Primecap Handles Change with Aplomb

A few weeks ago, several Morningstar analysts paid a visit to the folks at Primecap Management.

For a fund analyst, having access to a shop like Primecap--which has amassed a tremendous record as subadvisor of  Vanguard Primecap (VPMCX) and  Vanguard Capital Opportunity (VHCOX)--is a fun part of the job. The firm's managers are consummate investors. They know their stocks like the back of their hands and are unswervingly focused on the long term. But they're also very publicity-shy; the firm has long avoided the media glare, eschewing press requests and generally keeping a low profile at itsPasadena,Calif.,office. So it's always a treat to have a chance to converse with them.

The topic of this latest discussion departed a bit from the norm, however. Primecap has been broadening its horizons in recent years. In July 2004, the firm filed a registration statement with the SEC to launch three funds of its own under the Primecap Odyssey banner. Moreover, after functioning as a tightly knit unit for years, Primecap has been padding its ranks lately, bringing aboard seven analysts and a trader in the last five years, roughly doubling the firm’s head count. As such, the discussion turned to where Primecap saw itself heading, how it was managing that transition, and what implications that evolution could have on investors in funds that the firm manages.

By way of background, Primecap remains a highly specialized shop by today's standards. Rather than service hundreds of clients across a variety of business lines as many asset managers do, Primecap has kept to a very thin book of business and only manages money. In fact, until recently, they limited themselves to a mere 20 client relationships, including Vanguard. (They added five new clients to their rolls this month, bringing the total to 25, which is the new ceiling they've set.) That has meant Primecap hasn't had to marshal a large client-service or marketing force, contributing to the deeply engrained research culture that the firm has cultivated over time.

Where Primecap Is Heading
What's clear is that Primecap is aiming to better diversify its business. Currently, the firm is heavily dependent on Vanguard for revenue, as a disproportionate share of its assets under management derives from Vanguard Primecap and Vanguard Capital Opportunity. Thus, the launch of the new Primecap Odyssey funds would serve to gradually wean Primecap off of its reliance on Vanguard while establishing a public performance record apart from the two Vanguard offerings. This, Primecap argues, would give the firm the critical mass it needs to ensure that it can usher in its next generation of leaders.

Which brings us to the other undercurrent at work--succession planning. To this point, Primecap's effort has largely coalesced around a small core--chairman and cofounder Howard Schow, vice chairman and cofounder Mitch Milias, president and cofounder Theo Kolokotrones, and executive vice president Joel Fried. While that arrangement has been wildly successful for Primecap and shareholders, it leaves the firm vulnerable should key personnel depart. Thus, grooming a new crop of leaders to take the reins in future years has become a more urgent priority. More prosaically, the influx of monies expected from the new Odyssey funds (as well as a new Vanguard Primecap Core Fund, which is also slated for launch in the coming months) means that the firm won't be able to continue pouring assets into the same names. Rather, management will likely have to broaden the portfolios, which means coming up with a supply of new, thoroughly researched ideas. The only way to accomplish that goal without degrading the investment process is by bringing talented new people aboard.

As if to underscore the succession-planning point, Vanguard's board cited Primecap Management's need to "attract and retain top investment talent, and thereby enhance the organizational stability and depth of the firm" as one of the factors underpinning its recent decision to hike Vanguard Primecap's management fee four basis points. It also signals the seriousness with which Primecap is taking this effort. In all likelihood, Primecap's principals pressed Vanguard to revisit its compensation in order to bring it in line with what comparable peers are receiving.

Managing the Transition
Primecap has been adamant that the launch of the new Primecap Odyssey funds doesn't signal that they're taking their eye off of the investment process. So far, we're inclined to agree. Judging from the little we've seen, marketing and self-promotion do not seem to be the firm's forte. For instance, Primecap never issued a press release announcing the registration of the new funds. Further, they only recently added a toll-free customer service phone number to the Odyssey funds' registration statement, meaning that only now can prospective investors reach someone besides the firm's receptionist. Finally, they reportedly haven't hired any new marketing personnel, have no plans to spend a penny on distribution or advertising, and pledge to keep the same low profile as before. All told, Primecap hasn't changed much, if any, in the wake of the Odyssey funds' registration.

In addition, while the Odyssey funds are new, the processes that will support them are anything but. In fact, the Primecap Odyssey Growth and Primecap Odyssey Aggressive Growth portfolios will essentially be clones of Vanguard Primecap and Vanguard Capital Opportunity, respectively. Meanwhile, Primecap Odyssey Stock and the forthcoming Vanguard Primecap Core fund will leverage an existing process that Primecap already uses to run separate accounts.

We've also been encouraged that Primecap doesn't appear to be scrimping in its hiring or training standards as it brings new talent aboard. When we visited Primecap, we sat down with all of the firm's analysts and came away impressed not only with the depth of their industry knowledge but also their comfort with the underlying investment process. (Incidentally, the Ivy League remains a fertile hunting ground for Primecap--six of the seven analysts that the firm has hired in recent years are Harvard Business School grads; 10 of the 13 investment professionals currently at Primecap are Harvard MBAs.) Also heartening is the fact that analysts aren't being rushed along. As before, they are given plenty of autonomy and ample time to learn their industries. In fact, Kolokotrones estimates that management still expects analysts to take about three years to ramp up to a level where they can make significant contributions to the process.

In addition, some analysts are also being afforded the opportunity to buy into the partnership at reasonable levels. We think this is important because it better invests analysts in the firm's success, thereby empowering them at an early stage while mitigating the risk of personnel turnover.

Impact on Investors
The near-term outlook for Primecap's funds is unchanged. We remain strong believers in the contrarian growth approach that management plies. Further, recent developments do nothing to shake our conviction in the team's ability to execute. Based on everything we've seen, they've kept the focus where it belongs--on the investment process--while investing judiciously in additional resources that can support the firm's growth.

The longer-term picture is somewhat complicated by the prospect of asset growth. The firm will have to adapt in order to find capacity to invest the greater sums of money it receives. This need is accentuated by the significant overlap between the various strategies that Primecap runs. As mentioned, the new Odyssey funds will essentially clone their Vanguard siblings. What's more, we expect that the forthcoming Vanguard Primecap Core--which will dabble a bit more in cyclical fare than Vanguard Primecap--will typically have the lion's share of assets invested in names that Vanguard Primecap also owns. In addition, Vanguard Primecap and Vanguard Capital Opportunity share many names in common. Taken together, that makes for some weighty positions in a number of stocks: Primecap recently had slightly more than one third of firm assets, or $12.7 billion, invested in stocks where its holdings represented 5% or more of outstanding shares.

That said, we're not too concerned about maneuverability at this point. Primecap uses the same multimanager strategy that's the signature of Capital Research and Management, the advisor to the offerings from American Funds. (That's no coincidence--Primecap's Howard Schow, Mitch Milias, and Theo Kolokotrones all began at Capital Research.) Since the managers run their sleeves independently, they can maneuver more easily than it might appear at first blush. In addition, since managers trade infrequently and often buy on weakness, it's easier to build and trim positions without the heavy drag of market impact or opportunity costs.

Nevertheless, as mentioned above, Primecap will likely have to broaden the portfolios in order to keep position sizes to a manageable level. While we're comfortable with the infrastructure that the firm is putting in place to support that broader level of research, it could change the character of the portfolios some. Indeed, in the early 1990s, Vanguard Primecap's portfolio spanned 60 or so names, which is roughly half its current length. Yet, what shouldn't be forgotten is that the portfolio expanded to around 100 stocks in 1996 and has hovered at or slightly above that threshold ever since. Further, big bets on stocks have never been a large part of the process here. For instance, in 1993, the fund's top 10 holdings soaked up roughly 37% of assets versus 31.7% of assets as ofJune 30, 2004. Moreover, Primecap has made its name not on big sector bets but rather by deft stock selection. That means its success hasn't depended on timely sector rotations, a style that would likely be constrained by the firm's size in the future.

Next Installment
In the coming weeks, we’ll take a closer look at some of the intrigue that surrounds the continued closure of Vanguard Primecap and Vanguard Capital Opportunity as well as the impending launch of the Vanguard Primecap Core and Primecap Odyssey offerings. In particular, we’ll be curious to see whether Vanguard reopens Vanguard Primecap and Vanguard Capital Opportunity, which were originally closed to staunch an influx of hot money.

But with Vanguard Primecap Core and the Primecap Odyssey funds poised to make their debuts, it certainly seems as if any lingering worries over hot money have subsided. After all, if Primecap and Vanguard were still worried about short-term investors buzzing about the funds, they wouldn’t move ahead with introducing the new offerings, which would be vulnerable to the same flows (the Odyssey funds in particular, since they sport lower investment minimums). If those concerns have abated, then the question is whether Vanguard will open the shutters on Vanguard Primecap and Vanguard Capital Opportunity once again.

We’ll be keeping an eye on it and we'll report what we find.