How did you get involved in finance?
I got interested in investments when I was attending college. I went to Cornell and was majoring in nutrition. I had to take a class in agricultural economics, where, if you can believe it, we learned how to trade orange juice futures and pork belly futures. That was my first exposure to finance.
Finance and nutrition. I never would have suspected.
I didn't know much about the market before that. I became really interested in it, and I took several financial and economics courses. So I decided to get a job in the stock market. That was in 1984. And that's what I've been doing ever since.
How did you end up stewarding the Oppenheimer Emerging Fund?
I started managing money in 1990. I actually started with convertible securities. One of my customers at the company I worked at wanted to start a small-cap growth fund, but the customer also wanted to hire somebody who could act as a backup to their convertible bonds manager. Since I had been the convertible bond manager and analyst for the small-cap growth managers where I had worked previously, I had a background in small-cap growth stocks. So I went to work for General Motors Investment Management and started a small-cap growth fund in 1993. I worked there for five years, and then I moved on to Fortis Advisors to manage the Fortis Capital Appreciation Fund. When I started at Fortis in summer 1998, the fund had a Morningstar rating of one and an E rating by Investor's Business Daily. While I was there, the performance of the fund improved significantly and the fund received a four-star rating by Morningstar and an A+ rating by IBD. This was a great achievement because not many small-cap growth funds receive a high star rating from Morningstar.
How did you end up at OppenheimerFunds?
People I knew at the company called and said they were interested in starting a new emerging growth fund that would focus on micro- and small-cap. That's how I wound up here. I started working at OppenheimerFunds in October 2000 and the fund launched on November 1, 2000.
From the perspective of starting a fund, what do you see as some of the challenges of being the first to put down a footprint?
When you come into a new organization, the people who market the fund don't know you. They don't have much confidence in your ability yet because you haven't proven yourself within the organization, even though you may have a long-term track record. One of the biggest challenges is to build their confidence in you. Another challenge is gaining investor confidence. When we started the fund, the market was down significantly. The Nasdaq Composite is down almost 40% from that time. The Russell 2000 growth index is down about 21%. It's been a very challenging time to begin a new fund. Of course, from the investor's standpoint, if they see a new fund launch and it's down right away, it'll be a hard sell. But overall, I think it's going to be great to start a new fund and do what I did at Fortis. At Fortis, I took a fund that was underperforming and turned the performance around into a great product. That's what I hope to do at OppenheimerFunds. It'll be a challenge and that's what I enjoy.
I was curious about that. What are some of the important differences between starting a fund from the beginning and a turnaround job?
A turnaround is more difficult because the investors have already lost a lot of money, which leaves a bad taste in their mouths. That's a challenge you don't need to overcome when you're starting a new fund. The biggest challenge right now with a new fund is the market and people's perception of the current market.
What is unique about the Oppenheimer Emerging Growth Fund?
The purpose of the fund is to invest in companies that are in the earliest stages of growth and hold them throughout their life cycle. The emerging growth fund will invest in companies that at the time of investment are micro small-cap, but there is no restriction on holding onto them throughout their life cycle. This is different from a lot of other small-cap growth funds.
What's the rationale behind this approach?
Selling stock in a company because it's too big is not a great investment decision. You sell a stock because there's a change in fundamentals, a change in the management, it becomes too overvalued, or you change your reasoning behind buying it in the first place. But to sell? What if you bought Cisco [CSCO] when it went public and sold it just because it was worth $3 billion?
What are the risks involved in micro small-caps?
What many people don't understand about investing in an emerging growth fund is the volatility. People who invest in emerging growth funds need to look at them as a long-term investment and they have to understand they can't time the market. I talk to a lot of people who want to try to time the market on a short-term basis, but it's not an efficient way to invest. Even the best professionals are not that great at timing the market. That's why we stay fully invested. Emerging growth stocks tend to move in spurts; they're very volatile.
Can you give me an example?
Sure. Take for example the recent move we had in small-cap growth stocks during April 2001. We had some stocks that had substantial gains. If you hadn't invested correctly then you would have missed that entire move. But a lot of people think the market is bad, so they don't want to put their money in the market. A lot of investors get caught up in the day-to-day volatility and overlook the benefits of investing for a longer term, such as a five-year time horizon.
You mentioned some of the risks with emerging growth funds, specifically with regards to volatility. Do you think there are any inherent risks in new funds, or does that really depend on who's managing the fund?
It depends on who's managing the fund. You really have to look at the portfolio manager, the background of the portfolio manager, and the philosophy of the portfolio manager. Certainly, it's going to be riskier investing in a fund with someone with two years' experience at the helm. Then there are funds like ours where someone with 10 years' portfolio management experience, like me, is managing the fund.
You worked with small-caps and also mentioned your convertible experience. In addition to the success of a manager, should people also look at what kind of funds the manager was managing?
Yes. For example, my focus has always been growth stocks. When I managed the convertible bond portfolio, it was with a growth tilt. So I had a growth stock philosophy. Certainly, if you're looking to buy an emerging growth fund, you want to make sure they're truly investing in emerging growth companies and that the manager has a growth philosophy.
In terms of philosophy, I've talked to value managers who suggest that there is a "value ethos." They describe a value approach to life, boast about being bargain hunters, and so on. Is there something in terms of a growth stock philosophy that describes money managers who are drawn toward finding and managing growth stocks?
Everyone has his or her own idea of what's growth and what's value. My philosophy is that the price of a stock is driven by its earnings growth and a company that is successful and has good earnings growth is going to have a successful stock. But this doesn't mean we don't look for value. I try to look for growth stocks that are reasonably priced and are trading at good values. I'm not going to buy a stock that I don't think is a good value.
How would you differentiate growth and value managers?
It's difficult to differentiate between the two. I'm sure there are some value managers who buy stocks that still have earnings growth. We try to focus on companies that are in their earliest stages of growth. By that, we mean companies that have the ability and proprietary product or service that will eventually lead them to become a leader in their market. We also like to evaluate the management teams because we think that is critical to bringing these small companies to the next level, regardless of whether the company has the best technology or the best product. If management doesn't have the right strategy, experience, or background, it's more than likely the company will fail. We do a lot of fundamental research. We meet with management, analyze the products and marketplace to find the companies that we believe will be the leaders in the future. Part of that analysis involves looking at revenue growth, earnings growth, valuations like price to earnings ratiosU to their growth rates, and also looking at momentum indicators.
Momentum in the technical analysis sense?
Technical and price. Why don't I take you through my stockpicking process? It's very defined and involves three steps.
Let's hear it.
It starts with quantitative screens. We use a lot of proprietary screens to establish a universe of companies because there are more than 6,000 companies that trade below $1.5 billion market cap the area of the market cap the fund focuses on. We screen for earnings and revenue growth, quarterly earnings acceleration that is, sequential quarterly growth valuation measures, and the P/Es to the two-year growth rate. We use William O'Neil's relative strength measuresU as a measure of price momentum. We have all these factors weighted in a proprietary weighting and the companies are ranked in deciles analysis. We use the top three deciles as buy candidates. In addition to that we run various screens.
We want to spend our time doing the research on companies that have the best earnings growth and are trading at the best valuations. This first step of the process keeps us focused on companies that meet the screening criteria. Most of our time is spent on fundamental research: Does the company have any new, innovative products or services that will allow it to be a leader in the future of its industry? What are the catalysts for revenue and earnings growth? Is there potential for an upside earnings surprise? We look at their potential for margin expansion gross margin and operating margin.
What about the management of the company?
The management team is very important to us. We want to make sure the management has the experience to manage the company through a growth cycle. We also look for companies in which the management owns stock in the company because we like to make sure the interests of the company are aligned with those of the shareholders. As a final step, we use technical analysis and charts. We like to buy when relative strength is improving, when they're trading above the moving averages, when the moving averages are in an uptrend, and when we see insider buying.
So at the end you have a qualitative, fundamental, and technical analysis process.
Yes, as a final confirmation. We use technicals because the stocks are very volatile. Small-cap and micro-cap stocks can trade up or down 40% or 50% for no apparent reason, and sometimes we trade around our core positions to take advantage of that volatility. In April, for example, when we had some stocks gain as much as 100% or 150%, we took some profit at that time. This ended up being a good thing because now the stocks have corrected again. But the volatility in the last year and a half has been vicious.
You didn't specifically note the role of sectors in any of the three steps you mentioned. Do you spend much time considering sectors and sectors in the business cycle?
No, the portfolio is constructed using a bottom-up stock selection process. We don't do any type of top-down sector analysis at all. We're just trying to pick the best stocks with the best fundamentals trading at the best valuations. As a guideline to control risk and to stay diversified, we have a rule that we don't go more than two times the benchmark the Russell 2000 growth index of the portfolio in any one sector. But the sectors that tend to be heavily weighted are those where the best earnings are happening. It's a very stock-specific decision making process and not a top-down one.
Most people are thinking technology stocks will be the leaders of the next bull market. At this point, do you have any sense where some of that leadership in terms of a general market advance might be coming from?
I really don't look at it that way. I don't want to tell you that we love technology stocks or health-care stocks, because we just don't look at the market that way. Technology is a very broad industry. It has many subsectors and there are some technology subsectors that we happen to really like right now. But because technology is cyclical, there are some cycles we don't like at the moment. Their earnings growth rates are still decelerating and companies are still warning about bad earnings and we don't see a bottom yet in some areas. One technology subsector we
do like is the video game sector I guess that would fall under consumer/technology. We think this sector is on the verge of a major new upcycle.
Why is that?
There are several new game platforms being released this year. At the beginning of the year Sony PlayStation 2 was released, and finally the company has got its production under control by producing more units and making it available in the US. A recently released version of GameBoy was met with significant sales its first week. Nintendo is coming out with a new game cube and Microsoft is coming out with their X box. So you have four strong game platforms out in the same year.
So you like the companies producing the platforms?
We really like the companies that write software for the platforms, because you don't have to make a bet on success or failure on any one of those platforms. It's the largest product cycle in the history of any of these companies. Some of the stocks that we like in that area are THQ, Inc. (THQI) a software company that holds the licenses to games for all the Nickelodeon shows, like Rugrats, and all the ones that are popular in the six-to-12 age group. THQ also has the rights to the World Wrestling Federation games. Take-Two Interactive Software, Inc. (TTWO), which has some great games coming out, is also a stock we like. Activision, Inc. (ATVI) is another stock that we like. They have the Tony Hawk game their most popular and they have several new ones coming out. This is one area that has been very strong, mainly because of a new product cycle.
Figure 1: THQ Inc. (THQI) develops and distributes interactive entertainment software for the home video game market.
So even though companies like Sony and Microsoft create the consoles, your investment preference isn't so much for those companies as for those writing the software. Why?
By investing in these companies I don't have to make a bet on the success or failure of a box. For example, if Microsoft doesn't sell as many of its X box units as expected and Nintendo absorbs most of the market share, I don't have to worry about it. These software companies are going to succeed no matter which platform outperforms because they are writing games for all the platforms.
You mentioned THQ, Take-Two, and Activision. Are there other holdings in the fund that are outside of the video game sector that you think are attractive and worth paying attention to?
Sure. We own a company called SurModics, Inc. (SRDX), which makes proprietary coating for a variety of medical devices. Currently, they are in clinical trials with Johnson & Johnson (JNJ) creating stents to treat Restenosis. They have several other new technologies they are working on with their proprietary coatings. It's a stock we've owned for a while. It had been doing very well, going from 28 to 60, but in the recent market correction it pulled back to 43 volatile for these stocks. In one week it went from 60 to 43, but it has a $600 million market cap. The earnings and revenue growth is about 50%. We really like it.
Figure 2: SurModics, Inc. (SRDX), provides proprietary coating technologies for medical devices.
Apart from the medical and tech sector, is there anything more pedestrian that you're interested in?
We also like the education area. Career Education Corp. (CECO) is a stock we have owned for some time, which owns for-profit colleges. It's a company that has had consistent earnings and revenue growth and has become a leader in the for-profit post-education industry. It has about $1 billion market cap now and the stock has been successful.
Figure 3: Career Education Corp. (CECO) is a private, for-profit postsecondary education organization with more than 30 campuses in the United States and Canada.
Let me ask some general questions to wrap up. What should investors ask of their mutual fund managers or look for in the prospectus or reports to shareholders when they're investing in different funds?
They need to understand the managers' philosophy and how they pick stocks, construct the portfolio, and control risk in the portfolio. They need to determine the manager's investment horizon for the holdings in the portfolio. When investors select mutual funds to invest in they need to stay invested, stay diversified, and not worry about timing the market. They also need to dollar cost averageU. I think that works. It's difficult, even as a professional, to time the market. If you're an individual investor who's busy with a career, trying to pick the right time to take money out of the market and then put it back in is very difficult.
What's your outlook on the small-cap growth market?
It's a great time to be buying small-cap growth stocks. If you look at the historical performance of stocks coming out from a slowdown or recession, small-cap stocks tends to outperform large caps by almost 600 basis points. Small caps seem to outperform in periods of declining interest rates, which is what we're in now. They underperform in periods of rising interest rates, which is what we had last year. If you just look at the performance of small-cap growth versus small-cap value in 2000, small-cap growth was down 22% as measured by the Russell 2000 growth index, and small-cap value was up 22% as measured by the Russell small-cap growth index.
And that performance continued?
If you look at the first quarter of this year, that type of outperformance continued; value outperformed growth. But if you look at the last month, you can see an improvement in relative performance of growth stocks versus value. I think this is going to continue. If you look at the year-to-date return of the Russell 2000 value index, it's up 8.8% and the Russell 2000 growth index is down 5.6%. This kind of performance or variation or discrepancy doesn't last very long.
No. A similar situation occurred in 1999, where growth was outperforming value outrageously. I don't really want to trash value, but in environments like this, growth outperforms. And if you look at the valuation parameters on a valuation basis, growth really looks good versus value right now.
So value might have had its time in the sun?
I think so. Does that mean it's going to turn in one or two months? I don't know. If you invest now and have a two- to three-year time horizon, you'll make money in small-cap growth stocks.
Great to hear. Thank you for your time this morning, Laura.
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