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Equity Perspectives

Lord Abbett’s Growth Leaders Fund seeks to identify true growth companies whose innovation has the power to transform industries and provide high returns over time. Thomas O’Halloran, Lord Abbett Partner & Portfolio Manager, discusses the Fund’s guiding philosophy and investment process.

Q. Is the current slow-growth environment a good one for growth stocks?
A.
We believe it is. Innovation is remarkably vibrant, and growing companies continue to develop exciting new markets and products. This stands out more in a slow growth economy. In addition, growth companies are more valuable in a low-interest rate environment because this provides them with abundant financing, and their long-term potential value is higher in current terms.

Q. How would you describe the Fund’s investment philosophy?
A.
Our philosophy rests on three pillars. The first is that special companies have substantial earnings growth potential, which 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 special companies can deliver attractive returns per unit of risk when that research process is fortified by macroeconomic and technical analysis at the company and portfolio level.

Q. How does that translate into practice?
A.
Our primary focus is to identify U.S. and international companies demonstrating above-average, long-term growth potential. That means we look for 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 these companies help enable us to achieve our performance goal, which is to outperform the Russell 1000® Growth Index1 over a full market cycle. But we can never forget that we own stocks, not companies. That is why technical analysis is critical for both the pursuit of return and the management of risk.

Q. How does the investment process work?
A.
We employ a two-step process. First, we identify the high-quality 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 of the sales and earnings growth of a company, as well as what we believe the market reaction to that growth will be.

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. Will you look to invest in smaller capitalization stocks?
A.
While the Fund invests at least 50% of its net assets in established large-cap companies, the team has a deep knowledge of managing small cap portfolios and therefore seeks to invest in rising stars well before they become much larger.

 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. The market is a discounting mechanism that looks forward, so we always have to attempt to divine which way it is going next.

Q. How do emerging markets factor in 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 leading companies with exposure to emerging nations’ consumer growth. We recently increased our exposure to Chinese stocks, owing to this strong consumer growth as well as the liberalization of financial markets taking place in China.

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 high growth rather than GARP investors. While a GARP investor 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 are fully valued. As growth investors, we would rather own what we deem to be a special company at a high valuation than an average one for a discount. Typically, the portfolio holdings will trade at reasonable premiums, rather than discounts to the market, though the growth rate is higher. The key is to forecast the growth accurately. Richly valued companies often appreciate substantially if their growth potential is underestimated, because the compounding effect of their growth becomes much larger over time. 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 & 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 our 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% active weight (versus the benchmark weight of that particular stock). Variances from this stock weighting in the portfolio are based on our level of conviction in each security and our view of whether secular growth stocks are in vogue or out of favor. 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 large-cap 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. Generally speaking, the direction of the stock market is the most important determinant of a given stock’s return.

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 company risk. Second, the portfolio is diversified by company and sector. Third, we have a rigorous sell discipline. One of the most important things we do is take a loss as quickly as possibly when we are wrong. In addition, Lord Abbett has a dedicated risk management team that focuses on identifying risks from a top-down perspective, in order to ensure that our managers understand all the risks they are taking (such as stock, sector and macroeconomic risks) and to mitigate those that could be unintended.

Q. Touching upon risk, are we in a technology bubble?
A.
There certainly are some stretched valuations within the biotech and tech sectors, but for the most part, we believe that these reflect the extraordinary innovation taking place in both areas. Technology looks very attractive to us over the next 12–18 months. We believe the tech companies are very strong financially, with healthy balance sheets and leaner operating structures. More important, tech is enjoying strong secular growth, as cloud computing and mobility enable the Internet to become ever more pervasive.

Q. Is attending a company’s management meetings mandatory prior to investing in a company?
A.
The Growth Leaders Fund team typically will 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 seek to meet with and interview the managements of each company identified by our process. The frequency of these company visits 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.
We do set price targets for stocks in the Fund, although there is not a rule that the security must be sold when it reaches the initial target price. We establish upside and downside targets for those stocks, and review them on a continual basis. 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. When the positive fundamental or technical considerations that prompt us to buy turn negative, we sell. The earlier we can decipher these changes at the margin the better. The fundamental considerations relate to the company’s business model, management, industry conditions, or competitive position. These factors will drive changes in the growth attributes of companies. The technical considerations relate to the trends of the stocks, which usually go up before good fundamental developments occur and down before fundamental deterioration sets in.

The Fund also may sell securities to make adjustments to stock, factor and/or industry exposures by trimming and/or adding to individual positions, among other reasons. Selling is arguably harder than buying because it is often an acknowledgement that we were wrong. That’s why humility is so important.

Q. To sum up, what do you believe distinguishes the Growth Leaders’ strategy from other strategies in the category?
A.
We believe the strategy distinguishes itself through a portfolio construction methodology that reflects our strong fundamental research and adherence to a sound process. We believe the strategy 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 will enable the strategy to be nimble and flexible. One must be comfortable taking risk to pursue the high return potential of growth companies, as well as humble enough to quickly reverse course when things go in the wrong direction. We think the combination of such attributes offers the potential to achieve attractive risk-adjusted returns over time.

 

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

 

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