Fri, 11 Oct 2013
The broad stock runup in the first half of 2013 was a boon to ClearBridge Aggressive Growth, and comanager Evan Bauman says that the fund is well-positioned for the market going forward.
Shannon Zimmerman: For Morningstar, I'm Shannon Zimmerman here today with Evan Bauman, who, along with Richie Freeman, manages ClearBridge Aggressive Growth, a fund with about $8 billion in assets in Morningstar's large-cap growth category.
Evan, thank you very much for being with us today.
Evan Bauman: My pleasure, Shannon. Good to be here.
Zimmerman: Let's get started and talk a little bit about the fund. This is the fourth consecutive year that the fund has delivered really strong performance in both relative and absolute terms. Congratulations on your year. What's behind it so far in 2013?
Bauman: So I'll knock on Formica, first off, but it's been a very broad-based year, which is rewarding. It hasn't been one stock or one sector that's helped us. It's been a number of companies really executing, a lot of companies which have been able to show growth this year. When the economy is still growing slowly, a lot of our names have been able to outpace that growth. Number of the health-care and the biotech companies that we own have done very well.
A company like Biogen Idec, which has actually been in the fund since the early 1990s, has been a very strong performer due to a very exciting launch of a new oral multiple sclerosis compound. Amgen as well, which recently announced an acquisition of Onyx Pharmaceuticals, has been strong from an earnings perspective and a stock perspective. And a name like Vertex, which has been a company that also had very positive data on its cystic fibrosis franchise, continues to do very well. A number of the tech names, as well, SanDisk and Seagate to name a couple, have been strong performers. But, like I said, the nice part about this year is it hasn't been one or two things; it's been pretty broad-based.
Zimmerman: I have a couple of follow-up questions that come out of that. Take Amgen and the acquisition. So as news broke that that was something that was being considered by Amgen's management--because I know that for you and Richie both assessing a management team and their ability to allocate capital well is an important part of the consideration.
Bauman: Extremely important.
Zimmerman: Yes, as you add a new name or increase an existing one. So, in general, if you look at the academic literature, acquisitions tend not to work out certainly relative to share repurchases, and certainly even share repurchases don't do as well as dividends. How do you judge a management team's ability to allocate capital when they are more on the acquisitive side?
Bauman: We've historically been on the right side of the acquisitions: the companies getting acquired. We've had over 50 takeovers since the fund was launched almost 30 years ago. I think when you are on the buy-side and we've had a couple of companies, Valeant Pharmaceuticals and Amgen, which have been the actual acquirers, I think you want to look at what is the cost of capital, what are the other opportunities for that cash. If you look at Amgen, they've actually been great stewards of capital. They bought back a lot of stock in a very quick tender formation at much reduced prices relative to where the share price is today. They have been paying out a dividend. They continue to buy back shares, and then with excess cash they have been able to make, what it will be in a couple of years, a very accretive acquisition to their earnings.
If you can buy a company growing faster than yourself, as well as do other accretive activities with your cash, I think it has worked out really well. I think health care has been an area of increased consolidation. I mentioned Valeant, which acquired Bausch & Lomb earlier this year. That is a theme which we think continues. I think there is going to be a theme, which we've seen in our portfolio, where historically names like Genzyme, Chiron, Millennium, and ImClone have all been acquired, and what we're seeing today is Big Pharma continue to chase growth and do so through acquisition. Good acquisitions, we're big fans of, and I think, again, these are more than one-off deals. I think this is a theme that's here to stay for a while right now.
Zimmerman: Historically the fund has been one that has gravitated toward health-care names and biotech in particular. So you can do all of the sort of plain-vanilla hard-homework evaluation, understanding the companies, the quality of the management team, how its business operates, and where it derives revenue. But with health care, and particularly the smaller biotech names that sometimes are the ones that are acquired, there's a risk that is hard to account for in that same way as regulatory risk. How much of your time does that get when you guys are considering adding a new name or increasing your position in a company that might be subject to regulatory risk relative to its pipeline?
Bauman: That's a great question. I think it's very, very important, and I think it's a good part of the reason why we tend to own diverse companies.
Biogen has four drugs on the market--three of them are $1 billion sellers and one is an oral multiple sclerosis drug on its way to $1 billion in sales. And the firm has a deep pipeline of drugs, which obviously have some binary or regulatory risks, but that's at least muted by the fact that they're not the entire part of the story.
Zimmerman: So it's diversified pipeline?
Bauman: Diversified pipeline, diversified product portfolio and then, again, management that rationalizes research and development to focus on areas as Biogen has, which is neurology, where they have true expertise. There are always going to be failures in the pipeline. But I think that the way what we've tried to do is you limit that by buying profitable companies and then have some early-stage drugs which can be successful. The earlier-stage companies that we own tend to be smaller positions because they obviously carry a higher reward but also carry a higher risk, particularly from a regulatory risk perspective. That is how the portfolio is structured. The bigger companies are profitable. They have multiple drugs on the market, multiple drugs in the pipeline, and even our earlier-stage companies like ISIS Pharmaceuticals or Immunogen have multiple drugs in the pipeline. And they have partnerships with big pharmaceuticals firms that helps them to fund R&D, which can obviously be very expensive over time. So, that to us is the strategy that's worked, again, for almost 30 years in the fund.
Zimmerman: The fund has about 60 names, but about half of assets are just in 10 of them. And then Biogen, which you mentioned earlier, is about 11% position or close to?
Bauman: It's about 10%.
Zimmerman: Morningstar data show that you recently trimmed, but only at the margins of that position. I assume that's on valuation grounds?
Bauman: Less valuation, more size of the position. So we tend to manage size of the position, where over 10% will automatically trigger a trim back, just for diversification purposes.
Zimmerman: [You trim] for that reason, for risk mitigation really, I guess. Then setting that aside and setting aside valuation as a company approaches what you think it's worth, I assume that there is some selling that could go on there. For what other reasons do you and Richie sell, and walk us through a recent example of when you decided that a name is not for you?
Bauman: I'll make one comment on Biogen, which even though the stock is up, I guess, 53% year to date and was up the last two years significantly, the stock trades at about 20 times earnings, which is right around its growth rate of 20%. Actually its revenue growth rate this year will be over 20%. So, even though the stock has done very well, the valuation is still, I believe, relatively compelling compared with a lot of other companies in the market which don't have nearly that growth profile.
When I look at selling, it's really threefold; it's valuation risk, it's balance sheet risk, and then business risk. So, again, we talked about valuation, but you don't want to overpay regardless of how good the growth profile of the company is. It's what's kept us out of some great stocks, which for short periods of time do well and ultimately don't succeed forever.
On a balance sheet basis, we tend not to own a lot of highly leveraged companies. If the companies do have debt, they better have a lot of free cash flow to service the debt.
Then finally business risk. If we think there is earnings risk to the long-term picture of the company, we'll get out of something. But very often short-term volatility in earnings can give you an opportunity to buy more of something. An example is Cree, which is an LED company that we've owned for 11 years. Cree is a stock that's been very volatile from the time that we bought it, but it was in the low $20s last year after missing a few straight quarters of earnings, and today it trades around $60 a share and has a big addressable market of energy-efficient light bulbs. That's an example of volatility being an opportunity.
In terms of names that we've sold, we have sold names like Micron Technology, Motorola, Cabot Microelectronics, those are three names that over the last few years we have exited because of some of the reasons that I cited earlier in terms of earnings risk or balance sheet risk, or simply the market opportunity or addressable market just not being big enough.
Zimmerman: I know that you and Richie aren't just the fund managers, you're also substantially invested in Aggressive Growth. Thinking about prospective investors who might be thinking of dedicating a portion of their portfolio to your fund, what should they know beyond the things that we've already discussed as they begin to make that decision?
Bauman: Yes, I think the biggest word that I would use is consistency. This is a fund that will celebrate its 30th anniversary with my partner having incepted the fund Oct. 24, 1983. So, combined, we have 47 years at ClearBridge between the two of us, and the approach really hasn't changed throughout that entire time. It's very consistent, very much looking for sustainable growers, and making sure we don't overpay for our investments. I think when you look at the interesting part of the markets this year is, while we've done well, growth money really has been out-of-favor. It's really been income and a chase for yield, where growth funds as an asset class have been tough to attract assets, which has made valuations in the portfolio still really, really attractive. I'm a big shareholder. We manage it that way; we manage it by trying to buy the best companies without taking on new risk in the investments. And I think that despite the good start to the year, I think we're still really well-positioned for the market going forward.
Zimmerman: Evan Bauman, thank you very much for joining us today.
Bauman: My pleasure, Shannon. Thank you for having me.
Zimmerman: For Morningstar, I'm Shannon Zimmerman.