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Growth With High Quality

The managers of Mar Vista Strategic Growth talk as much about capital preservation as they do about making money.

Tom Lauricella, 12/02/2016

In every issue, Undiscovered Manager profiles a manager on the Morningstar Manager Prospects list, which is compiled by Morningstar’s manager research group.

For growth-stock pickers, the managers of Mar Vista Strategic Growth MVSGX sure spend a lot of time talking about protecting shareholder capital.

The investment process behind the Mar Vista fund, which has outperformed roughly three fourths of its peers since its launch five years ago and was added to the Morningstar Prospects list of up-and-coming strategies earlier this year, revolves around high-quality stocks, wide-moat businesses, and deep dives into valuations.

But the Mar Vista team doesn’t stop there. The team calculates a margin of safety on every name in the portfolio. And there’s an assigned “devil’s advocate” to argue against any stock the team is considering buying. All this supports a sentiment investors will hear repeatedly from the Mar Vista team: Capital preservation is just as important as making money.

For Silas Myers and Brian Massey, two of the fund’s managers, this approach was in part forged by what they saw firsthand during the Internet stock bubble collapse beginning in 2000.

At the time, Massey and Myers were analysts at Roxbury Capital Management where the Mar Vista Strategic Growth strategy originated. In the 1990s, Roxbury was known as a valuation-conscious growth-stock manager. But just as technology stocks were nearing their peak and performance-chasing was rife in the fund industry, Massey and Myers watched as the Roxbury fund managers turned away from their more conservative approach. The Roxbury managers began populating the portfolios with expensive, momentum stocks only to inflict huge losses on shareholders and leave the firm with a tarnished reputation when the bubble popped.

“Capital preservation is equally as important as appreciation,” Massey says. “We had a front-row seat in 2000–2002.”

Myers and Massey began managing the Strategic Growth strategy in 2004 while still at Roxbury. Today, along with co-managers Joshua Honeycutt and Jeffrey Prestine, they are owners of Los Angeles-based Mar Vista, which carries on the revitalized Roxbury strategy.

Lessons Learned
At Mar Vista, they operate with a set of priorities aimed in the opposite direction of their dot.com-era experience. “The way we view the world is that we are partners with our investors,” Myers says. Says Honeycutt, “We’ve taken the long-term time horizon of building a franchise and thinking beyond just a good couple of years.”

Since its inception in November 2011, the Strategic Growth strategy has returned 13% annually, coming up just shy of the S&P 500, but outperforming 74% of the large-growth competition. Over the past three years, the fund is up 8.6% per year, 35 basis points a year ahead of the S&P and ranking in the top quintile of large-growth funds. And it’s a track record built on lower volatility than the broad stock market. As a separate account offering, Strategic Growth has posted gross returns of 9% per year for the last decade compared to 6.6% on the S&P 500.

The mutual fund has just $28 million in assets, but the separate account strategy has $2.4 billion under management. Overall, Mar Vista manages roughly $3.5 billion.

“They’ve been flying under the radar,” Morningstar fund analyst Greg Carlson says.

With a compact portfolio of 30 to 50 stocks and a focus on high-quality names, volatility in the strategy has been fairly muted. “It could be a significant holding in a portfolio,” Carlson says.

Carlson notes that with an expense ratio of 0.9%, Strategic Growth’s fees are above the 0.85% average for its comparison group. But Mar Vista expects the expense ratio to fall below average as the fund grows in size.

Winding Path
Mar Vista and its managers have travelled a winding path to its current state as an independent money manager. Massey joined Roxbury in 1996 as a stock analyst following healthcare and financials. Myers joined Roxbury in 2000 from value manager Hotchkis & Wiley, covering industrials and materials. Honeycutt, who follows consumer stocks, joined the firm in 2000.

Prestine, who covers technology and energy names, joined in 2006 from Seneca Capital Management. In 2007, the team was spun out of Roxbury. At the time, Roxbury was partially owned by Wilmington Investment Management, and the ownership structure made it difficult for the managers to have meaningful equity in the firm.

The spin-out enabled the managers to have a direct stake in the firm, which meshes with Mar Vista’s broader philosophy aligning its incentives with investors. Effective with the start of 2015, Mar Vista became 100% owned by the four managers. Myers sees this ownership structure as a key differentiator from many other money managers. “We are partners with our investors,” Myers says. “We are all owners of the firm, and all have input into the portfolio.”

Multistep Quantitative Process
Mar Vista hunts among stocks with a market capitalization of $2 billion and up. The managers screen their investment universe down to 150 to 170 names with a multistep qualitative process. “Quantitative screens won’t uncover the beauty of the business models we really appreciate,” Honeycutt says.

The first step is to look for wide-moat companies, those with durable competitive advantages such as high barriers to entry or switching cost advantages.

The second layer is to identify companies that not only generate substantial excess capital but also have the ability to reinvest at attractive returns to generate future growth. They also look for management teams whose incentives are aligned with smart capital allocation.

For each name, the managers estimate a company’s intrinsic value using discounted cash flow models. They then look for those with growth potential, but trading at attractive discounts. Their timeframe on investments is three to five years, leading to low turnover of well under 30% depending on market volatility.

From their intrinsic value estimates, the team then ranks stocks by a margin of safety score, and after accounting for other risk factors such as macroeconomic correlations between names, it tilts the portfolio toward those with the best risk-reward profiles.

“The best time to invest is when it’s ‘heads we win and tails we don’t lose much,’” Honeycutt says.

A Compounding Machine
This approach has led them to stocks such as American Tower AMT, a company that has been in the portfolio for more than 10 years, a time when the stock has risen twice as fast as the S&P 500. Mar Vista says American Tower’s narrow moat is based on the attractive location of its cell towers and high switching costs. Another positive, Massey says, is strong secular growth prospects in emerging markets such as Brazil and Mexico, as well as in the United States as cellphone companies switch from 4G devices to 5G.

American Tower generates return on capital north of 10% in the United States and 20% to 30% in emerging markets, Massey says. “They’ve got a standalone business generating a lot of capital and reinvesting at very attractive rates. It’s the poster-child of a compounding machine.” Yet Mar Vista thinks the stock is still cheap and thanks to its pricing power and secular growth trends, has a very high margin of safety. “On many factors, American Tower hits all the points in our checklist.” Massey says.

Mar Vista will also tread into names that might not fit the bill of some more conservative investors. For the past four years, the fund has owned shares of TransDigm Group TDG, which manufactures and distributes aerospace components.

TransDigm employs what Myers describes as a “private equity model” in the aerospace parts business, borrowing money to acquire the makers of high-margin aircraft components, which then have a virtual lock on replacement parts on specific aircraft models for years or even decades to come.

The managers say that the firm’s high degree of recurring revenue allows it to support the higher debt leverage that comes with acquisitions. Since they first added the stock to the portfolio in 2013, it’s roughly doubled in price.

Behavioral Traps
Along with their value-investing tools, Mar Vista layers in some lessons from behavioral analysis of mistakes that many investors tend to make— including themselves.

“We try to understand our own personal biases, and we’ve created methodologies to reduce their impact,” Myers says. One of which is the role of a devil’s advocate. “We don’t want to fall into a group-think situation where everybody falls in love with a stock. Somebody has to take the other side of it,” he says.

Another pitfall they try to avoid are stocks that become value traps—names that start looking cheaper as their stock price falls but in reality are suffering from businesses that are falling short. A related pitfall is that investors will often anchor themselves to their original purchase price and be unwilling to sell below that mark even if the signs are pointing to the exits.

To manage these mistakes for underperforming companies, the managers set a “line in the sand” in the form of specific performance metrics the company needs to meet or else they hit the sell button.

This approach came into play with their recent stake in Advance Auto Parts AAP, a stock they bought in the fourth quarter of 2015 on the expectations that it would be able to benefit from the competitive advantages of same-day parts delivery through its acquisition of Carquest. The deal, they believe, would boost operating margins and lead to 15% to 20% compounded intrinsic value growth.

Instead, shortly after Mar Vista took a stake, operating results began to falter, and Advance Auto’s chief executive stepped down. As the company’s results deteriorated, Mar Vista set metrics for market share and operating margins. When the company failed to meet those targets, and as the managers lowered Advance Auto’s intrinsic value estimate, they dumped the stock.

The team’s focus on mitigating downside risk has been paying off for investors without sacrificing much of the upside. Over the past five years, the strategy’s downside capture was less than 92% of the declines in the S&P 500 while the fund captured 106% of the index’s gains. For the large-growth category, the average downside capture is 98% and upside capture 111%.

The Mar Vista team is aware that’s been a tough slog for many actively managed stock funds, but the managers believe they add value through their stock selection.

“Active managers have had a tough time of it,” Massey says. “But we think we have instilled some structural advantages in our process that are durable.”

Tom Lauricella is the editor of Morningstar Direct.

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