Primecap Rides Health to Top Growth Fund: Riskless ReturnCharles Stein
Primecap Odyssey Aggressive Growth Fund, run by a firm that’s best known as a money manager for Vanguard Group Inc., beat peers over the past five years with a heavy dose of health-care stocks, many held for years.
The $2.8 billion fund had the best risk-adjusted performance among major U.S. growth funds, a category that includes household names such as Fidelity Growth Company Fund and Growth Fund of America, according to the BLOOMBERG RISKLESS RETURN RANKING. All eight mutual funds run by Pasadena, California-based Primecap Management Co., including five for Vanguard, have beaten the Standard & Poor’s 500 Index since inception.
“These guys have made some great calls on health care, and as the numbers bear out, this has been a great fund to own,” said Daniel Wiener, chief executive officer of Newton, Massachusetts-based Adviser Investments, which manages $2.5 billion and owns shares of the fund.
The fund, started in 2004, has about a third of its holdings in medical stocks, a call that proved prescient in a five-year stretch when health-care stocks returned more than three times as much as the U.S. equity market. In letters to shareholders, the Primecap managers have said they want to buy quality stocks that offer better growth prospects than the market expects.
Primecap was started in 1983 by three managers who previously worked at Capital Group Cos. in Los Angeles, which runs the American Funds, the third-largest mutual-fund family. One of the founders, Howard B. Schow, died last year at age 84. After two decades of sub-advising funds for Vanguard, Primecap created three mutual funds under its own name in 2004, including Odyssey Aggressive Growth.
Like their American Funds counterparts, the Primecap investors divide a portfolio among several managers who each run a piece independently. The fund’s turnover ratio, a gauge of how much the holdings change in a year, is about one-fifth the industry average, according to Morningstar.
“They look to make long-term investments in what they have determined to be great companies,” Dan Newhall, a principal at Vanguard.
Primecap Odyssey Aggressive Growth gained 3.3 percent, adjusted for price swings, in the five years ended May 10, according to data compiled by Bloomberg. Its total return was No. 1 among 87 U.S. growth funds with at least $2 billion in assets, more than making up for volatility higher than about two-thirds of the competition. The fund focuses on small and mid-cap stocks, which tend to be more volatile than larger ones.
The fund is run by Theo A. Kolokotrones, one of Primecap’s founders; Joel P. Fried, who has been with the firm since 1986; and Alfred Mordecai, who joined in 1997. The managers declined to be interviewed for this article.
The $4.4 billion Eaton Vance Atlanta Capital Smid-Cap Fund gained a risk-adjusted 2.9 percent, second-best in the group, with the third-highest total return and about average volatility. The $11.4 billion T. Rowe Price New Horizons Fund, rose almost 2.9 percent and ranked third, combining the second-best total return with above-average volatility.
American Funds has two competitors in the ranking. The $29.4 billion Amcap Fund ranked 26th and the $121 billion Growth Fund of America, once the biggest U.S. mutual fund, came in 69th. The $46 billion Fidelity Growth Company Fund, run by Boston-based Fidelity Investments, was 36th.
The risk-adjusted return isn’t annualized. It’s calculated by dividing total return by volatility, or the degree of daily price variation, giving a measure of income per unit of risk. Higher volatility means the price of an asset can swing dramatically in a short period, increasing the potential for unexpected losses.
The Primecap managers, in shareholder letters, stress the progress being made in medical science, from development of new drugs to advances in gene sequencing. Along with information technology, health care is a field where “the U.S. has a strong competitive advantage relative to the rest of the world,” they wrote in November.
Pharmacyclics Inc., a New Brunswick, New Jersey-based drug maker that is developing an experimental therapy for blood cancers, made the biggest contribution to the fund’s returns over the past five years, according to data compiled by Bloomberg.
Shares of Pharmacyclics rose more than 80-fold over the past five years, from $1 to about $88 a share. The stock was the fund’s largest equity holding as of March 28.
Pharmacyclics and its partner, New Brunswick, New Jersey-based Johnson & Johnson, said in February they will submit their ibrutinib therapy to the U.S. Food and Drug Administration this year. The drug won “breakthrough” status from U.S. regulators, making quicker approval possible.
Other medical stocks that have boosted returns include Cepheid Inc., a Sunnyvale, California-based diagnostics company, and cancer drugmaker Seattle Genetics Inc. of Bothell, Washington. Both have soared at least fivefold since March 2009.
“We don’t go for 20 percent or 30 percent gains,” Schow told Forbes magazine in 1994. “We go for triples, quadruples, octuples. But that takes years.”
Several of the fund’s holdings were taken over during the five-year period. American Italian Pasta Co., the stock with the second-biggest contribution to the fund’s returns, almost quintupled in price in the two years before it was bought out in 2010 by cereal maker Ralcorp Holdings Inc., one of several stocks Primecap owned that benefited from acquisitions by bigger companies.
The managers accumulated American Italian Pasta shares in 2006 and 2007 after the dry noodle maker lost fourth-fifths of its value after a 2002 accounting scandal.
Another holding, Medarex Inc., a Tyler, Texas-based cancer drugmaker, was taken over at a 90 percent premium in 2009. 3Par Inc., a Fremont, California-based maker of data-storage systems, more than tripled in price in 18 days before it agreed to be acquired in 2010 after a bidding war.
Last month, Bayer AG agreed to buy Conceptus Inc. for about $1.1 billion, or 20 percent above the previous closing price for the Mountain View, California-based contraception device maker. Conceptus was the fund’s 13th-biggest equity holding.
“When your companies are acquired it is a reflection of that fact that you are buying good quality franchises that are undervalued in the marketplace,” Thomas Perkins, manager of the $12.4 billion Perkins Mid Cap Value Fund, said in a telephone interview.
Primecap manages $48 billion for Vanguard and about $70 billion altogether, according to the Valley Forge, Pennsylvania-based firm. The $33 billion Vanguard Primecap Fund returned 13 percent a year since it was opened in 1984, compared with 11 percent for the S&P 500 Index, according to data compiled by Bloomberg. The $8.7 billion Vanguard Capital Opportunity Fund gained 13 percent a year, versus 5.1 percent for the index since February 1998, when Primecap took over.
Primecap Odyssey Aggressive Growth buys smaller stocks than the other two Primecap branded funds, and holds shares that “typically provide little current income,” according to the Primecap website.
“They own more speculative companies in this fund,” David Kathman, an analyst for Morningstar, said in a telephone interview. “They are willing to go out more on a limb.”
That willingness to take risks hurt the Primecap aggressive-growth fund in 2007, when it trailed 93 percent of peers, a slump the managers blamed on “disappointing stock selection” in health-care and technology.
Among picks that have misfired in recent years are BlackBerry maker Research In Motion Ltd. of Waterloo, Ontario, and Redwood City, California-based video-game maker Electronics Arts Inc. In the year ended Oct. 31, the two holdings lost 61 percent and 47 percent respectively, according to a regulatory filing by the fund. The managers acknowledged “poor stock selection” in industrials, consumer stocks and technology in a May 2012 letter to shareholders.
“These managers will have stretches when they underperform,” Vanguard’s Newhall said in a telephone interview.
Even so, the fund beat 68 percent of peers in 2011 and 94 percent last year, according to data compiled by Bloomberg.
Stock picking in technology has hurt performance over the past five years, the data show. The fund’s technology stocks returned about one-third as much as that sector in the S&P 500 Index. Primecap Odyssey Aggressive Growth had 29 percent of its money in technology as of Jan. 31, almost twice the weighting in the U.S. benchmark.
The managers did better staying away from most financial and energy stocks, two sectors that lost money in the past five years. The fund had 2.4 percent of assets in financials and 3.3 percent in energy as of Jan. 31, compared with about 17 percent and 10 percent, respectively, in the index.
In a 2009 letter to shareholders, the managers said all Primecap funds had been light on financials since they were begun in 2004. In a November 2011 letter, they said energy had done well over the past decade because of rising demand from China, India and Brazil.
“Contrary to conventional wisdom, this trend is unsustainable,” they wrote. “We have frequently found the risks to be greatest in stocks and sectors that have been viewed most favorably by the consensus.”