A Closer Look at a Fund Manager of the Year

Morgan Stanley portfolio manager Dennis Lynch and his investment team faced stiff competition on the path to be named Morningstar's Domestic-Stock Fund Manager of the Year for 2013. Growth-oriented strategies have been on a tear over the past few years, with growth indexes largely triumphing over the actively managed crowd. The Russell 1000 Growth Index, for example, gained an annualized 20.4% over the past five years through the end of 2013, beating about three fourths of roughly 400 distinct large-growth strategies. Active managers in the mid- and small-cap range of the growth spectrum have seen similar challenges: The Russell Mid Cap Growth Index trounced more than 85% of funds in the mid-cap growth category, while the Russell 2000 Growth Index pulled ahead of almost 60% of small-growth offerings.

Yet Lynch and his team have demonstrated their mettle--as well as their market-cap dexterity--via  Morgan Stanley Institutional Growth (MSEGX),  Morgan Stanley Focus Growth ,  Morgan Stanley Institutional Mid Cap Growth (MACGX), and  Morgan Stanley Institutional Small Company Growth (MSSMX). All four funds handily outpaced their respective indexes in 2013 (click on the video for a deeper dive into the sources of Morgan Stanley Institutional Growth's success in 2013). They also sport impressive long-term results.

To get there, the team members follow an investment process that, on the face of it, appears fairly straightforward. They focus their search on companies that are leaders within their industries, looking in particular for business models that upend existing paradigms. These firms frequently dominate their niche markets, enjoy strong and defensible competitive advantages that keep competition at bay, and often have the high returns on capital to show for it. It's no surprise, then, that  Google (GOOG) has held a spot in the Growth fund ever since the company's August 2004 initial public offering, just months after Lynch and his team took over the fund. As the world's dominant search engine, the firm enjoys net margins in excess of 20% per year.

The team's flexible approach to finding companies with attractive business models sets it apart from competitors, though. One of the main ways that it does so is by trying to exploit investors' systematic biases and blind spots. For instance, spin-offs and the leftover "stub" companies frequently elicit the team's attention, as the team members find that those companies are often misunderstood and have few comparable competitors. That drove the team to purchase  Motorola Solutions (MSI), the business that remained following the spin-off of Motorola's headset business, Motorola Mobility. Whereas many analysts and investors were focused on the headset story, Lynch and his team liked the wide moat enjoyed by Motorola Solutions. As a provider of emergency communication services to local law enforcement and fire departments, the company enjoys strong pricing power because it offers a particularly robust wireless network--a key feature for municipalities operating under emergency situations.

Of course, flexibility can be a perilous tool, oftentimes causing unexpected results. The funds' wide portfolio construction latitude contributes to this as well, as the team pays little heed to any index's sector weights and regularly keeps 20% or more of the portfolios in internationally domiciled companies. So, while most of the funds display the return patterns expected of a strategy that focuses on market leaders--over the team's 15 years managing Small Company Growth, for instance, the fund outpaced the typical small-growth peer in 55% of down markets and 58% of up markets-- it's not hard to find deviations from the norm. In 2011, for example, Small Company Growth's roughly 30% stake in foreign companies particularly exacerbated poor performance, and the fund's 9% loss that year put it behind more than 85% of its peers.

Despite that degree of unpredictability, Lynch has developed an investment culture that's well equipped to handle the burdens of flexibility. Important components of that culture include an emphasis on continual learning and reading. The team founded and continues to run the Morgan Stanley reading network, which gathers articles and other pieces from an eclectic set of sources. Articles in the past include a story on Oregon State's no-huddle offense--an example of how those in other fields have disrupted the status quo. Neurosciences pieces often make their way into the compilations, and they run the gamut, giving insight into topics such as consumer behavior and personality traits.

The team even devotes an analyst on the team to conducting deep-dive, big-idea research rather than to making specific stock recommendations. That analyst's work allowed the funds to benefit from a rare-earths supply shortage in 2010, and more recently, it helped the team get in front of electric cars via a late 2012 investment in  Tesla Motors (TSLA), just months before the stock more than tripled in value in 2013. This analyst is also charged with developing off-the-beaten-path contacts, and that network has been a fruitful source for the team's investments in private companies. While these investments usually make up small stakes of the portfolios--usually less than 5% of assets--getting in early can make for attractive entry points. Many of these holdings have seen some controversy, although several pre-IPO investments have so far proved successful, including  Facebook (FB) (initially purchased in 2010 and went public in 2012) and  Twitter  (purchased in 2009 and public debut in 2013). A small stake in the now-bankrupt Better Place, which built infrastructure to support electric vehicles, serves as a reminder of the perils of investing in such early-stage companies.

This carefully cultivated culture has helped the team deliver some of the strongest results in the industry during both 2013 and over the long haul. The culture, combined with an experienced and long-tenured team, gives Morningstar confidence that investors prepared to hold tight through short-term volatility will continue to be well rewarded in the long term.

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