The Primecap Way of Managing Funds

Back in April, we took a look at the reasons Primecap Management is one of the best stewards of shareholder capital in the mutual fund business. The firm has been around since 1983, subadvising  Vanguard Primecap (VPMCX) since 1984 and  Vanguard Capital Opportunity (VHCOX) since 1998, and running its own Primecap Odyssey funds since 2004. It has achieved outstanding long-term investment results while also keeping the interests of fund shareholders front and center. Fees are very low across the lineup, the portfolio managers are heavily invested in all the funds they manage, and there's a topnotch culture in which those managers almost entirely avoid publicity in order to focus on investing.

This has all worked very well for the past 30 years, but what about the next 30 years? Can they keep it up? Primecap has been going through a bit of a transition lately after losing two of its three founders: Howard Schow died in April 2012, and Mitch Milias retired from portfolio management duties at the end of 2013, though he has remained with the firm in other capacities. With all this in mind, Morningstar recently visited Primecap and met with all of its investment professionals in order to get a better understanding of what makes the firm tick, what's behind their great investment returns, and how they're planning for the future.

Primecap's offices are surprisingly low-key for a company that manages almost $90 billion in assets. The firm's 35 employees, including 16 portfolio managers and analysts, occupy one floor of an office building in downtown Pasadena, CA, with one receptionist to greet visitors and few signs of glitz or glamor. Until a few years ago, the chairs in the main conference room were the same ones the founders had originally bought in 1983. Such pragmatism and thriftiness is very much in keeping with the valuation focus and long-term thinking that permeates Primecap's culture. This is not a firm that throws around a lot of money on surface frills to impress people; they prefer to let their investment results speak for themselves.

The strategy behind those investment results, which could be described as patient contrarian growth, reflects many of the same features. The portfolio managers look for companies with great long-term growth potential, but they don't want to pay too much, so they focus on stocks that are temporarily out of favor for one reason or another. They're also willing to wait a long time for stocks to come around if necessary. Lots of money managers say that they look for cheap stocks with good growth potential, but Primecap is notable for the consistency and discipline with which they implement this strategy. That long-term focus means that there will inevitably be periods when the funds underperform in the short term, but they have always come back strong eventually.

Another thing that sets Primecap apart is the firm's flat organizational structure and the autonomy it gives to its investment professionals. Unlike fund shops built around star managers who make all the major decisions, such as Janus in its heyday, or those that are team-managed and make decisions by consensus, such as Dodge & Cox, Primecap divides its portfolios into sleeves that are managed independently--similar to the American Funds, where Primecap's founders got their start. Of course, there's plenty of interaction among the portfolio managers and analysts, and lots of overlap in the holdings of the different sleeves, but ultimately everyone is responsible for his or her own sleeve and evaluated on its performance.

The biggest sleeves are run by the four named portfolio managers of the firm's six funds--Theo Kolokotrones, Joel Fried, Al Mordecai, and Mohsin Ansari--but nearly all of Primecap's investment analysts manage some money as well. Each analyst is responsible for certain sectors and industries and is expected to research those industries independently and come up with potential investment ideas that are written up and presented to the whole team. Once an analyst formally presents an idea, he or she is given some "research dollars" (consisting of actual client money) to invest in that stock, and the portfolio managers can buy it for their sleeves if they find it attractive enough. After a few years, each analyst will have a research dollar portfolio of recommended stocks. Everybody's portfolio is visible to everybody else, so that there's "nowhere to hide," as several people told us.

If an analyst's portfolio performs well enough, that analyst might be given more money to invest in his or her sector, or money to invest more broadly across sectors. Those who continue to perform well over several years can eventually be made portfolio managers, though there is also a career analyst path. This system is at the core of Primecap's succession planning, in which analysts who prove their investment mettle over a long period (typically eight to 10 years) earn increasing money management responsibilities. That's what happened with Mohsin Ansari, the shortest-tenured of the four listed managers on the Primecap funds: after starting with the firm in 2000, he got some portfolio responsibilities in 2008, was officially named a manager of the Primecap Odyssey funds in October 2010, and was named a manager of the firm's Vanguard funds in April 2012 after the death of Howard Schow. More recently, James Marchetti, who has analyzed health-care stocks since 2006 and a broader range of stocks for the past couple of years, was given more portfolio responsibilities after Mitch Milias' retirement, and he is likely to be officially named comanager of the mutual funds in the near future.

This environment, in which analysts are basically thrown in the deep end and expected to figure things out on their own, isn't for everybody. Although Primecap hires extremely smart people from the top business schools, roughly half of the analysts they've hired over the years have left at some point. That attrition rate isn't as concerning as it might appear at first glance, because the people who remain really understand Primecap's philosophy thoroughly and have proven themselves as investors. There are still plenty of veterans going strong, including founder Theo Kolokotrones and Joel Fried (who joined the firm in 1986), alongside newer analysts to provide fresh perspectives. Primecap has hired eight new analysts since 2009, including one who will start in fall 2014, and several of them have already contributed significantly to the funds with their stock picks.

The Primecap funds went through some slow stretches in recent years, but they all excelled in 2013, with  Primecap Odyssey Aggressive Growth (POAGX) and Vanguard Capital Opportunity especially standing out. Primecap will undoubtedly continue to evolve as people come and go, but the culture and processes that have been put in place go beyond any one person and make us confident in the firm's ability to continue posting good investment results.