Brandywine's Friess: 'We Felt Justified All Along'

A transcript of his email conversation with <I>TSC</I>.
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Just a year ago, Foster Friess was a pariah, heavily criticized for moving out of stocks in 1997 just as they got ready to take off. He ended 1998 with a negative 0.7% return in his

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Brandywine fund.

Now, though, with a 42.7% return so far in 1999, his critics will be having a hard time denying that Brandywine's back. Over the last two days,

conducted an email interview with Friess as he zipped about the country. Below is a slightly edited transcript of that exchange.

Back in the Black



Nearly half of the year-to-date returns in your fund have come just since the beginning of the fourth quarter. What do you attribute that recent performance to, and what's your outlook for the coming year?


: First you'll notice in the trailing 12 months Brandywine is up 57% vs. 25% for the

S&P 500

. To answer your first question, we attribute this performance to the fact that we stuck to our disciplines and continued to "block and tackle" and buy companies that meet the criteria we've used for the last 30 years.

We demand three years of earnings history before a company crosses our radar screen, and our modest approach to price-to-earnings ratios keeps us out of astronomical P/Es. Our disciplined approach is why we think we're doing well now, as well as why we did well for the past 30 years and will do so for the next 30.

We really don't have an "outlook" for the coming year with regards to the overall picture. We believe that "one should never invest in the stock market, but rather invest in individual companies." Our outlook is pinned to each individual company rather than macro perspectives.

Our P/E ratios for the year 2000 run in the mid-20s range, with an average growth rate of 41% for current holdings. Our strategy typically looks at the next six quarters, as most managements we talk to find it very difficult to predict earnings beyond six quarters out.

We believe there are three things that determine a stock's value. The first is earnings, the second is earnings and the third is earnings. Obviously, there are other factors that drive stock prices, but our strategy is very committed to the earnings power of individual companies.

The fund's recent advance comes on the heels of a momentum-driven run-up in mega-caps and Internet stocks that occurred outside our universe of potential holdings. In late April, investors broadened their focus and again recognized the merit of individual-company fundamentals. Since April 30, Brandywine gained 33.8% vs. less-inspired increases of 6.4 %, 8.5% and 5.6% for the S&P 500,

S&P MidCap


Russell 2000

indices, respectively.

We follow the same disciplines no matter what the current environment, knowing that reasonably priced, rapidly growing companies that exceed Wall Street expectations will be rewarded over the long haul. Technology-related stocks -- from electronics retailer


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, up 28% this quarter, to telecom equipment maker

Nortel Networks


, up 47% -- are the biggest contributors to recent gains.

Software companies also continue to benefit as their customers shift spending from Y2K work back to their core businesses.




Parametric Technology



Serena Software




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aided results with gains of 98%, 64%, 74% and 35% this quarter. Selected PC makers such as




Apple Computer

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are up 71% and 39%, respectively.

Robust earnings growth driven by strong industry trends has been rewarded, and positive signs continue to surface. For example, worldwide semiconductor sales, which foreshadow demand for computers, cellular phones, consumer electronics and other technology-driven products, are expected to grow 21% in 2000, according to the

Semiconductor Industry Association


Going forward, we sense smaller- and mid-cap stocks will continue to earn their way back into the spotlight.

Prudential Securities

reports that after small-cap company earnings fell 5.6% and 3% in the September and December quarters last year, respectively, small-cap companies eked out 1.3% profit growth in the March quarter of 1999, followed by a more impressive 10.4% gain in the June quarter. Our smaller picks such as


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Teletech Holdings

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are up 213% and 114% this year.

On the 1997-98 Selloff



When you and your funds built up large cash positions in late 1997 and early 1998, you received a lot of criticism for sitting on the sidelines while the market continued to climb. Do you now feel justified in those moves given your recent performance? Critics might say that even though you're doing great now, you could still be doing better had you remained fully invested.


: Addressing question about our cash build up, I want to again pass along my thanks to

Jim Cramer


understanding the very powerful positive influence of our decision, when he said, "It looks like Foster was dead right about Asia, and he deserves our praise. He would have buried his fund with the stuff that he owned at the time." I'm very grateful to have had dinner with Jim and get the chance to appreciate what a fine human being he is. Please pass my regards along to him.

People who didn't take the time to understand what it is we did and did not do usually uttered the criticisms we received. They did not have the insights that Jim was able to bring to the question for example. If you look at the shareholder letter we sent and see how well we held up in the period, when many of the stocks in our universe were in very choppy waters, you'll see why Jim came to this conclusion and why those who criticized us did not take the time to understand what it is we do.

Some of the key things they missed were that we require three years of earnings history before a company comes on our radar screen and that we have typically avoided over-researched, big-name, highly visible, high-P/E companies -- the


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Home Depots

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of the world. Instead, we prefer to find a # 7 company in an industry, figuratively speaking, headed for the # 3 spot because its recognition increases and its P/E expands.

Concerning the stocks we sold, 80% of them declined with 50% of them falling between 50% and 90%. I hope this gives you a feeling as to our take on your question on whether we feel justified in those moves. We exited specific stocks very quickly that we needed to sell.

This market was driven more by liquidity than fundamentals in the March quarter of 1998. The evidence is in companies such as


(DIS) - Get Report



(NKE) - Get Report



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, which were up 8%, 13%, 16% and 18% in the March quarter, but then faded an average of 25% through mid-October, as people became aware of the fundamentals that we were more tuned in to early on.

Most people now realize that the March quarter in 1998 (when the S&P went up 14% and we were up 3%) was driven by the $29 billion of capital that foreign investors pumped into U.S. equities -- exceeding foreign inflows in 1994, 1995 and 1996 combined.

Another unwarranted criticism was that we were "pressured back into the market just before it tanked." The reality is we were buying all during the time we were selling except for maybe eight or 10 trading days. Because we rightly saw the need to exit these companies in the semiconductor, capital goods and oil service areas, which performed very poorly for almost the next eight to 10 months, our normal rate of buying did not keep pace with those sales.

Also the rate of buying was perhaps a little slower then it would normally be because of our fundamental discipline of not buying into companies where we see unrealistic investor expectations.

We felt justified all along in sticking to our disciplines. The critics made the error of comparing our results to earnings-less Internet stocks and the mega-cap, high-multiple stocks -- both of which we typically avoid.

We knew the companies we eventually bought would perform well despite the short-term setback.





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have added over $400 million to Brandywine since their purchase in the March and June quarters last year with most recent purchases up 160% and 94%. Other March 1998 picks, such as

American Eagle


, Apple Computer and

Citrix Systems

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, gained 26%, 29% and 75% before sales.

Rational Software


, purchased in April of 1998, increased 86%.

We believe the misperception is more a reflection of our critics' lack of insight about the market's narrowness and our strict disciplines rather than knowing the reality of what we really did.

Now that some of these lowered earnings stories have come out, people should have a greater appreciation for the fundamental research our team generated. That one quarter again allowed the less careful critics to not appreciate how well we did in the 12 months ended March 1999.

They compared us to peers and indices that do not reflect what it is we do. There was a time when people invested in gold stocks and were compared to how the gold stocks did and people who invested in Japanese stocks were compared to how Japanese stocks did. In our situation our critics compared us to earning-less Internet stocks and the large, mega-cap, "brand name," high-multiple stocks, which we have consistently told people we make great efforts to avoid.

We wouldn't have done better if we held on to the companies that our disciplines dictated we sell at the time. Our team exited oil-service and semiconductor capital-goods companies just weeks before earnings completely deteriorated, oil prices dropped and excess capacity developed in the semiconductor industry, making the decision to sell specific stocks incredibly timely.

Should Investors Return?



Brandywine is still in net redemptions for 1999. What would you say to investors who are still thinking of leaving out of fear of further volatility in the fund? What would you say to those investors who have already left? And what do you think your recent turnaround says about going against a good manager who has had a bad year?


: For those investors who may still be thinking of leaving because of volatility, I believe they would be best to leave, as our fund will always be volatile just like the equity market is volatile. Keep in mind that in the

Long-Term Capital


Crimii Mae

debacles last year

Dell Computer

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Cisco Systems

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dropped 40% each in about eight days. While we did not own those stocks at that point in time, it does indicate that the market for equities can be volatile.

The amazing thing is that many of the investors who left us went into indexing. I believe the unfortunate reality of what we currently have, that we didn't have when I started in the business 30 years ago, is a lesser appreciation for the fundamentals of the companies.

I don't believe index investors have examined the fundamentals of each of the underlying securities comprising those indexes to find out what their P/E ratios are or what their fundamental outlook is in terms of future products and cost structures and earnings. They simply have looked in the rear-view mirror and seen how these index funds have outperformed active managers and are making a switch right at the wrong time, just as active managers are now going to have a field day running circles around the S&P 500 in the next two, three or four years.

The other thing that we noticed as people redeemed is hardly any of them asked about the underlying fundamentals of the companies in which we invest -- lower P/E ratios and the faster growth rates far surpassing those in the S&P 500. For instance, in the first week of October 1998 when we had our highest redemptions, the average P/E ratio for our companies based on the trailing 12-month earnings was in the mid-20s range, about the same as the S&P 500. But the growth rate for our holdings was 62% vs. 13% for the S&P 500!

Concerning your comment about "betting against a good manager who has had a bad year," if you look at the statistics, we really had poor relative performance for only the March 1998 quarter, and we believe that was driven more by the prior referenced foreigners' influence on the market's liquidity than the market's fundamentals.

While the fund will always be volatile, just like the equity markets are volatile, we believe we've reduced some of the significant risks that are in the market by avoiding super-high P/Es and by the strength of our fundamental research, where we watch our companies very carefully and spend a very significant amount of time talking to customers, suppliers and competitors.

By typically having three years of earnings history and by having more moderate P/E ratios, we believe we moderate the risk, but the volatility on a short-term basis can still be there even though the underlying fundamentals of the companies are not as volatile.

We can point to a company as high quality as Cisco Systems, where the earnings estimates fluctuated hardly at all when the stock went from 35 a share in August 1998 down to 23 on the Oct. 8 low, only to rally to nearly 46 by year's end. I believe investors should pay more attention to the predictability and the reality of future earnings and not get so preoccupied with market swings, which are often a function of what

Alan Greenspan

had for breakfast.

As for net redemption issues, we're glad to see that last week we had net inflows of $7.6 million.

These new and existing shareholders who are able to see through the superficial analysis of our critics and believe in us and believe in the extremely well experienced and in-depth research team, which now includes 35 people, and who believe in the strategy that earnings do matter, that there are P/Es beyond which a company has greater risk, and that fundamental research and being careful about knowing what companies' future fundamental progress will be are all that matter in the end.

Knowing that our efforts helped a long-time shareholder retire when he wanted to or a university client expand its library is our greatest reward, so we stay focused on creating prudent, long-term growth and don't waste energy worrying about critics.

Attracting new money is not our focus. We want long-term investors that won't be shaken by the short-term volatility that is sometimes a normal byproduct of growth investing.

We're excited that our existing shareholders and clients are comfortable with our approach, and committed to making sure we produce the kind of results they expect and deserve. We turned down a number of prospective clients representing more than $100 million in new assets so we could concentrate on restoring performance for all those who demonstrated such loyalty through the difficult period for our kind of stocks.

Keep in mind that the loyalty of many of our clients spans more than a decade, and we are grateful that their faith is in us and that our strategy is rewarding them. I think it is that message we want to send to the investors who have honored us with their trust, which is a more important message than what we might say to investors who departed.

We would welcome any former shareholder with a long-term investment horizon to come back.