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By Janet Yang, CFA | 01-15-2014 11:00 AM

Lynch: Growth Picks in Emerging and Established Franchises

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.

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