Bottom-Up Success

Steven Barry and Ernest Segundo say low-priced, mid-cap firms with recurring revenues make attractive investments

Steven Barry and Ernest Segundo Jr., co-managers of Goldman Sachs Tr:Grth Opportunities/A (GGOAX ), are bottom-up investors who buy businesses based on thorough fundamental analysis. By leveraging the firm's active growth equity team, they have been able to find low-priced firms in the mid-cap range that have offered attractive investment opportunities.

What is noteworthy is that Barry and Segundo have excelled in the current market environment while many other portfolios have faltered. For the one-year period ended in June, the fund soared 16.8%, versus a loss of 3.9% for the average mid-cap blend fund. Year to date as of the end of June their fund is up 8.8%, while its peers are down 5.5% on average. One key to the team's success: focusing on firms with strong free cash flow. The portfolio is too new to be ranked by Standard & Poor's. Other key points: Top holdings include Triton PCS Holdings A (TPCS ), Ambac Financial Group (ABK ), SABRE Holdings A (TSG ), and Cendant Corp. (CD ). The fund invests across a variety of industries and holds about 80 names. Its largest exposure is to media companies at about 20%.

Rick Micchelli of Standard & Poor's FundAdvisor recently spoke with Barry and Segundo. Edited excerpts from their conversation follow:

Q: The fund is classified as a mid-cap blend offering? Is that a fair categorization?

A: We are buyers of growth businesses, but because of the diversity of the fund -- its breadth across industry sectors -- it tends to have a more blended feel. That is where the ratings agencies have placed us.

Q: How would you describe your investment philosophy? What kinds of things do you look for from your companies?

A: Since we are buyers of businesses, we want to make sure they are high-quality growth businesses. We look for a variety of things. One thing we really like is recurring revenues. They tend to add stability to a business. Of course, we also look for strong management teams that have demonstrated that they can run the business well. We look for businesses that have high returns on equity and on invested capital -- businesses that generate strong cash flow. We focus on free cash flow, in particular. We want well-positioned businesses poised for long-term growth as a result of a strong brand or strong market position. We want them to be in a defensible niche. We tend to shy away from commodity and cyclical type businesses. Lastly, it is all the better if we can sense some sort of catalyst for improvement or change or re-evaluation by Wall Street.

Q: Where does your research start?

A: We spend an inordinate amount of time focusing on cash flow statements, balance sheets, and income statements. They tell the story of a business. We leverage a team of 20 investment professionals that have been doing this for a long time. Decisions are not based on an economic forecast, nor the price of oil, nor inflation. It is company-by-company, very bottom-up driven. It is based on fundamental analysis.

Q: Once you find companies with the characteristics you like what is the next step?

A: We ask ourselves if the business is reasonably valued. Is it trading at some sort of discount to what we think it is worth based on calculations such as private market value, discounted free cash flow or cash flow models, or comparable transactions we might have observed elsewhere?

Q: Why do you think the fund has outperformed its peers by such a wide margin?

A: One reason is our focus on cash flow. Over the last two years it has been a very interesting market, to say the least. Access to capital has caused a lot of volatility in companies. However, we think about how an income statement, a balance sheet, and a cash flow statement intertwine to give you a sustainable business, compared to one that has to continuously come back to the capital markets to fund its business plan. This makes us different than a lot of other growth managers. The anticipated growth of many companies evaporated when the capital markets turned less friendly back in March 2000. They could not access capital.

Q: How is the portfolio structured?

A: We have not gone out on a limb. Whereas some competitors may have a 60% or 70% weighting in technology or very high weighting in biotech, we have built the portfolio by looking at all industries across the board. However, we don't feel that we have to own every industry. Disciplined portfolio construction is an important part of what we do.

Q: How do the sectors break down?

A: The largest is our media exposure, which accounts for about 20% of the portfolio. That is followed by the consumer area at about 16%, and technology at about 17%. Finance is about 11%. Health care is 12%-13%. Energy, the more growth-oriented part of energy, is about 7%-8%. We spend a lot of time in the media and telecommunications area, where there are franchises and strong cash flows. We kind of get our faster growth in those sectors. The predictability and the value of the franchise can be much more accurately gauged.

Q: Some of your top holdings include Triton PCS HoldingsA (TPCS), SABRE Holdings`A` (TSG), Ambac Financial Group (ABK), Amphenol Corp`A` (APH), ITT Educational Svcs (ESI), and Cendant Corp (CD). Could you pick one or two and discuss how they illustrate your philosophy?

A: Sabre came to our attention a little over a year ago. The catalyst for change was that they acquired one of our travel services companies called GetThere. This is a company that uses the Internet to help corporations become much more efficient with their travel costs. Sabre has been the leader in reservations systems. When the two companies got together Sabre was a very slow growing company, but one with strong cash flow and a leading market position. As soon as they acquired GetThere, they used the Internet as their new vehicle for accelerating growth. The GetThere enterprise, combined with Inc, of which Sabre is a majority owner, has made it more of a bricks and clicks operation. The company has doubled its growth rate from say the high single digits to the mid teens. Something that we really like here is that they are toll takers. Every time a ticket is sold they get a small piece, basically about $10 per ticket. As different booking systems that Sabre uses expand, they actually benefit when there is an airline fare war. Air travel is a growth business, but has high fixed costs and potential for strikes. Instead, we play it by owning the toll keeper.

Q: What about Triton?

A: Triton is a cellular provider in the AT&T Network. It was a new company back in August 1999 when it went public. CLECs and other businesses ran into trouble with the capital markets shut. But Triton has a business model that allows it to generate significant cash flow the minute it turns on its tower, or gets antennas onto its system. Since they are part of the AT&T network they get roaming traffic right off of an AT&T subscriber. It could be a New York subscriber traveling through North Carolina, but they are going to get revenues. This has been a story where despite a lot of volatility in the telecom sector, Triton has been an excellent performer. It is fully funded for its growth plans and has been cash flow positive for three quarters even though it is only a two-year-old company.

Q: Cendant has performed well, but it went through an accounting crisis a few years ago.

A: The accounting is no concern to us. The chance of an accounting problem with Cendant is about zero, given how it has been cleansed and scrubbed and observed by multiple parties. It is attractive because it is a low fixed asset business, meaning it depends mostly on franchise revenues as opposed to bricks and mortar. We had an opportunity to buy this enterprise at a very inefficient price. Over the last eight months or so they got all the issues of the past behind them. They re-focused on driving the top line and growing the enterprise using their powerful cash flow. They have had upside surprises over the last three quarters with earnings estimates rising.

Q: Have you seen any evidence or impact on companies resulting from the rate cuts yet?

A: From my perspective, as companies have been reporting second quarter earnings, I would say no. This is again why we focus on businesses that are strategically positioned because we don't know what the economy is going to throw us. Even if we know, or somebody told us, it probably would not change our investment approach. Several months ago people were fairly confident we would see a second half recovery, but the conference calls I have been listening to this earnings season would call that into question, suggesting it is probably going to be pushed out more into 2002. That said, many stocks, in general, will anticipate a recovery. We don't know when, but if we own good businesses at reasonable prices good things happen when the sentiment improves.

From Standard & Poor's FundAdvisor

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