Grand Prix's Big Mo
Bob Zuccaro's investment management shop Target Investors has been around since 1983, but it was only in 1997 that he decided to launch a mutual fund. The obvious name, Target, was already taken, so he and his colleagues batted around other names. "Grand Prix was the 13th name that came up," Zuccaro recalls. "But it was catchy and suggesting something that's fast, symbolic of what we do."
It turns out the name couldn't be more, well, on target. The Wilton (Conn.)-based fund has established an astonishing record in a period when many funds have been posting turbocharged returns. The fund earned 111.8% in 1998, following that up with 147.8% in 1999 (table). This year the fund was up 70% in March, but is now up just 5.4%. Still, that tops the Standard & Poor's 500-stock index and trounces the Nasdaq composite.
NO NEWBIE. Zuccaro is a momentum investor, a sort much maligned of late with the plunge in the Nasdaq and in high-flying technology stocks. Momentum investors have been painted as inexperienced traders who chased hot stocks, bid prices up to absurd levels, and then turned tail and caused the market to plunge. No doubt that description fits some, but certainly not Zuccaro or the Grand Prix Fund. He's 57 years old and has worked in the investment business since 1967. Zuccaro doesn't invest in initial public offerings or in companies that are losing money.
What Zuccaro buys are the stocks that are leading the market in price appreciation and earnings gains. He also invests in those that are surprising Wall Street the most with higher-than-expected earnings gains. In a bull market, Zuccaro's aggressive strategy may seem to be a layup. "You wonder what will happen if earnings and stock prices stop going up," says Edward S. Rosenbaum, research director at mutual-fund research firm Lipper Inc. Zuccaro says he is not fazed by the inevitable downdrafts, since he has invested through six bear markets and five recessions. "There's always some stocks going up," he says.
Before starting the fund, he was a "growth at a reasonable price" investor. He would, for example, buy stocks with 30% earnings growth when they traded at price-earnings ratios of 15. The idea was to sell when a stock hit its target p-e, usually the same as its growth rate. When the performance of that strategy lagged in 1996 and 1997, he realized the stocks making the biggest gains were stocks that he never would have bought based on their p-e's. By conventional yardsticks, they were overvalued to begin with, yet they made big gains because of their momentum.
To pick the fund's investments, Zuccaro screens some 10,000 stocks on price, earnings, and positive earnings surprises, and looks for those that are in the top 10% on all three criteria. That process alone winnows the pool to under 100. Then he ranks each by criterion, and the 25 with the highest combined scores--the fund is a concentrated, or focus, fund with just 25 stocks--go in the portfolio.
One result is that Grand Prix is usually buying a stock when it's making a new high. Indeed, on May 16 he bought Quest Diagnostics Inc., a medical service company, and Three-Five Systems Inc., which makes display modules for cell phones and other electronic devices, as the two shot up to new highs. "It sounds counterintuitive, but it's not," says Zuccaro. "If a stock makes a new high, most of the shareholders are making money, are not looking to sell, and there's less resistance to it going up." If you buy a stock near its low, he explains, shareholders are probably waiting to sell as it gets near to the price they paid. Those sellers can be a big drag on the stock.
Kari Bayer, a quantitative analyst at Merrill Lynch & Co., says investing by price momentum is a proven strategy. It beat the S&P 500 in all but three of the last 12 years, with an average annual return of 25.3%, vs. 16% for the S&P over the period. In Merrill's studies, earnings momentum and earnings surprise strategies clocked returns close to the S&P. Merrill's work, however, uses the S&P 500 stocks. With a broader universe that includes faster-growing companies, earnings momentum strategies should be more rewarding.
Perhaps where Zuccaro adds the most value is with his sell discipline. Should a stock fall 10% from its high, out it goes. That limits the downside. Over the past year, Zuccaro dumped Legato Systems at 69 (it's now at 14), Emulex at 160 (now 54), and Charles Schwab at 63 (now 45). One change Zuccaro made of late is that when the Nasdaq becomes especially volatile and many stocks move down more than 10% in a day, he sells only a portion of his position. "Otherwise, I would end up with half the fund in cash, and that's not appropriate for an equity fund," says Zuccaro. A high cash position would put the fund at a disadvantage on the rebounds. "I've seen the fund come back 20% in two days," he says. "That wouldn't happen if you had a lot of cash." He now has 12% in cash.
The 10% rule accounts for many but not all of the portfolio's sales. For instance, Zuccaro sells if there's negative news from a company. And as earnings season approaches, he compares his own profit forecasts with the Street's. "If we don't see a positive earnings surprise of at least 5%, we sell." Finally, sometimes a stock is sold to make room for one with a higher score.
BIG SPREAD. All of this makes for lots of trading. During 1999, the fund had 764% turnover, which means the average holding period for a stock was around six to seven weeks, vs. a little less than a year for the average U.S. equity fund. Frequent trading could also result in a lot of short-term capital gains distributions. That hasn't happened yet, mainly because asset growth--from $0 to $500 million in a little more than two years--has allowed the fund to spread the gains over more assets. But as the fund matures, the hyperactive trading may prove troublesome to taxable investors.
Still, if Grand Prix continues to win the performance races, shareholders may not mind. After taxes, he might still be way out in front.