot of growth portfolios. They have high profitability, and they are high versus their cost of capital. Yet it’s surprisingly stable. One secular trend that gives us confidence in the sustainability of their performance is that as autos become more complex, it leads to more attractive salvage rates. With more and more cars, it’s too expensive to repair ones that get damaged. So Copart’s supply of inventory gets bigger.

IBD: You began your current stake in August. Why then?

Caruso: Over a multiyear period, Copart’s infrastructure did not perform efficiently to exploit new inventory when it arose due to (hurricanes). So the company invested money to upgrade its capabilities. In the August hurricane season, investors questioned whether Copart had done enough, lowering Copart’s share price. We bought on that uncertainty.

IBD: For the most part, you’ve been building your stake in Edwards Lifesciences. Why?

Vinay Thapar: They pioneered development of transcatheter aortic valves. Before that, patients had to do through open-heart surgery and go on a bypass machine to have their valves repaired. Edwards got around that by engineering a product that could be inserted by snaking a catheter through an artery in the leg.

It is far more minimally invasive and results in faster discharge from the hospital. The average patient cost is 10% to 15% less than the open-heart procedure. Yet the product has higher than average gross margins and operating margins. We expected an uplift in return on the company’s invested capital (ROIC), and that has occurred. There’s about an 18% ROIC, which is close to the upper echelon in other companies.

The company forecasts the market to be about $5 billion-plus by 2021, and it’s only $2.5 billion to $3 billion now. Beyond that, they’re looking at using the same procedure for a different valve, the mitral valve, which would be a new market.

IBD: Zoetis is another name in which you’ve been building your stake. What’s fueling your interest?

Thapar: They’re the leader in pharmaceuticals for animal health. Our thesis is that after their spinout from Pfizer, they had an opportunity to improve their operating performance. They right-sized their number of SKUs (items for sale), they closed manufacturing facilities. Those improved their gross margin. And they committed to investing in higher returning R&D projects.

Their single-digit top-line growth above the market growth rate, along with cost improvements, had led to higher returns. Going forward, their pipeline of products is yet to be reflected in their stock price. And they’ve committed to reduce their inventory balance, which will improve their return on invested capital.

IBD: S&P Global is another holding whose EPS growth has accelerated. Why has that happened?

Caruso: We’re modeling annual revenue growth in the 6% area for the next four or five years, along with low single digit earnings growth.

Their index business has been a big part of their success. And their ratings business is a best-in-class franchise. In a low-rate environment with a good level of volatility, the expectation is that if there’s an increase around the world, their ratings business should benefit and maybe some parts of their index business.

IBD: You’ve been in Nvidia a long time. Does this story have much runway left in front of it?

Caruso: It’s been in this portfolio since 2014. Their graphical chips have found new applications. Think AI (artificial intelligence), think hyperscale data centers, think VR (virtual reality), think auto vision.

But Nvidia’s GPUs are general purpose chips. And we think there are application-specific chips from early-stage companies that will become competitive for market share in the next 15 to 18 months. So we’ve been trimming our position.

IBD: Booking Holdings (BKNG) is Priceline’s new name. Why do you like that particular online travel agency?

John Fogarty: They changed their name to reflect their primary assets in the online travel portfolio. Their appeal is their dominant position in Europe, where the hotel market is far more fragmented than in the U.S., where the industry is dominated by chains. Bookings can take advantage of Europe’s fragmentation, so they enjoy a higher commission rate as a result.

IBD: PayPal (PYPL) is a relative newcomer to the portfolio. Why did you introduce it?

Fogarty: We began to buy it in the fourth quarter of 2017. The growth of PayPal is essentially riding the increased adoption of online payments and, in particular, mobile payments. We’re attracted to their rising return on assets trajectory — not just their growth, but their increased profitability.

IBD: Anyone want to add any comments?

Caruso: John summarized our thoughts about PayPal. It’s taking market share, we expect it to grow in the high teens over the next three years and it complements our Visa (V) exposure.

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