Nov. 20 (Bloomberg) -- Morgan Stanley’s Dennis Lynch looks for small companies he can buy and hold for years as they grow into bigger businesses -- a search that has led to investments from Pandora Media Inc. to Twitter Inc. Sometimes he is willing to pay prices that look expensive by traditional measures.
Lynch’s picks made the $2.2 billion Morgan Stanley Institutional Fund Inc. - Small Company Growth Portfolio the top performer among U.S. stock funds over the past year on a risk-adjusted basis, according to the BLOOMBERG RISKLESS RETURN RANKING. The fund surged 69 percent in the year ended Nov. 18 for the highest absolute return among 686 equity funds with at least $1 billion in assets, helping to offset above-average volatility.
Lynch, who invested in Facebook Inc. and Twitter when they were still private companies, said companies in their early stages with room to grow can command multiples of earnings and cash flow far above the norm for established firms. The Morgan Stanley fund has invested in Internet radio station Pandora and real estate data provider Zillow Inc., which sell for estimated price-to-earnings multiples of more than 900. The trick is to compare the current price to what businesses could earn five years into the future, assuming they realize their potential, Lynch said.
“It may look like you are paying a lot at the time, but if a company has a large enough potential you may look back and find you got in at a cheap entry point,” Lynch said in a telephone interview from New York, where he is based.
The stocks in the Morgan Stanley fund trade at an average of 113 times earnings and a price-to-cash flow ratio of 26, compared with 49 and 18 for the Russell 2000 Growth Index, a benchmark for small-capitalization growth-oriented companies, according to data compiled by Bloomberg.
Shares of Oakland, California-based Pandora sell at an estimated 958 times earnings, and Seattle-based Zillow trades at an estimated price-to-earnings multiple of about 2029, according to data compiled by Bloomberg. Pandora and Zillow shares have more than tripled in the year ended Nov. 19.
Bloomberg’s risk-adjusted return is calculated by dividing total return by volatility or the degree of daily price-swing variation, giving a measure of income per unit risk. The returns aren’t annualized.
Morgan Stanley’s small-cap fund produced a risk-adjusted return of 4.6 percent in the year ended Nov. 18. Its volatility was 15.1, compared with 13.5 for the peer group. Lynch said he doesn’t target low volatility, citing Warren Buffett’s saying that large, lumpy returns beat smaller, smoother gains.
While acknowledging Lynch’s strong long-term returns, Janet Yang, an analyst for Chicago-based Morningstar Inc., wrote in a note last month that shareholders have “had to endure some stomach-churning periods of performance to get there.”
The fund lost 42 percent in 2008, trailing 60 percent of peers, and 9.1 percent in 2011, behind 91 percent of rivals, according to data compiled by Bloomberg. The fund gained 28 percent on an annualized basis over past five years to beat 89 percent of peers, and returned 9.8 percent when adjusted for volatility over the same stretch, the data show.
The $4.6 billion Primecap Odyssey Aggressive Growth Fund gained an adjusted 4.2 percent over the past year, with the second-highest total return and above-average volatility. The $1.2 billion Teton Westwood Mighty Mites Fund, which ranked third, combined higher-than-average returns with lower-than average volatility.
Lynch, 43, runs the growth team at New York-based Morgan Stanley Investment Management, a 17-member group within the bank’s money-management unit that oversees $30.3 billion in stocks of all market values. Lynch’s group also runs Morgan Stanley Institutional Fund Trust-Mid Cap Growth Portfolio, which beat 87 percent of peers over the past five years and the Morgan Stanley Focus Growth Fund, which invests in large-cap stocks and beat 98 percent of rivals over the same period, according to data compiled by Bloomberg.
Morgan Stanley’s small-company growth fund owns less than half as many stocks as the typical small cap growth fund and has lower fund turnover, trading its stocks about one-fourth as often as peers, Morningstar data show.
Lynch’s largest holding as of Sept. 30, Corporate Executive Board Co., has been in the portfolio for more than a decade. The firm, which sells research on best practices to large companies, has many of the qualities Lynch looks for in his investments: it dominates a niche market, it can grow at a good pace over time and has what he considers a sustainable competitive edge. In this case, that advantage is the relationship Arlington, Virginia-based Corporate Executive Board has built up with Fortune 500 companies over time.
“That is a powerful network effect you couldn’t easily duplicate,” said Lynch.
Corporate Executive Board and Lynch’s second-largest holding, Advisory Board Co., a Washington-based company that provides similar research to the health-care industry, were both spinoffs of the same private company. Lynch calls spinoffs “a good place to go fishing,” because they aren’t always well-scrutinized by other investors.
The biggest contributor to the fund’s performance over the past year, according to data compiled by Bloomberg, is another company that was split of from a bigger company: Fiesta Restaurant Group Inc. Fiesta, which is based in Addison, Texas, broke off in 2012 from a company that owned Burger King Worldwide Inc. franchises.
Fiesta has two restaurant chains, one of which, Pollo Tropical, has the potential to grow much larger, said Lynch. Fiesta shares have more than tripled in the past year. The stock sells for a price-to-earnings ratio of 87, compared with a ratio of 34 for the Russell 2000 Growth Index.
Lynch isn’t concerned. Investors, he said, are often put off by the high prices commanded by early-stage retailers and restaurants without appreciating how big the companies can become down the road. Chipotle Mexican Grill Inc., throughout its history, has sold at higher price-to-earnings ratios than rivals, he said.
“Knowing what we know today it probably should have traded at multiples so high they would have seemed absurd at the time,” said Lynch.
Chipotle shares have climbed about 13-fold in the past five years. The stock currently trades at a multiple of 54 times earnings.
The Morgan Stanley fund has a heavier concentration of consumer discretionary and information-technology stocks than its benchmark index, data compiled by Bloomberg show. Lynch said the many Internet stocks in the portfolio shouldn’t be thought of as a bet on a particularly industry. The firms have different business models and compete in different businesses.
“What they share is that they use the Internet to disrupt industries,” said Lynch.
Lynch’s funds invested in Facebook of Menlo Park, California, and in San Francisco-based Twitter when they were still private companies, according to Morningstar’s Yang. Facebook has gained 74 percent this year; Twitter has gained 61 percent since going public this month.
The small-cap fund has fewer health-care stocks than the benchmark index and very few early-stage biotechnology firms, said Lynch. While he is comfortable owning volatile stocks, biotech shares represent a different sort of risk.
“Biotech is tricky,” he said. “We don’t like the fact that in one day the business can change and you may have to take a significant loss.”
Lynch said he doesn’t invest based on any particular view of the economy or the stock market, reasoning that trying to add value that way won’t work.
“What we try to do is identify companies in which we have confidence, regardless of what happens to the economy,” he said.
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