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Equity Perspectives

Tom O'Halloran explains how Lord Abbett's Growth Leaders Fund seeks to identify "true growth" companies whose innovation has the power to transform industries and provide capital growth. 

 

Lord Abbett's Growth Leaders Fund seeks to identify "true growth" companies whose innovation has the power to transform industries and provide capital growth. Thomas O'Halloran, Lord Abbett Partner & Director, discusses the Fund's guiding philosophy and investment process.

Q. For all the worries about strong economic headwinds, growth stocks have done well in recent years. How sustainable is that trend, and why?
A. Although there is plenty to worry about, the economy has expanded over the past four years. This has provided growth stocks with a decent tailwind. More importantly, innovation continues to be alive and well, and growing companies continue to develop new products and services and to exploit new markets.

Q. How would you describe the Growth Leaders Fund's investment philosophy?
A. Our philosophy rests on three pillars. The first is that certain companies have substantial earnings growth potential that enables them to move to higher market capitalization categories. Second, it takes an experienced team using a disciplined fundamental research process to identify such companies. Third, we believe these companies can deliver attractive returns per unit of risk when that research process examines risk management at both the company and portfolio level. Technical analysis strengthens our fundamental research approach, both in the pursuit of return and the management of risk.

Q. How does that translate into practice?
A. Our primary focus is to identify companies that we believe demonstrate above-average, long-term growth potential. That means companies possessing inherently good business models, managed by competent and credible people, and that are leading or gaining market share in healthy industry environments. We consider companies that possess these four attributes to be special companies. The premise of our philosophy is that we believe these companies can enable us to achieve our performance goal, which is to outperform the Russell 1000® Growth Index1 over a full market cycle.

Q. How does the investment process work?
A. We employ a two-step process. First, we identify the market-leading growth businesses through fundamental research. Second, we select the stocks of approximately 75–100 companies from this elite subset for inclusion in the portfolio based on their growth attributes and technical profile. This second stage requires the forecasting and evaluation of the sales and earnings growth of a company, as well as an assessment of market expectations of that earnings growth. [Of course, these forecasts are based on current market conditions, which can change at any time, and, therefore, are not a guarantee, and companies are consistently evaluated for inclusion in a portfolio.]

Q. What percentage of the portfolio is devoted to large caps?
A. Under normal market conditions, the Fund will invest at least 50% of its net assets in established large cap companies; the remainder of the Fund's assets may be invested in mid and small caps.

Q. How flexible is this strategy?
A. We believe that this process is flexible enough to adapt to different market environments by moving among our preferred secular growth names and cyclical, defensive, and stable growth stocks. We take into account the economic cycle, as well as the stock market environment, in determining how the different companies in different industries and/or market capitalization segments are likely to perform. This may prompt us to over- and underweight certain stocks and/or sectors, as well as market capitalization segments.

Q. How do emerging markets factor into this strategy?
A. The superior growth rates of emerging nations relative to the developed world are creating stronger economic environments for their citizens, helping to lift them out of poverty. This is now giving rise to a growing middle class in these nations. The implications for increased spending are staggering. Ernst & Young, for example, predicts that three billion people will join the middle class by 2030, mostly in Asia. This bodes well for market-leading companies with exposure to emerging nation consumer growth.

Q. How do you navigate between GARP [growth at a reasonable price] and GARP "traps"?
A. Although valuation is an important part of our process, we consider ourselves to be growth rather than GARP investors. While a GARP investor primarily seeks to buy at a "reasonable" price, a growth investor will take valuation into account, but will not let it be a barrier to buying great companies that appear to be fully valued. As true growth investors, we would rather own what we deem to be a special company for a full price than an average one for a discount. Typically, the portfolio holdings will trade at modest premiums, rather than discounts to the market, though the growth rate will likely be higher. The key is to forecast the growth accurately. "Fully valued" companies often appreciate substantially if their growth potential is underestimated by the market. Growth stocks that appear attractively valued may be GARP "traps" if their growth disappoints. When this happens, it is often because of a change in the business that will endure. The momentum of these adverse developments is often underestimated.

Q. Who else is working on this strategy?
A. Joining me on the Growth Leaders Fund team are Arthur Weise, CFA, Partner and Portfolio Manager, and Associate Portfolio Manager Vernon Bice. We are supported by Lord Abbett's centralized pool of mid and large cap research analysts and the small cap growth team.

Q. How do you decide on the size of individual investments and sector weightings?
A. An average position is a 1.0% weight. Variances from this stock weighting in the portfolio are based on our level of conviction in each security. While industry exposure may be up to 25% of the overall portfolio, we maintain a diversified exposure to major market sectors. We use technical analysis to support our fundamental research. This involves scrutinizing changes in relative price strength and money flows as early indicators of potential stock price appreciation and depreciation.

Q. Do top-down economic views affect your investment decisions?
A. Lord Abbett's investment approach to this growth strategy is bottom-up, meaning the team identifies and selects securities based on in-depth company, industry, and market research and analysis. However, we always have a top-down economic view. This can have a significant influence on how we weight stocks, sectors, and market-cap segments within the portfolio.

Q. How do you manage risk?
A. We manage risk in three ways. First and most important, our fundamental process is designed to lead us to companies that have much lower operating company risk. Second, the portfolio is diversified by company and sector. Third, we have a rigorous sell discipline. In addition, Lord Abbett has a dedicated risk management team that focuses on identifying risks from a top-down perspective to ensure that our managers understand all the risk we are taking (stock, sector, and macroeconomic) and to mitigate those that could be unintended.

Q. In the wake of some "hot" initial public offerings [IPOs] and stretched valuations, there has been a lot of talk in the media about a brewing technology bubble. Does tech have more room to grow, in your view?
A. There are some stretched valuations within the tech sector, but they are not widespread enough to constitute a tech bubble. Technology still looks very attractive to us over the next couple of years. We believe the tech companies are very strong financially, with healthy balance sheets and leaner operating structures. In addition, tech is enjoying strong secular growth due to the Internet and the boom in mobility.

Q. Is attending a company's management meetings mandatory before investing in a company?
A. The Growth Leaders Fund team will typically not buy a security without prior direct contact with management of the company. Management contact is an integral part of the growth leaders strategy and the team’s buy/sell decisions. Our portfolio managers and research analysts are responsible for conducting in-depth interviews with senior management. The frequency of these company meetings is on an as-needed basis. We also consider developments taking place at suppliers, customers, and competitors to develop a more complete analysis of the company's fundamentals.

Q. To what extent do you rely on price targets?
A. Price targets are a guide rather than a trigger, and they need to be adjusted on a regular basis due to changes in fundamental factors and market action.

Q. Can you expand more on your sell discipline?
A. The selling discipline generally is the mirror image of the buying discipline. In other words, while positive developments surrounding a company and/or its growth attributes will prompt us to buy, when these considerations turn negative, we will be prompted to sell. We sell or trim securities if the security no longer meets the Fund's investment criteria, including: 1) a negative directional development at the company level, which could include an adverse change in the company’s business model, management, industry conditions, or competitive position; and 2) a change in the growth attributes of the company (whether this is a change in the growth rate, lofty expectations, or excessive valuation) that leads us to believe that growth will no longer drive stock outperformance.

Q. To sum up, what do you believe distinguishes the Growth Leaders Fund from other funds in the category?
A. We believe the Fund distinguishes itself through a portfolio construction methodology that reflects our strong fundamental research and adherence to a sound process. We believe the Fund has an advantage given our considerable familiarity with successful companies in the small cap universe that have grown to become mid and large cap names. We also believe that incorporating a top-down economic view and analyzing changes in relative price strength and money flows enables the Fund's strategy to be nimble and flexible. We think the combination of such attributes offers the potential to achieve attractive risk-adjusted returns over time.

—Reported by Steve Govoni

 

 

1 The Russell 1000® Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecast growth values.


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