When Lanny Thorndike researches potential investments, he burrows so deeply into the company that he could probably tell you how the Southeast sales director takes his coffee.
The co-manager of the $27 million-in-assets
Century Small-Cap Select fund hunts for companies with earnings growth above their peers but with stock prices cheaper than their peers. Sure, everybody wants those companies. But for Thorndike and his team, the difference is the process: a methodical, in-depth analysis of the company's profitability, growth and valuation prospects. The process also includes talking with second-tier managers, competitors and vendors to make sure the company passes muster.
If this all sounds time-consuming, it is. But it's hard to argue with the results: The fund, first offered to individuals in early 2000, has returned an average annualized 14.86% a year for the past three years. Century Small-Cap Select ranks No. 1 among all small-cap growth funds over one- and three-year periods.
In this week's
, Thorndike discusses his investing process and the companies it unearths. He counts several health care companies among his favorites, is lightening up on financials and is starting to find some compelling tech stocks. Which ones? Read on.
1. How have you managed to turn in the performance you have during these past few years?
Blind luck. (Laughs.)
No. I'm not sure I can attribute it to any one thing other than we spend a lot of time on balance-sheet investing -- looking at return on equity and growth in book value. Those are two metrics that we focus on more than other investors. If companies can't deliver above 15% return on equity over rolling three-year periods, those generally aren't the stories that interest us.
If we can see companies that can grow book value over five-year periods, if they are mostly growing through acquisitions it's very hard to do. We adhere to a couple of metrics that most other people don't really pay attention to. We focus on how you can return an investment on the money that shareholders give companies, which, at the end of the day, is what your shareholder equity number is.
We start with a screen of about 3,300 stocks that we examine on a monthly basis. We have about 15 variables we screen that break down into three groups: profitability metrics, growth metrics and valuation metrics. There's five or six within each group. Every week, we screen those 3,300 stocks on those criteria. Each analyst, including myself, picks three stocks that we are going to do a quick-and-dirty analysis -- about a 12-page analysis, which takes about two hours to do -- on for the following week. We hope that one or two of those names end up on our watch list and we vote to do more research on it.
So our watch list has maybe 450 names, we're hoping to add one to two a week. That's how we come up with new names. It doesn't tend to be a top-down analysis. It's more bottoms up, based on the company's fundamentals. Among other things, we examine return on equity, price-to-book and the ability to generate balance-sheet cash flow to finance its eternal growth as opposed to having to look externally to finance its growth. That's how we come up with new ideas.
Each analyst has a goal of analyzing 80 companies a year -- that's a lot, and it really sets us apart. We feel the biggest differentiator with companies is meeting with the second-tier management of a company. Not just the CEO or the CFO, but the director of claims, the head of product sales in the Southwest -- getting a sense of where the rubber hits the road.
If the Graham and Dodd folks and Buffettologists focus so much attention on return on equity, why don't more investors?
It's more complicated than you think. Sometimes, to get to long-term trends historically, everyone wants to find a quick answer. Earnings are the quickest thing to find and people just want to own fast growers. The stories that are easy to understand and growing faster are the ones that people gravitate to first.
Unfortunately, with return on equity and balance-sheet investing, you have to dig into the footnotes and do some long-term analysis. The downside is that can take three or four months to do the kind of work that you need to do on a stock. A lot of investors aren't patient enough to do that kind of analysis.
2. What do you think about the small-cap growth these days?
Over the next six months, I think we're very much back-end loaded in terms of earnings. I think we're still encouraged by the prospects for growth. But right now, earnings really have to be driven by revenue growth. And we haven't really had revenue growth -- right now, it's single-digits at best. The expense cuts have been the biggest generator of growth. I don't think we're going to see another big wave in small-cap investing until we see revenue growth turn up in the second half of the year -- probably late in the second half.
We've lightened up on financial stocks -- banks, for instance. We've spent a fair amount of time in health care. And in technology, although there are some interesting things there, we think it's still early.
3. It seems like the tech recovery is always just around the corner. What gives you the sense that this time it's really going to happen and that we're not in a longer-term correction?
We've got a lot of stocks that are trading near book value and generating free cash flow. That hasn't happened in 10 years. The question is: Is there demand for their product? That's why the jury's still out. I think we're early.
The problem with our process -- it can take a month or two for an analyst to get comfortable with a stock -- is that it's fairly cumbersome. We're not that nimble. Therefore, we try to do a fair amount of work ahead of time so that when things present themselves we're in a position to act on them.
You're still fairly light in technology.
It's about 9% of the portfolio right now.
4. What stocks do you like in the sector?
We own some technology service companies. One company we like is
( WW), it's in the benefits-management outsourcing business. We think it's a good performer.
Charles River Associates
is in the litigation and consulting business.
In the materials and processing area, we like a firm called
. In computer software, we like
( ONES) and
, which is a company we happen to like a fair amount.
In the biotech area, there's a firm that does veterinarian biotech and diagnostic services called
What is it you like about Idexx? They've been posting solid growth.
Two things we look for are high recurring revenue and high return on equity. Idexx basically is in a couple different lines of business. It has a veterinarian medicine business in Carolina. But it also has a veterinarian diagnostic and testing business where it sells not only machines, but tests for heart worm and Lyme disease tests and such. It is layering on new tests that pet owners are increasingly doing. By bundling those tests, it has just launched a new system that does it much more effectively.
Like the blades and razors business, it gets to sell both the test equipment and the test kits themselves. So there's a fair amount of recurring revenues there. Management's done a good job. A new team came in about a year ago and the new product seems to have gained some legs. From a valuation standpoint, we think that it's still attractively valued and the growth rates are going to look good for the next couple years.
5. When investing in small-caps, how do you factor in the potential destructive force of a large company entering the arena -- say a pharmaceutical giant muscling into the small company's turf?
You have to find a defendable niche. It's not easy and you screw it up every now and then. But your hope is that you can ask enough questions to determine what is the competitive matrix to signal to you that a big competitor is moving, or that the company isn't going to reach critical mass. The question you have to ask is: What can go wrong here? How can the landscape change?
6. Your fund gravitates toward service sectors -- financials, health care and the like. In your prospectus, you talk a little about how macro trends come into play in your investing in service-oriented companies. Can you elaborate?
Sure. Service-based businesses in general are harder to be replaced by cheap Asian or imported talent. They tend to be delivered on a localized basis. They tend to be less capital-intensive than producing some technology or manufacturing product. Therefore they have a higher return on equity.
Service-based industries are harder to replicate or have substitutes for, and they are easier for us to analyze. At least, we feel they require a specialized knowledge. The downside of service-based companies is that management teams have a great deal of discretion in how expenses get allocated. Because there is no inventory, management can decide how much of its research and development gets capitalized on the balance sheet and, therefore, what gets hidden from the income statement. So, you have to spend a lot more time digging through the footnotes and maybe even statutory accounting to say: What are the assumptions that management is using and if we were to normalize that to their peer group, what would that do to earnings?
You really have to do a much deeper-level analysis to get that apples-to-apples comparison in service-based businesses. We happen to think that the way we look at companies lends itself to looking at service-based companies as being more predictable deliverers of value.
7. You discuss broad trends like population demographics, technological advances and globalization as coming into play in your investing. Can you discuss how these broad changes factor into your stock-by-stock decisions?
We describe ourselves as value investors in growth industries, or vice versa. But in general, we want to buy stocks that are trading below their peer group in valuation and are growing earnings at a faster rate than their peer group and their overall market. A big part of how we find those companies is asking: What's growing faster than GDP? If GDP growth is, say, 2% to 3% on average, plus inflation, what companies are growing faster?
Well, demographics are, basically: the population's growing at 2%. So, what areas are growing faster? Well, the aging of the population is one. The fastest-growing segment of the population is the over-85 portion. So what are some of the industries that benefit from that trend? Lifestyle management, senior care, retirement planning -- and the baby boomer bubble is sort of working its way through. Those are some tail winds, and if you can find some sectors that naturally are going to grow faster than the overall economy, that makes the stock-picking a little bit easier to do within those sectors.
In general, we're not excellent at sector analysis. We're much better at fundamental, company-by-company research. That's our hallmark. We spend about 90% of our time just looking at companies bottom up. But it does help if you can find sectors that are growing faster than the market; then, you want to find the companies that are the best players in those sectors.
8. How do you modify your valuation expectations as a company grows?
We have a price target on every stock we own. And as the stock gets within 5% of the upside target, we're either trimming it or revisiting the price target based on fundamentals.
Has this led to increased turnover recently? Stocks rise and fall a lot more quickly these days.
I would say we're larger in cash than we have been in awhile. A big reason for that is because a lot of stocks are just at our entry point, and a lot of stocks are just getting near our price targets. So we're trimming some positions, and we're excited by some companies where we hope the valuation gets just a bit lower.
9. Health care makes up a sizable chunk of your portfolio. What do you like about the sector, and how do you approach investing in health care?
Health care makes up about 30% of the portfolio.
There are three things you examine: the company's product, the company on a quantitative basis and the company on a qualitative basis. First, do you understand the products and services?
Then, you break it up and ask: Do you understand management? Are they good people? Are they good managers? What's the tier-two management like? The second-tier is really where the strategy gets implemented. How good are they at bringing their vision to market? This is especially important with small-cap stocks, where the CEO is the entrepreneur or the visionary. Can they take it to the next level or the second product, based upon the team below that person? That's a big thing to deal with on a qualitative basis.
We try to talk with two competitors, two vendors and two customers before purchasing. Again, that takes a fair amount of time to track down. But we feel that taking a private-equity viewpoint with our investments helps us stay away from stocks that eventually blow up. We do a lot more front-end work, which means we don't get into a stock in the first or second inning, but hopefully it helps us avoid some of those momentum-oriented stocks that seem to have a good concept but not a very good product.
On the quantitative side, it really means digging into the numbers and focusing on footnotes 13 through 15, where we're talking about stock options dilution and software capitalization. Increasingly, disclosure is getting more and more available in the financial statements, but it's not necessarily clearer. (Laughs.) The disclosure is there, but tying it in and being able to get a sense of normalized earnings of the last two to five years is tough.
Putting those three things together takes a lot more time than just looking at a screen and saying, "It's cheap, let's buy it." I think it's the homework that is important.
The other important thing is asking: Once you own a stock, are the reasons you have it today the same reasons as the day you bought it? It's easy to get complacent. I like to think of my job as paranoid investing: making sure continually that it still lives up to the reasons we bought it. It's easy to fall in love with a stock when you've done so much research on it. My job when interacting with analysts is to make sure we're still looking at it analytically.
10. Which health care companies meet your criteria?
Pharmaceutical Product Development, Inc. is in the clinical-research testing area. They do preclinical trials.
is a health care distributor. Both of them have very competitive valuations and faster growth relative to their peer groups.
We also like
, which is in the health-benefits area.
That's a pretty impressive operation -- very decentralized, tough barriers for entry.
CorVel CEO Gordon
Clemons doesn't even need to be publicly held. He's got a good managed-benefits organization, basically a hired PPO. I think he's got a good niche.
How long have you held them?
Probably a year and a half, two years.