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Making the Call on Smartphone Winners and Losers

Waddell & Reed's Erik Becker and Gus Zinn are avoiding potential losers in the mobile space while stacking their core portfolios with firms likely to benefit from global smartphone adoption.

Esther Pak, Morningstar Assistant Site Editor, 04/04/2011

Erik Becker and Gus Zinn are comanagers of Waddell & Reed Core Investment UNCMX and Ivy Core Equity Fund WTRCX. They recently answered our questions on the thematic component to their investment strategy and also discussed how they've positioned their portfolio in response to their convictions of a global economic rebound. Finally, they elaborated on how they evaluate firms for long-term earnings potential and discussed some red flags that could trigger the sale of a holding.

1. Your approach combines top-down themes with bottom-up stock-picking. What are the advantages of this approach versus a strictly bottom-up strategy?
Our primary driver in stock selection is exploiting multiyear earnings catalysts that are underappreciated by the market in companies that have strong or strengthening competitive advantages. Within that, earnings catalysts are diversified across company-specific and thematic projections.

One advantage of this approach is the full utilization of the research capabilities at our disposal. The central aspect of the firmwide research process is a daily roundtable discussion with the majority of our research staff, including equity analysts and fund managers, fixed-income professionals, international analysts and managers, and members of our senior management team.

All information relevant to investment decision-making is discussed. This challenging and collaborative environment leads to superior theme selection and development because ideas are explored from a variety of angles. Linkages are explored, and everyone benefits from and hears the same information. Similarly, company-specific ideas are consistently challenged, which we believe leads to a heightened standard of thinking across the organization.

2. In his recent report on your fund, Morningstar analyst Josh Koeck wrote, "[The fund's] themes are developed in collaboration with other Waddell & Reed managers and analysts." Are you pursuing any themes that are exclusive to this portfolio and not necessarily the result of any collaborative work? If so, what's an example?
Our centralized research process that spans the entire investment organization ensures that each analyst and fund manager has input to and benefits from the overall process. The collaborative approach ensures that individual management teams are aware of dominant themes and growth drivers in the marketplace. At the same time, the process serves to highlight important areas of risk.

For example, our research process was helpful in 2007 and 2008 in ensuring that all the investment professionals here were aware of risks associated with the financial crisis and the knock-on effects across a broad swath of the economy. Each fund management team incorporates aspects of the firmwide process in ways that are consistent with each fund's style and objective. Therefore overlap of dominant themes is relatively common.

Capitalizing on an emerging heavy truck cycle is a theme that has been somewhat unique to the large-cap core product. Beginning in 2009, we began positioning for a rebound in developed-market truck sales by purchasing companies such as Cummins CMI, Paccar PCAR, and Eaton ETN. We were enticed by evidence of an improving economy, knowledge that the existing truck fleet had a finite useful life (due to wear and tear), valuations that did not embed a recovery, and a host of ideas that fit well within our objectives.

3. In late 2010, the fund was homing in on a theme of mobile broadband technology. Is that still an emphasis for the portfolio, and if so, how is it reflected in your holdings? Do you believe other market participants are underestimating the growth potential of this area?
Mobile broadband continues to be a prominent theme within the portfolio. In fact, we believe that we are still relatively early on in the development of the theme. Latest numbers suggest that the global adoption of smartphones is somewhere around the 20% range. Over time, we expect that number to move closer to 80% as technology evolves and becomes more affordable in areas outside of the United States. This shift has massive implications for the food chain, be it service providers, handset manufacturers, chip companies, networking vendors, or companies that supply capital equipment into the chain.

We have no doubt others have recognized this theme as perhaps the most important global technology trend during the next three or five years. Importantly, where we differ is in our analysis of the winners versus the losers should the theme play out as we expect. We have made a very conscious decision to not own companies where the business models are being disrupted by the massive shift. Those are companies such as Nokia NOK, Research in Motion RIMM, Microsoft MSFT, Cisco Systems CSCO, Intel INTC, and a host of large PC original-equipment manufacturers that effectively lose as tablets gain acceptance in the marketplace.

On the other hand, we have built large positions in a small number of companies that we perceive to be the winners, such as Apple AAPL in hardware, Juniper JNPR in networking, Broadcom BRCM in chips, and Lam Research LRCX as the provider of capital equipment to the chip industry. The commonalities of the winners include a unique technology or the creation of an ecosystem that is extraordinarily difficult to replicate (as in the case of Apple). In the end we believe there will be far more losers than winners, and the name of the game is as much not owing the losers as it is holding the winners.

4. In general, it appears that the most recently available portfolio was positioned to capitalize on an economic rebound, with plenty of exposure to media, retail, consumer-hardware, energy, and manufacturing stocks. Would you say that's the case? If so, what has driven your conviction?
Our portfolio has been positioned since the middle of 2009 to capitalize on a global economic recovery. Our largest overweights in the portfolio are in the consumer discretionary and industrial sectors. One area of high conviction within the firm has been a confidence in high-growth economies as well as a belief that many high-quality domestic firms were uniquely positioned to capitalize on global growth trends. Particularly appealing to us was the idea that many industrial firms in the U.S. engaged in unprecedented reductions in their labor force, administrative expenses, and capital spending as a result of the financial crisis. The result has been a very powerful profit recovery that has confounded skeptics overly focused on the sluggish nature of the U.S. recovery.

Turning to consumers, we both are consistently on the lookout for pockets of the market where businesses are undergoing secular change. Media is a great example where the proliferation of distribution models for media content is serving to drive up the price of high-quality content during a long period of time. This is leading to a secular change in the earnings prospects and returns for big media firms, such as CBS CBS.

Additionally, we have not bought into the idea of long-term consumer deleveraging as we believe much of the balance sheet repair for the consumer has already taken place through an increase in the savings rate to 6% (from a negative number a few years ago) and a record level of bad-debt charge-offs throughout the banking system.

5. How do you determine a firm's long-term earnings potential? Could you also provide some examples of key red flags that help inform the fund's sell discipline?
Determination of a firm's long-term earnings potential involves a number of things. We start with a basic understanding of what a company does, what the historical levels of profitability are, and exactly what makes it unique in the market place. Second, we try to understand the secular and cyclical dynamics associated with the market place. We ask exactly how fast is a given market growing, and is it growing thanks to unique characteristics of the market or simply economic forces at work.

Third, what are the competitive dynamics of the market place? Are there companies that have created unique competitive advantages be it scale, technology, brand, and so on that will allow that company to grow at a faster rate than the overall industry? Finally, we determine how strong the management team is at a given company and whether the decisions of that team give us more or less confidence in the future earnings capabilities of the business.

We are always on the lookout for information that can lead us to change our views on future earnings prospects. Clearly, macroeconomic variables are very important for a number of companies. Beyond that, we pay very close attention to the key sources of competitive advantage and any diminution in them. Is a company's technology lead for, for example, shortening? Are new business models destroying or lessening the value of old business practices (think Amazon AMZN versus Best Buy BBY)? Have key visionaries responsible for the development of a company retired or moved on? Bottom line, we focus intently on monitoring the sources of upside earnings potential that led us to buy a stock in the first place. Any change in those characteristics leads us to re-evaluate the investment thesis or sell the stock entirely.

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