Archived 12/11/97
Highlighted Stocks
Sterling Commerce
MCN Energy Group
Coca-Cola
Cardinal Health
Dollar General
We’re not paying too much more than the market, and we’re getting a lot more.
The World
According to GARP
Ed
Brown’s a traditional guy. His hard-nosed approach
to calculating value ensures that the price is always
right.
By
Eneida Guzman
With the market up over 30% so far this year, it's getting harder to find good stocks at a reasonable value. As a result, money managers -- no matter what their investment philosophy -- are often relegated to chasing stocks trading at lofty levels. Ed Brown of Brown Capital Management thinks that is a fool's game.
The president and founder of the Baltimore-based institutional money-management firm represents the GARP investment approach -- looking for a limited number of issues offering "growth at a reasonable price." Why limited? "Investors can diversify so much that they end up being the market," Brown says.
An avid cyclist and world traveler, the 57-year-old Brown is considered one of Wall Street's most successful students of the markets. Last year he was named to Wall Street Week's Hall of Fame, a group whose past honorees include investing legends Peter Lynch and John Templeton. He opened Brown Capital in 1983 and currently oversees $3.3 billion for clients such as Texaco and the Oregon state government. Brown talked to Investor about his latest "value creating engines," and how he measures risk in stocks.
What is Brown Capital Management's investment philosophy?
We call our investment philosophy GARP, which stands for growth at a reasonable price. We're bottom-up, old-fashioned fundamentalist in our approach. The result of this valuation-and-fundamentals-driven GARP approach is that we look at the portfolio characteristics. You will find that our prospective earnings-per-share growth rate is much greater than the market's weighted earnings-per-share growth prospectively. By prospectively, I mean that we're looking over the next three to five years in terms of their prospective revenue growth and prospective earnings-per-share growth. Therefore, the portfolio that we put together represents what we mean by GARP. The prospective earnings-per-share growth over the next three to five years is usually at least twice the market's EPS prospective growth. For instance, we look for companies that are growing at, say, 19% versus the markets' growth rate of 8%. We also look for companies whose profitability or return on equity is greater than the market. And lastly, we also like to pay less than the market's P/E on 12 months' forward earnings for these superior characteristics.
It must be difficult to find great companies that are trading below the market's price/earnings multiple.
Right now we're paying a slight premium to the market, but our goal is to pay no more than, and preferably less than, the market's P/E on 12-month forward earnings, and have the profitability of the portfolio of the companies greater than the market. So in essence, we're constructing a portfolio of what we see as very good growth companies getting a lot of bang for the buck. In other words, we're not paying too much more than the market, and getting a lot more in terms of favorable characteristics of the market.
Super Market Caps
GARP Funds
We construct risk premiums for each company individually.
There are a lot of GARP money managers. What is interesting about your approach is your valuation model.
We prefer to gauge our risk in the stocks we invest in against an asset that has absolutely no risk and a guaranteed rate of return. We use the five-year Treasury note as "the riskless asset," or "risk-free rate," as opposed to the 90-day Treasury bill or the 30-year Treasury bond. And the reason we use the five-year Treasury note as "the riskless asset" is, as I mentioned, we're evaluating the prospects of the companies that we're investing in over the next three to five years.
So we say to ourselves: What investment return can we get with absolute certainty over that investment time horizon? And it's the coupon interest on the five-year Treasury and, of course, we are guaranteed our original investment. Therefore, it's the riskless asset for our investment time horizon. Then we have individual risk premiums assigned to the companies that we invest in. And our interest-rate valuation methodology gives us a high degree of probability that we will achieve this desired risk premium above the five-year Treasury note over our investment time horizon.
How do you measure the risk premium?
We actually construct the risk premiums for each company individually by looking at past data. We look at what type of embedded risk premium on top of the five-year treasury that the market has historically demanded of each company we invest in. This helps us determine how much we're willing to pay for growth, in terms of a P/E, that we can translate into a price based on 12-month forward estimated earnings. If we pay no more than this price, or this P/E today, we have a high degree of assurance of realizing this excess return or risk premium over the next five years.
Let's take Oracle (ORCL) as an example. With the current coupon for the five-year note at 5.8% and consensus P/E estimates for Oracle at 28, our long-term estimated EPS growth for Oracle calculates to 30% per year. That is the maximum P/E we will pay for the stock. We think that over the next 12 months Oracle will earn $1.30 a share. Therefore, if Oracle earns $1.30 over the next 12 months and hits their maximum P/E, they should be trading at $39 a share (vs. the current price of about $30). The minimum risk premium that we feel comfortable taking is paying up to $39 a share for the stock. All things being equal, if the stock trades higher than $39, we won't buy it, because the market won't compensate us for taking the risk of paying a higher price for the stock.
Your investment strategy is to latch onto value-creating engines. What have some of those been recently?
We have estimated earnings-per-share growth over the next five years for Sterling Commerce of 30% per year based on today's stock price and our estimate of earnings per share for the next 12 months. It is currently selling at roughly 27.5 times next 12 months earnings. So we think that even though the P/E on an absolute basis might seem high, with a 30% earnings-per-share growth and adjusted for risk, it represents a very good value in a very solid growth area over the next three to five years.
What are some of your other values?
Another company that we think will increasingly be recognized -- and we don't think it's fully recognized today in the investment community as "a growth company" -- is MCN Energy Group (MCN). We think it's looked at more as a gas-distribution company, as a gas utility. But they derive a little over 30% of their earnings from exploration and production of primarily gas. And we think that segment of the business will increase to more than 50% of their total earnings over the next three to five years. It's now growing in excess of 30% a year, and they've structured that side of the business in a very interesting way. They are very cost-conscious in regards to their overhead, and they've formed over 90 partnerships with production companies.
A Riskless Benchmark
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Coca-Cola has been a recent purchase for you.
Unfortunately, for us, we didn't own it in the first quarter. That was true of many of what I call the "super market" caps that did so well in the first quarter --companies like Coca-Cola (KO), Gillette (G), Procter & Gamble (PG). But we're very disciplined in determining how much we will pay for growth, and at the time we thought they were overvalued. But since June, Coca-Cola stock has come down about 20%. And so we think that it now represents a reasonable value. It still trades at a fairly rich multiple, but again, risk-adjusted, we think it represents a good potential return. It's selling at about 36 times 12-month forward earnings. That's down from around 45 times in the earlier part of the year.
Health care is one of your investment themes that has worked out well.
Cardinal Health (CAH) is an example of that. It is a distribution company of health-care products and pharmaceuticals to drugstores and the health-care industry. And it has been very successful in acquiring and consolidating other companies. So now it has become kind of the dominant distribution company in the health-care industry. Because they have excellent systems, high-quality management, and are in a growing area, they have been able to produce excellent results. We think Cardinal can grow at about 23% a year over the next three to five years. It's selling at about 29 times our 12-month forward estimating earnings.
We like Dollar General (DG). It's a value-focused retailer. They operate in a lot of small towns, but they've also entered some urban markets. Their target market is the lower-income consumer. They offer very good values to that consumer for everyday products. It is a good unit-growth story. They have a lot of opportunity for adding new locations over the next two to three years. And same-store sales have been increasing on a consistent basis. It's a company that we are estimating can produce earnings per share growth of about 23% per year. It's selling at a price/earnings multiple of 28 based on 12-month forward estimated earnings.
A Riskless Benchmark
Super Market Caps
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In addition to managing $3 billion in pension accounts, you also manage some mutual funds.
We have three mutual funds that parallel what we do in our private accounts. The same investment team that manages our large institutional accounts manages them. We have the Brown Capital Management Equity Fund, which invests in mid-/large-cap companies. We also have the Brown Capital Management Balanced Fund. It invests in stocks as well as bonds, and the equity portion is mid-/large-cap. The stock portion of the portfolio is basically identical to our equity fund. And then we have the Brown Capital Management Small Company Fund .
Small company fund? Is that like a small-cap fund?
Yes. We purposely say small-company mutual fund rather than small-cap because we look at revenues and not just market capitalization. For this fund, the revenues for any company must be $250 million or less at the time of the initial purchase. And the reason we measure small companies this way is that some very large companies can become small capitalization stocks if the price falls far enough. So we're not looking for fallen angels. In fact, we used to joke, when IBM (IBM) was in its downward spiral a few years ago, that if the stock price kept falling, it could end up as a candidate in the small-cap portfolio. We think using the revenue maximum gives us a nice universe of truly small, emerging growth companies to look at and invest in.
You manage over $3 billion and you position, at the most, 50 stocks in any given portfolio. That's on the low side.
We want to know the companies that we invest in very well from a fundamental point of view. We think we can follow up to 50 companies in each of our investment categories and know them extremely well and stay on top of them from a fundamental research standpoint. Also, we think we can get adequate diversification with not more than 50 individual holdings. So it gives us the best of both worlds -- to be able to stay on top of the companies fundamentally and not become overly diversified.