If the Chinese calendar had a Year of the Stock-picker, 2002 would be it. Since broad market indexes are all down, only the most discriminating investors have triumphed. With that in mind, BusinessWeek asked some smart stock-pickers how they do it.
Each of these pros has a very different style. John Buckingham, who writes The Prudent Speculator newsletter, holds stocks for years. His picks have delivered a 26.2% annualized return over the last decade (as of May 31). Ajay Krishnan, who runs the Wasatch Ultra Growth Fund, zooms in on the fastest growing companies. His fund earned a 17.2% average annual return (through June 14) over the last three years. Leah Zell invests abroad. Her Liberty Acorn International Fund delivered just 0.5% a year return over the last three years. That may not sound impressive, but her peers lost nearly 4.9% a year. Arup Datta of Numeric Investors Small Cap Value Fund has produced a stellar 31.6% a year for the same period. He constantly screens for mispriced stocks, and pounces on them when they show up.
The Prudent Speculator
You could call John Buckingham the Cool Hand Luke of Wall Street. The 36-year-old editor of The Prudent Speculator never gets upset by market conditions. "What accounts for our success is our stomach more than our brains," he says. "We will hold on to a stock despite horrendous news about it in the market." What Buckingham buys: cheap stocks, mainly those trading below book value and at less than one times sales.
To find such bargains, Buckingham feasts on the unloved and misunderstood. One recent purchase is Trenwick Group, a property-and-casualty reinsurer hit hard by September 11 claims and a weak balance sheet. Still, Buckingham sees an opportunity here. "Insurance pricing is better than any time in the last decade," he says. "Trenwick is also selling assets to shore up its balance sheet."
Buckingham looks to exploit market volatility as well--which takes him to the beleaguered semiconductor stocks. "Often, you can buy chip stocks at $20 each and sell them at $60 and buy them back again at $20 in the space of a year." ESS Technology (ESST), which makes chips for DVD players, is one favorite. "The DVD business is booming, and ESS controls 40% of the DVD chip market," he says. "It has been blowing away earnings expectations, yet it has been beaten up because of the tech sell-off and some concerns about the company's accounting." Buckingham thinks the accounting concerns are overblown.
For similar reasons, he also likes energy company Williams Cos. (WMB), which has been hit by fears of Enronitis. "In this environment, any hint of impropriety is looked at as the gospel," he says. Buckingham thinks Williams was unfairly tarnished by accusations that the company tried to corner the California energy market. Williams denies the charges.
Although Buckingham "loves volatility," he does control risk in his portfolio through diversification and by trimming back his winners. Cheapness also provides its own buffer zone, he says. When a stock is truly beaten up, it doesn't have much room left to fall.
Wasatch Ultra Growth Fund
Growth stock investing in a bear market is no easy chore. But that's what Ajay Krishnan of Wasatch Ultra Growth Fund is paid to do.
Krishnan seeks companies with annual earnings growth of at least 25%. Also, their businesses "fit into an overriding growth theme or consumption trend." For instance, Accredo Health (ACDO), a distributor of protein-based drugs, fits into the biotechnology revolution. "Most of the new drugs produced by biotech companies are protein-based," he says. "They cannot be distributed by drugstores because they must be refrigerated, and patients need special training to use them." Another theme is the need for smaller microchips: Monolithic System Technology (MOSY) and Cabot Microelectronics (CCMP) make equipment to do that.
Krishnan assigns companies a "confidence rating" based on their likelihood of reaching his earnings targets. He's willing to pay more for "Future Stars"--stocks with high confidence levels--such as Accredo Health. He'll pay less for "Potential Stars"--telecom/tech companies Wireless Facilities (WFII) and PDF Solutions (PDFS)--for which the forecast is less certain. He also buys stocks with lower growth estimates but a high probability of meeting them. Examples: Pediatrix Medical Group (PDX) and AmSurg (AMSG), medical service companies.
This valuation discipline keeps him from overpaying for stocks and helped him avoid the bear's claws in 2000 and 2001. Says Krishnan: "The biggest mistake people make isn't buying bad companies, but overpaying for good ones."
Liberty Acorn International
Leah Zell specializes in international investing, but her strategy is applicable in all markets. Her mutual fund, Liberty Acorn International, buys stocks of small and mid-size companies that dominate their industries. "The essence of a good company is one that has barriers to entry to competitors," she says. "That gives us confidence that its earnings and cash flow are sustainable." One example: Intrawest (IDR), a Canadian ski-resort operator with prime locations in British Columbia and Colorado. "The ski business is a tough one to break into, and these guys are pros at it," says Zell. "It takes a long time to build a resort, and environmental regulations are onerous."
Companies with good niches still need to be attractively priced. So Zell zooms in on price-to-cash-flow ratios as a check on value. Interest rates in the company's home country also come into play. The higher the rates, the less she'll pay for the stock.
Zell has 20 analysts scouring the globe for companies "that don't have a following on Wall Street." Usually, she favors small stocks, which she says are currently in "the sweet spot of the market." But occasionally she will buy a larger company such as Nintendo (NTDOY). "It's hard to find good companies in Japan," she says. "Nintendo has a huge slug of cash on its balance sheet and a dominant global franchise in electronic games."
Numeric Investors Small Cap Value Fund
Arup Datta uses a computer to pick stocks for Numeric Investors Small Cap Value Fund, since he wants to be able to choose from a pool of 2,500 to 3,000 companies--and do it quickly.
First, Datta searches for companies with attractive valuations and positive earnings momentum. That means seeking stocks with low price-to-book and price-to-earnings ratios. But he doesn't demand rock bottom p-e's if the company has good growth prospects. And, he adds, "we're looking for a short-term catalyst that will drive the stock up in the next six months." That could be as simple as the company beating the earnings forecasts of Wall Street analysts. One example: Fresh Del Monte Produce (FDP), which has topped estimates in each of the past five quarters.
Second, Datta employs an earnings-quality screen, looking for companies with cash flows significantly above their earnings, an indication that profits come from operations and not from accounting tricks. Since investors often value companies by earnings and not cash flow, the profit potential of such companies is often underappreciated. One such company: auto-parts supplier ArvinMeritor (ARM). Says Datta: "Cash flow at the company is huge." By Lewis Braham