Transcript

Erin Kerr: Hello this is Erin Kerr, portfolio manager at Choate Investment Advisors. Joining me today is Kevin Seth, a partner and portfolio manager at Edgewood Management. Thanks so much for joining us, Kevin.

Kevin Seth: Thanks for having me.

EK: Perhaps we can start by learning more about what types of companies you at Edgewood look for in a typical investment.

KS: It has to be growth, so what has to be a growth company, defined generally by us, but certainly in a growth industry. So once we kind of find something that we think is something that we can model out for five years, it’s a growth business, then we’re going to do a screen through market cap where we start kind of fishing around 20 billion dollars and then it’s financial strength. Most of the companies that we invest in have debt levels that are less than the average S&P 500 companies, in many instances, our companies have no debt at all. So, it’s really financial strength, cash flow, margins, and how sustainable is their business model and what is the competitive advantage that they’ve got that we think we can bank on over the long term. And a lot of that success will boil down to our analysis of management. Can they execute on a plan that they kind of highlighted to us.

EK: So it seems like it’s more than owning a technology sector fund or simply buying a growth index. Why do you think now is a good time for active management?

KS: We are definitely growth investors and not tech investors but every company that we only invest in technology to get to where they are. In this particular environment, growth is an asset-light, generally asset-light businesses. And in a slow-growth environment, growth stocks can do very, very well because they are asset-light. They are not landed with debt and with bank borrowings like you will find in many industrial names. So as the world is awash now in liquidity, and interest rates are very low, it’s all trying to find a return in zero percent interest rate bonds are not great return. So that money is seeking returns in equities and growth equities kind of fit the bill right now because they can grow in a low growth GDP environment, which is what we’ve been experiencing right now for a couple of years and which we’re experiencing coming out of COVID as things will be picking up. These growth stocks in many instances have weathered very, very well.

EK: So selection and agility seem important right now. How have you adapted your investment approach to navigate through this period and where are you seeing opportunities?

KS: So we haven’t changed our approach at all. We still call management, we zoom executives and have teleconference calls with everybody. So that has not changed. We are looking in a different direction towards healthcare. Our assumption is that going down, coming out of COVID and in the future, there will be other pandemic outbreaks. There’s just going to be a lot more testing. A lot more testing of employees, a lot more testing for families, a lot more testing, and all of that is going to be with demand to have quicker results. So there is a number of interesting companies that now, we’ve kind of dusted off, that was interesting prior to COVID that are more interesting now and it gets to evaluation. So we haven’t changed what we’re doing, we haven’t changed our methodology. We are now looking at a couple of different companies that look a little more interesting to us today given what is going on than in November, December when we first dug into them.

EK: So the market has come back substantially from lows earlier this year and many are saying that this recovery is ahead of fundamentals. How do you feel about company valuations or how should investors be thinking about valuations right now?

KS: So we look at how the stock market discounts, future cash flows and earnings and the market and certainly our portfolio, the present value has gone up a little bit, but I think if you look out 3 to 5 years, certainly by 2022, when things kind of get back on track, our companies are going to be earning a lot more money than they are today. So, 2020 is a little bit of a black hole, things get better in 2021. So we don’t think valuations are necessarily stretched and I think with the world awash in the liquidity that we have seen from every central bank, whether it be Australia, Europe, Scandinavia, Japan, China, the amount of liquidity that is now in the systems, so the money supply around, probably means with interest rates as low as they are as well, that you’ve got a different long-term PE market, PE value for the market. You know it was 15-16 times when interest rates were a lot higher. Interest rates now are going to be at zero to 1% for a very long time. And the Fed Chairman just said that they are not thinking of raising rates and they are not thinking about raising rates at least until 2023 or 2024. That puts a different multiple on risk assets like equities. So, we’re impressed with the move up not completely surprised given the type of companies that we own and the earnings prospects that we have for the next year and the year after.

EK: So if it’s not valuations, what keeps you up at night?

KS: I guess it would be geopolitical disturbances, whether it’s North Korea or Iraq. It’s what you don’t know that you don’t know. Nobody saw COVID coming and that certainly was a real kick. I think a strong second wave of COVID would take the wind out everybody’s collective sails and I certainly worry about that. But, it’s the kind of Black Swan events more than anything. We’re in a position now versus the great financial crisis where banks are in a very good position, this isn’t a financial crisis. So the banks are in a very good position, you’re obviously going to have had some small businesses go out of business because of this which is a shame, but this is something I think something that we can analyze as a recovery. So, what does keep me up is a big second wave of Corona and the unknown geopolitical unknowns that tend to have very big that cause very big market swings.

EK: So how have growth companies evolved over time? Would you tell us something about a profile of a growth company fifteen years ago compared to today?

KS: That’s a good question. I think 15 years ago when I was at Edgewood, growth was considered large cap pharma, which we owned a lot of. Growth was considered large international banks that were expanding their footprint around the world and we owned a number of banks back then. Large cap growth was certainly consumer products companies and you can think of all the big consumer products companies that were finding new markets by going abroad, they were also doubling their margins over time with the implementation of SAP software for inventory management and for sourcing. Big box retailers became the fad as consumer spending was surging back then to the point where the consumer was certainly over-leveraged and wasn’t saving nearly as much as they are today. That benefited a lot of retail. And those are very difficult areas today to make money in. They are certainly not the growth stocks that they were. Top line growth on a lot of those businesses, particularly the consumer package companies are very, very low. So what you are getting is some earnings per share through share repurchase and some leverage, but you’re not getting spectacular top line growth. Top line growth at Edgewood is very, very key. That directs everything. Because with good top line growth you can get really good leverage and eventually even earnings per share. So it’s one of the first screens we look at is revenue. And today, you know growth companies and the ones that have been most successful, tend to be technology-oriented asset-light businesses that don’t need a lot of bank borrowing or capital. That’s a lot of intellectual property and very smart management. It’s a very different set of companies today for the most part than what everyone owned fifteen years ago.

EK: Edgewood has a very unique portfolio construction with only 22 companies. Could you talk more about why only 22 companies and your process for determining those 22 companies?

KS: Sure, the 22 could have been 25 it could have been 20. Twenty-two certainly makes it diversified enough for a mutual fund, but we’d always been concentrated. The firm was founded on behalf of as you mentioned a couple of different families and over the years we diversified those stocks into a portfolio and Mr. Breen the founder didn’t want to diversify. So he would always, always concentrate it. And we’d range between 22 to 27 stocks back then. We are really kind of solidified the number at 22 about 16 years ago when we had two partners join from WP Stewart. And we already got a sense that owning a fixed number of companies and having a concentrated portfolio was going to produce better results because we had managed money for another large client that only wanted fifteen stocks. And that 15 stock portfolio tended to do somewhat better because it was one in one out and it was our top conviction list of names. And so the important thing about 22 stocks is we have to sell as stock to buy a stock. So you’re not getting this portfolio to creep of adding you know small positions in the portfolio just to make somebody happy. We also think it’s a way and we’ve proven out over kind of fifteen years now that we can beat the index and generally many of our peers by being concentrated because a lot of mutual funds companies and portfolio managers own between 75 and 100 stocks. And to own that many stocks and beat an index by design you have to be over weighted industry and you have to own the worst companies in that industry because they do the best when that industry recovers and you also have to own the best companies. So owning, overweighting a sector or an industry is one way of beating the S&P if you’re correct. But it also means you’re not going to hold on to that for a long period of time. We own these 22 companies, our portfolio turnover is very low. We know them very, very well. When there is a problem, it tends to give us an opportunity to buy more of it. Whereas when you’re making up kind of a sector bet, you’ve got to own everything in that sector and hope that that is what’s going to give you the outperformance.

EK: Besides your unique portfolio construction, how else is Edgewood different:

KS: I think the one thing that separates us apart from many money management firms is our culture and Alan Braid who is my partner and President of the firm has been very focused on building a firm where everybody’s intellectual capital is used. So, we don’t run with the CIO. At Edgewood, we have the six partners who are the investment committee. We have to agree 6 to zero to put a name in the portfolio. So the whole idea is to get performance, not to get a name in the portfolio and so we all have to agree why we’re buying this stock because it’s going to be in everybody’s portfolio and we can sometimes have one or two people hold out on a name for quite a while until they get comfortable with whatever the issue is before we can get a consensus. And sometimes we don’t get a 6-0 consensus and that stock will not get into the portfolio. It’s very different than running a money management firm where one person has most of the say.

EK: Well thank you very much, Kevin. Thank you so much for joining us today.

KS: Thanks for having me.

The information provided in this recording is for informational purposes only. While Choate Investment Advisors makes every attempt to present accurate information, the information on this recording may not be appropriate for your specific circumstances and it may become outdated over time. The views expressed on this podcast are personal opinions only and should not be construed as financial advice for your given situation. Moreover, the views expressed by Edgewood Management are not necessarily endorsed by Choate Investment Advisors and Choate Investment Advisors may decide to select investments on a different basis at any time and without prior notice. Finally, as everyone should know past performance is not a guarantee of future performance.

Edgewood Management LLC is not affiliated with Choate Investment Advisors.