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Timothy Hartch and Michael Keller, BBH Core Select

Skittish about stocks? The managers of BBH Core Select have carefully constructed a 30-name portfolio that has been more stable than the market.

Laura Lallos, 04/26/2010

A scion of the 200-year-old white-shoe private bank Brown Brothers Harriman & Co., BBH Core Select BBTEX enables the general investing public to rise above the fray.

Comanagers Timothy Hartch and Michael Keller take a sensibly conservative approach to stocks. They are very particular and very patient. First, they seek strong balance sheets, significant free cash flow, and high return on capital from companies that can sustain such performance by selling essential products to loyal customers. Only 150 or so large-cap names make the cut. Then they insist on a discount of at least 75% to intrinsic value; they might eye a prospect for several years before it is priced low enough to buy. Once a stock is in, it is held on average for at least three years.

The result is a portfolio concentrated in fewer than 30 names that has proved more stable than most broadly diversified core funds or the market. For the past five years--since current management took over and implemented its strategy in 2005--the fund has one of the highest returns in the large-blend category, an annualized 5.6% through Jan. 31, with one of the lowest risk profiles.

That makes this fund "appropriate for most of our clients, in the large-cap core space," says Walter Zagrobski, a senior vice president at Boston's Appleton Partners, the investment advisor to Cambridge Appleton Trust. Zagrobski says BBH Core Select can even stand as a sole holding for small accounts with long-term time frames. Cambridge Appleton Trust began investing in the fund about a year ago after meeting with Hartch and Keller. Zagrobski liked the fund's low-turnover, tax-efficient strategy and the fact that it invests in a limited number of names that the managers know inside and out. "What impressed us is their depth of knowledge about the management and financial metrics of all their holdings. We had to cut them off after five or 10 minutes on each stock [in order to get to everything]."

Fact-Based Stock-Picking
Indeed, as Keller describes it, stock-picking at BBH is an exhaustive collaborative process. The managers and their team of seven analysts "will spend hours sitting in the same room trying to develop a shared conviction." They check their own emotions against fact-based, written summaries developed for every investment before it is added to the portfolio. They add to positions in companies that continue to live up to their risk/reward profile when discounts to intrinsic value deepen, and they begin trimming when the price rises within 10% of that target.

That deliberative process led to a decision to sell the fund's bank stocks in 2006, one factor in the fund's subsequent category-leading returns. Keller makes it sound so simple: "It was a credit-related decision." The management team worried that credit concerns would affect even the best commercial banks-- a weakness obvious to many only in hindsight. That said, the managers were not making a sector call against banks; they never make top-down calls. Rather, because they prefer to err on the conservative side when estimating earnings growth, the credit risks made these stocks uncompelling. As the fund isn't measured against a market benchmark for sector weights, there was no need to maintain exposure.

Credit concerns are still an issue, says Keller, but the fund recently bought its first bank stock since then, U.S. Bancorp USB. "USB was consistently profitable through the credit crisis, and they passed the government's stress tests rather easily. Our capital is better protected in a bank where the credit underwriting culture is conservative and has been for many years."

Again, this is a bet on a particular bank, not banks in general. "People think that there is not much difference among commercial banks, but USB's strong underwriting discipline has differentiated it, and it is primarily a deposit-funded institution, so money is coming in the door regularly at low cost. The stock was trading well below even conservative estimates of earnings, and we were pleased to bring it into the portfolio."

Johnson & Johnson JNJ, another fourth-quarter purchase, is in many ways a similar story. Hartch acknowledges concerns for the industry as a whole, in this case pricing pressure on U.S. health care. But Johnson & Johnson sets itself apart with strong consumer brands that are essentially unaffected by health-care reform issues. What's more, its medical- devices business promises to grow steadily, and its pharmaceuticals will be relatively less vulnerable to generic competition than competitors' over the next few years.

"The company's free cash flow is greater than its net income and can be used for dividends, buybacks, and acquisitions. Yet the stock is trading at near 12 times free cash flow," Hartch says. "Wall Street expectations are quite low, but the company has very strong franchises and an effective management team. This is not a high-growth play, but given the valuation, it is quite compelling."PAGEBREAK

Sustainable Leaders
Steady, single-digit growth is a common refrain here. That's the theme that attracted David Copeland, a principal of Strategic Wealth Partners, in Deerfield, Ill. "The types of companies they select are growing faster than the economy, but not unsustainably fast. That allows them to provide more-consistent performance."

Several favorite picks dominate fragmented markets and so have room to grow simply by gaining market share. Dentsply XRAY, for example, produces light dental equipment and consumables. The dental industry promises significant long-term growth as developed-markets populations age and emerging markets evolve higher standards of care, and Dentsply is well positioned to strengthen its lead. Despite a global recession, management increased investment R&D and its sales force in 2009, and the company gained a significant share of the implant market.

Then there's Ecolab ECL, "one of the best fits for our criteria," Keller enthuses. "The growth opportunity is almost unbounded." The company leads a highly fragmented market, selling cleaning and sanitizing products to hotels, restaurants, and food-sanitation and health-care companies. These are essential services, and an innovative leader can gain and retain customer loyalty. "Ecolab has the scale to reinvest in R&D and continue to innovate. Their products cause less color loss to hotel textiles, for example, and require less water for dishwashing," and so can command a premium price.

Other holdings are already entrenched leaders. Intuit INTU dominates small-business and personal-finance software with QuickBooks, Quicken, and TurboTax. Dell DELL has a lock on a loyal corporate customer base and a direct sales business model that cuts out middlemen. The corporate market seems set to migrate to Windows 7, which will also require companies to upgrade aging hardware.

Microsoft MSFT itself will benefit from that Windows 7 upgrade, of course. Further, Keller believes it has not yet "moved its piece on the chessboard" when it comes to taking on the threat posed by the likes of Google GOOG. With thousands of developers working on its Azure platform, Microsoft is "uniquely positioned to set the agenda for the change from desktop to cloud computing." That said, Keller makes a typically measured assessment: "There are more existential threats than I can recall in the past, and that is reflected in our valuation."

The ability to spend cash wisely is one of the main attributes Hartch and Keller look for in company management. Even though Liberty Global and Liberal Media Interactive don't boast squeaky-clean balance sheets, both are controlled by John Malone, who has a proven track record for leveraged growth. "We have enormous respect for him," says Hartch. "Of course, Comcast [a cable company, as is Liberty Global] is a larger position because it has lower debt load."

As for stellar capital allocators, the fund's top holding is Berkshire Hathaway BRK.A, at 6% at the end of January. As Keller puts it, "You won't be shocked that with our way of thinking, we are well versed in the lessons and career of Warren Buffett." Keller considers Buffett's purchase of Burlington Northern BNI "a reasonable value for an asset that is a politically advantaged transportation mechanism." What's more, the railroad is a "decent hedge against inflation; it has an irreplaceable asset and can price accordingly over time."

Evergreen Approach
Hartch and Keller are hardly running for the hills to stockpile gold, but hedging against inflation is a theme that threads through the portfolio. "We are not being driven by a macro call," Hartch emphasizes, "but it is important to be cognizant of potential challenges. Businesses with pricing power are good in any environment, but particularly in this one. Otherwise, profit margins become squeezed."

Waste Management WM and Vulcan Materials VMC, for example, have innate competitive advantages built on irreplaceable hard assets--landfills and aggregates, respectively--that also stand as barriers against inflation. Natural-gas producer EOG EOG serves that purpose as well. Granted, as Hartch says, "energy doesn't meet all of our criteria; it's a commodity, so it doesn't have a loyal customer base, but it is obviously essential." That said, management isn't investing in energy as a commodity per se. "EOG has low operating risk, low development costs, and one of the best returns on capital in the industry due to its focus on technology," Hartch says.

All told, Hartch and Keller's approach may be a reassuring one for clients who are skittish about stocks and the economy. Morningstar mutual fund analyst Ryan Leggio notes that their strategy is reminiscent of that of Bruce Berkowitz of Fairholme FAIRX, Morningstar's domestic-equity Manager of the Decade--but less daring. Berkowitz's current position in Berkshire Hathway, for example, is about twice this fund's stake. Hartch and Keller's insistence on a significant discount to intrinsic value also brings Longleaf Partners LLPFX to mind--but this fund will never delve into the deep turnaround plays that led Longleaf to a 50.6% loss in 2008. That does mean that the fund may not shine in rallies. Although its 21.7% loss in 2008 was far less drastic than the S&P 500's, its 2009 gain of 21.6% was five points behind the market's (and far less than Longleaf Partner's 53.6%).

Hartch emphasizes that the fund aims for absolute returns, not a benchmark in any one year. "It is important that new investors have a good understanding of our approach," he says, "and my sense is that they do." Indeed, the fund saw regular net inflows throughout 2009. "Investors are worried after this significant increase in equity prices. Whether they missed out on it, or fear giving some back, they want a strategy with an evergreen approach."

With the overall portfolio recently trading at a 73% discount to intrinsic value, now seems an eminently sensible time to buy.

Laura Lallos, a former Morningstar analyst and editor, is a frequent contributor to the magazine. 

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Laura Lallos is a former Morningstar analyst and editor, and a frequent contributor to Morningstar Advisor magazine.
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