Don't Fence Him In Foster Friess explains his individualistic approach to managing the Brandywine fund.
(MONEY Magazine) – Foster Friess is riding high once again. Since launching Brandywine back in 1985, the colorful growth fund manager has racked up superb returns with his strategy of scooping up rapidly growing stocks and selling them the moment they exceed his cautious price limits.
Back in 1998, Friess made a controversial move. When his research suggested that many companies held by Brandywine were likely to report weaker earnings growth, he sold off the bulk of the portfolio. He stashed the proceeds--more than 75% of the fund's assets--in cash, since he didn't see new investment opportunities that fit his stringent criteria. Result: Brandywine finished 1998 with a 0.65% loss, placing the fund near the bottom of its midcap-growth category. Shareholders howled at what they perceived as poor market timing, and Friess and his management team endured tough criticism in the press.
Today, after the collapse of many high-priced stocks, Friess' caution looks a lot like prescience. Since '98, Brandywine has performed impressively. The $5.8 billion fund soared 53.5% in 1999; in 2000, when many growth funds plunged, Brandywine was up a solid 7.1%, thanks in large part to a timely decision to sell off the fund's tech stocks the previous summer. MONEY's Penelope Wang caught up with Friess to get his views on his comeback and today's market.
Q. With the recent market crash, do you feel vindicated about your decision to go to cash back in '98?
A. There were a lot of distortions in the press at the time. The first one is that we didn't "go to cash." We sold companies one at a time after our research uncovered fundamental outlooks that didn't support their prices. The second distortion is that those sales were a mistake--80% of those companies subsequently dropped in share price, with half falling 40% to 90%. How is it a mistake to sell stocks just before they lose value?
Q. Would you go into cash again?
A. We won't "go to cash" again because we didn't in the first place. However, if at some future point we hold stocks poised to plummet, we will sell them. If those sales outpace purchases because the alternatives that fit our disciplines are equally troubled, cash levels will rise as a normal byproduct of our process. We did make one rule change in 1999: If we seek to raise cash levels above 20% of assets, we must first get the approval of the board of directors. This change was not to limit our ability to manage the fund but to acknowledge that the board should be involved in decisions of that magnitude.
Q. You made a smart move when you unloaded your tech stocks last year. With the Nasdaq down, do you see many buys?
A. Some people argue that tech stocks are cheap now. But that's not true relative to earnings. When the E in a company's P/E falls just as fast as the P, it's no more reasonably priced than before the decline. Plus, how much better is it to own a company whose P/E declined from 100 to 50? It's still too expensive. In our opinion, growth stocks are companies that are growing earnings, not losing money and cutting thousands of jobs. This is not to say tech companies that have fallen on hard times won't rebound, but right now the bulk of the growth is elsewhere.
Q. Apparently you see growth in energy right now, with Duke Energy ranking as your largest single holding. What do you like about that stock?
A. Energy companies might seem like defensive holdings, but the fact is, they're hitting the cover off the ball right now. Duke's 51% March quarterly earnings gain topped estimates by 24%. This is one of the best-positioned utilities in the U.S.
Duke stands to benefit from the pronounced shortage of power. It is one of the top five electricity-trading operations and is an important player in gas trading. At $47, the stock is reasonably priced at 17 times consensus earnings estimates of $2.76 for 2002.
Q. Your second largest holding is Boeing--what's the potential in a defense stock these days?
A. Boeing is an exciting company to hold with George W. Bush in the White House. Any increase in military spending is good news for Boeing. Its publicly stated backlog for commercial aircraft shows excellent growth in that business as well.
Q. You've recently added UnitedHealth Group and Tenet Healthcare to the fund. Do you think health-care businesses can deliver expanding margins?
A. Health-care companies enjoy some of the best pricing power in a slowing economy. UnitedHealth, a health-care services provider, continues to raise prices somewhat faster than medical costs are rising overall. So margins are holding or expanding slightly. Continued efficiency improvements are driving fixed costs lower, and the company is using its $1.5 billion in annual free cash flow to reduce debt and buy back shares. Tenet, which runs hospitals, beat expectations with its 25% earnings growth. The pricing pendulum appears to be swinging back in favor of hospitals--we're seeing actual bed shortages in some areas.
Q. You recently hired the former treasurer of Compaq as a consultant to help evaluate earnings and alert you to accounting maneuvers. What sort of bookkeeping tricks are you looking for?
A. We look for companies that grow earnings by selling products and providing services, not companies whose results are boosted by factors unrelated to their ongoing businesses. Overfunded pension funds, venture-fund-like equity stakes and so on are neither predictable nor related to a company's core business. Take Northrop Grumman. It reported $538 million in pension income as stemming from continuing operations in 2000. That was about 55% of its total pretax income of $975 million. The company acted in accordance with accounting rules. But those earnings have little predictability.
Q. You focus heavily on price/earnings ratios. But many investors these days are paying more attention to price-to-sales ratios. Is P/S a useful valuation tool?
A. We call investing based on price-to-sales ratios the "I Love Lucy" strategy. In one episode, Lucy and Ethel were selling salad dressing they made in their kitchen, but losing 10[cents] a jar. When Desi challenged them, they said they would make it up on volume. It didn't work for them, it didn't work for the dotcoms and it won't ever work. Successful companies turn growing sales into growing profits for shareholders.
Q. You tend to hold your stocks for only a few months, which makes your fund relatively tax-inefficient, according to Morningstar. Does that concern you?
A. Tax-efficiency is a myth. The biggest flaw is that it doesn't tell you anything about the huge embedded gains looming over shareholders in most index and buy-and-hold funds. Why should anyone zero in on some made-up ratio when it gives no insight into how shareholders actually fared? Brandywine has outperformed 75% of the funds in the midcap growth category after taxes over three years, and 81% over 10 years. Cashing out is the final score. Shareholders whose funds generate the most money for them are the winners.