Wed, 15 Jan 2014
Morningstar's 2013 Domestic-Stock Fund Manager of the Year describes how he and his team size up the growth giants of today and tomorrow.
Janet Yang: Hi, I'm Janet Yang, fund analyst here at Morningstar. Today, I have with me Dennis Lynch, who is the Manager of Gold-rated Morgan Stanley Institutional Growth and Morgan Stanley Institutional Small Company Growth, among a few other funds.
Dennis and his team are also the winners of the Domestic-Stock Fund Manager of the Year Award for 2013.
Dennis, we're really glad to have you here today, and congratulations on the award.
Dennis Lynch: Thank you. We're very honored.
Yang: Your team takes a pretty interesting approach to growth investing. One of the things you do is divide your companies into categories called emerging franchises and established franchises. Can you talk about how those categories fit into your overall investing framework?
Lynch: When we talk about established franchises, we're typically referring to companies that have been around a long time or their competitive advantages have been proven for decades in many cases. Often, they're a little bit more mature in their profile. Maybe they don't have the highest growth rates, but they are still growing nicely, high-single-digit to double-digit type top-line growth. Typically, those companies also have free cash flow yields that can be compelling. But the most important thing when I think about the established franchises is: What is the competitive advantage? How can it be sustained? Because we're likely going to own the companies for long periods of time, assuming we're right.
Why we have these two frameworks is, in the cases of more mature companies, we typically look at them and analyze them a certain way, looking for higher free cash flow yields in the case of established franchises, but then, in the case of emerging franchises, maybe focusing more on what we would call endgame, or how big the company can be over a long period of time.
Typically in these cases, you're dealing with companies that are earlier in their lifecycle. They might have a first-mover advantage or a network effect, and they might not have a significantly high current free cash flow yield. But prospectively, looking out in terms of the markets that they're trying to penetrate and where they are in their lifecycle, there is still potentially a very compelling investment case, because the equity CAGRs [compound annual growth rates] as we look out in our five- to 10-year projections, imply very healthy returns.
So, it's a way for us to think about … we're looking at a company, are we dealing with something that's been around long time, where there's a lot of historical proof statement. Or are we dealing with something that's a little bit newer, but we still want to pay a close watch because we certainly see some sort of first-mover advantage and network effect or ecosystem advantage that makes us excited in addition to a very large endgame potential.
What I would say overall is, our portfolios over time have typically been about half of each, reflecting a balanced approach, because there are different market environments where the market tends to favor the established types of companies versus the higher-growth and emerging ones. Over time, that's generally worked well, though we don't always get the distribution of returns correct. So at times, as you've mentioned in your coverage of our team, there's going to be some lumpiness and volatility, but we hope to smooth that out to some degree by having this balance of different ideas.
Yang: Maybe as an example, Amazon. It's a stock that was a top contributor last year. You've had it in the portfolios for over a decade now. Where does that fit in that framework, and how has the team's view on Amazon evolved over the years?
Lynch: It started off back a decade ago as more of an emerging franchise. I think at this point, it has graduated into more of an established franchise. It's a very unique company. It's certainly one that still has a very large endgame potential relative to its business size. Not many companies its size can have the high growth rates that it's been able to achieve.
The thing we think is most unique about Amazon is that it marries the Internet or technology-type advantages that come with the Internet companies. They are able to offer long-tail inventory. They're able to aggregate customers through the Internet. They're using the Internet to build the business that way. But they also have, over the last decade or more, built a massive logistics network that is physical and has significant scale and really no one can equal it.
So there's a combination here where they have a technology advantage that comes along with their Internet presence, but also this physical sort of blocking and tackling that really would be very hard to replicate from scratch.
We think it's probably one of the best competitive advantages of any company we own. It still has a very big endgame potential when you think about the global consumer market that it's tackling. It's really sort of analogous, and no analogy is perfect, but when you think about what happened with Wal-Mart over a multi-decade period--how far that company grew and how quickly. In fact, there are some asset managers that owned Wal-Mart in the '70s, that if they hadn't sold their Wal-Mart position, it would be bigger than their assets under management.
So occasionally, it's rare, but occasionally, you find a company that has these very unique attributes: a very large endgame, really, really strong competitive advantage, as I mentioned. Then when you marry that with a very strong culture of being customer centric and customer oriented--almost to a fault, some people would say, from the standpoint of profitability--and a leader, Jeff Bezos, who is willing to be different and reinvest constantly into the growth of the business. We think it's a highly unique idea, and we've certainly been happy long-term shareholders.
I'd say that often I see Amazon in the financial press referred to as not-shareholder-friendly, and I would just say that having been fortunate to own it from $35 to more like $400 recently, I consider it really shareholder-friendly, actually. We think he's doing a great job, and it's a really great combination of people and competitive advantage and endgame.
Yang: Now in contrast to the longtime holding in Amazon, Tesla is one that just entered the growth portfolio in early 2013. After you put it in, it went up 300%. Fair to call that an emerging franchise?
Lynch: I think it's fair to call the timing of that a little bit lucky. It certainly is an emerging franchise. What wasn't lucky about it is that we had spent at least a number of years looking and researching the electric car's potential relative to the very big automobile end market, with 50 million or so sold a year. This is something we wanted to be on top of. In fact, as I think was noted also by Morningstar, we had an unsuccessful private investment in one electric car company along the way. But what we learned from that mistake, as well as the research we've been doing generally in the area, was that Tesla might have the right approach versus the company that we had not fared well with.
So it was really a combination of multiple years of research, time, and effort that led us to initiate a small position at that time. Now we didn't expect the sudden runup and the quick adoption that happened over the last 12 months. So, to some degree, that part was lucky, but we do think it's an emerging franchise.
The way we handled these--I should have mentioned this up top--but we typically with emerging franchises buy smaller-type positions initially, something like 50 to 100 basis points, because they do have the potential to have dynamic benefits, but there is risk.
In the case of Tesla, I think what's happened, and the reason why it's gone up so much is, there has been a quicker-than-expected adoption. There have been benefits on the financing side to having a higher stock price and raising capital. Overall, a lot of things have gone right. I think people's first instinct is, you should sell. It's gone up a lot, valuation.
To be fair, because of the real-world challenges that they face, we have sold some. Certainly Elon Musk and his team have done a sensational job executing so far, but there is risk in terms of, as you ramp up the number of cars sold, production, a lot of real-world blocking and tackling. Unlike an Internet company … we've had cases where we've owned Internet companies that have gone up dramatically in a short period when people have figured out that their businesses are better than expected and/or their businesses have exploded in terms of selling more advertising quicker than expected. But here there's a little more of that real-world blocking and tackling.
So we are acknowledging that the valuation is reflecting a lot of success for the Model S and the Model X. We have sold almost half the position over the course of the year. Having said that, we do think there's some interesting optionality in the form of, if they can pull off the third-generation, Generation III, car that they've been talking about, which we won't know for a few years. So again, there's risk to the time horizon as well. But there is enough potential here that we still think it could be a big idea. So, we're happy owning half of what we started with, but allowing the business to continue to compound for us, assuming the execution continues.
Yang: So, your successes in 2013 were pretty broad-based, but not everything worked.
Yang: For a stock like Intuitive Surgical--down, I think, 20% in 2013--are you still a believer?
Lynch: We're kind of almost hopeful not everything works at the same time. If everything is working at the same time, sometimes it says something about your diversification. So, we certainly had some stocks that didn't do well. Intuitive is one of them. We've owned Intuitive for about five years, and they are the dominant provider of robotic surgery. We think that ultimately that's a better way of doing surgery, and I think there are some really nice ecosystem benefits that they have in the form of doctors being taught on this platform at medical school. So, there are just legions of doctors coming into the workforce, expecting to use this platform, and there really is no other platform that compares. That's a really powerful kind of backdrop from a competitive-advantage standpoint.
They also have a really compelling type of business model; it's a razor/razor blade type of situation. They sell the box to hospitals, and then they benefit from the consumable stream that comes from that as its being used constantly. We like those kinds of businesses that have high visibility in that regard.
I think in the last year, what you've seen is uncertainty around health-care reform, Obamacare, and also probably a little bit of the old guard fighting back, debating the merits of robotic surgery. We feel confident it's a better approach. But people are championing data saying it shows that it isn't. Now, we think some of that data doesn't necessarily include all the benefits, like how long you stay in the hospital after the surgery. There are always ways to package information to make a point. In fact, it sort of reminds me a little bit of the large software companies for years saying, software-as-a-service is not really that much more profitable or much more economical to the end-user. Let me show you a bunch of statistics that sort of ignored certain big parts of the benefits.
So, we think that's been a short-term headwind for the company, [as well as] some of the things I just mentioned about the health-care reform and maybe some of the debate around the data. But ultimately they have a very strong advantage. They are way ahead and we think there is platform company potential here.
Like any company--I mentioned some risk related to Tesla earlier--there are risks. They are more of a closed system. They own the entire platform. If there was an open-source type of approach, maybe developed by some of the competitors, that could become interesting. But there are FDA processes here that take years to potentially come through. So, we think there is a very strong competitive advantage in place.
And by the way, I forgot to mention, there is a very big endgame. 200 million surgeries a year; they are involved in very small fraction of those. Now, initially, not all of them are necessarily eligible for what they provide today, but given that they are a technology company and how that's developing, and the fact doctors are getting used to using it, we think that's a really big pie to potentially penetrate over time.
It is an example of, not everything works every year, and we're not momentum. I feel like sometimes growth investing used to be analogous with price momentum investing and just sort of trying to find out what's going up in a short period of time, and really that's not how we do things. We will have companies like Intuitive this year that just don't perform well in a given year. As long as we think the thesis is intact, we are going to continue to own the position and potentially add to it.
Yang: Dennis, thanks so much for joining us and congratulations again on the award.
Lynch: Thank you so much. It's great.