Vanguard Growth

I am a fan of Bob Turner and am always interested to hear his insights. However, I must disclose that I do no however use his fund in my practice. Instead, I prefer to use Harbor Capital Appreciation as my conservative Large Cap Growth mutual fund. Over the last ten years Harbor Capital Appreciation has outperformed Vanguard Growth Equity with less risk (a lower standard deviation). The graph shows the performance of Harbor Capital Appreciation (the red line) versus Vanguard Growth Eauity (the blue line) I believe Turner's investment approach is soundly executed within Vanguard Growth. It's just that others seem to eke out a better return following a similar investment philosophy. Morningstar considers Vanguard Growth Equity to be a three star fund (out of five possible stars). Here is a current research report on the fund written by Litman Gregory.

FUND UPDATE: Vanguard Growth Equity (VGEQX)

Category: Larger-Cap Growth Managers: Bob Turner Date of Interview: 1/10/07

With: Bob Turner

In early January, Bob Turner (founder of Turner Investment Partners, and lead portfolio manager on Vanguard Growth Equity) visited our Orinda offices, where we discussed his view on the market, holdings in the portfolio (as well as holdings he doesn’t own), and a few firm-related issues.

Turner continues to see good earnings growth in the market, although last year, higher earnings growth did not translate into higher stock prices. In fact, he says companies with the highest earnings growth performed the worst. Citing an internal study, Turner says that companies ranked in the top half of the Russell 1000 Growth Index based on long-term earnings-per-share growth forecasts (i.e., the fastest-growing companies) were basically flat in 2006. Meanwhile, the slower-growing half of the universe was up approximately 16% on average. This made for a tough 2006, as Turner’s investment philosophy is that earnings expectations are the primary driver of higher stock prices. Accordingly, Turner looks to buy companies with the highest earnings-growth prospects, while trying to avoid companies with slow (or declining) growth.

Turner remains optimistic that the firm’s high-earnings-growth focus will be rewarded. He suspects that over the next 12 months, the economy should continue to slow, causing the profitability of some companies to decline. Companies that are able to maintain above-average growth, i.e., growth stocks, should do well. In short, he anticipates that investors may be willing to pay a premium for superior earnings growth, resulting in higher stock prices. While he’s not sure when things will turn, he says, “We have a discipline and we’re sticking with it. We don’t deviate because that’s when things turn against you, and that’s when you blow up.”

Turner’s focus on the fastest-growing companies has led him to continue holding Apple Inc., a stock the team has owned for several years. It’s important to remember that Turner manages the portfolio sector-neutral to the Russell 1000 Growth Index (meaning his sector weightings approximate those of the index), so in order to beat the benchmark, making active company bets is necessary. As of year-end, Apple was a 1% position in the benchmark, but over 2% in the fund. Turner remains confident that Apple will continue to grow and beat consensus earnings expectations. When assessing whether a company can exceed expectations, Turner’s process is more of a qualitative mosaic, where the objective is to gather vast amounts of information from the company, competitors, suppliers, third-party research, etc., and triangulate on the probability of a positive earnings surprise. Building complex earnings models and coming up with an exact earnings number is not part of Turner’s investment approach.

Turner says that the mosaic for Apple is a “little tricky,” in that it’s harder to pinpoint future sales numbers, in part because Apple is so secretive about their upcoming products. By contrast, Turner says it’s easier to estimate sales for less-innovative companies, where calls to distributors provide good insight into inventory levels and other supply/demand metrics. But with Apple, Turner says, “You don’t get any of that.” Researching Apple requires more of a big-picture analysis, and “reverse engineering” methodology. For example, Turner says that forecasting sales of Apple’s PC division requires them to determine how much market share Apple has, and then checking on sales at Dell and other PC makers to get a sense for demand.

Turner adds that part of the analysis for Apple is anecdotal, where the success of products is gauged by how long the lines are in the retail stores and how long the turnaround time is for new orders. “What we’re not going to do is just trust Steve Jobs [Apple’s CEO], and say everything he does is great, and just own this stock blindly. We want to make sure everything is on track,” says Turner. While modeling company earnings is not a competitive edge for Turner, the team does work to understand the impact that margin expansion/contraction or promotional deals have on earnings.

As for future growth, Tuner believes Apple’s penetration in the PC market will continue to increase as iPod users are drawn to consider Macs. Apple also continues to rapidly expand its retail stores, which Turner says have the highest sales per square foot of any store in the world. He also expects international sales to provide the next leg of growth. Turner says that while iPods account for 75% of portable music players in the U.S., there are hardly any in the rest of the world. Growth can also come from new product introductions.

Turner says Apple trades at a premium valuation relative to its growth rate “although it’s not outrageous.” Valuation does not play a big role in Turner’s investment process, and Turner says one thing he’s learned over time is to let his winners run. “When you own tech stocks that are generating outsized extra return, often the best practice is to do nothing and simply let them continue to generate extra return. In some cases, we have learned this lesson the hard way. We have held some big tech winners but succumbed to the temptation to take profits in them—only to buy them back later at higher prices. When it comes to our tech winners, inertia strikes us as a sensible investment strategy. We think our ideal holding period for such stocks is forever or until there’s a good earnings-related reason to sell them, whichever comes first,” says Turner.

Microsoft is one of the biggest active bets in the portfolio, in the form of an underweighting. The stock is the largest company in the benchmark (3.7% as of year-end) and Turner has no exposure to this name. In his view, Microsoft is in a disadvantaged position on a secular basis. Turner says the software industry is moving to an on-demand, open-source world, and away from a closed-source proprietary model. He says that sustained leadership is far less common in the tech sector these days. Although Microsoft has lots of cash flow and tries to be innovative, Turner says “they’re just too big, and it’s hard to get that going. When you look at the secular forces, they’re aligned against Microsoft.” Another negative is competitive threats from Google, which is subtly rolling out spreadsheet and word-processing capabilities. “We know Microsoft can go up, we just feel like the stocks we own can go up more,” says Turner. Finding tech companies that are growing fast at any given time is fairly easy, in Turner’s opinion. The hard part is determining how long those companies can keep growing fast. Those that grow fast and for a long time will be the leaders.

Litman/Gregory Opinion

Vanguard Growth Equity was up 6.2% in 2006, underperforming the Russell 1000 Growth Index iShares benchmark, which was up 8.9%. Although the fund’s performance history dates back to March 2002, we start the record in 1997 when Turner changed the portfolio-construction methodology for comparably run institutional accounts, switching from an equal-weighted product—it held around 100 holdings with 1% positions—to allowing individual positions to account for up to twice the stock’s weighting in the Russell 1000 Growth Index. Since changing the portfolio-construction methodology in 1997, the fund’s annualized return is 6% (through 2006), compared to a return of 5.2% for the Russell benchmark. (Note that prior to the iShares’ inception in May 2000, we use the Russell 1000 Growth index adjusted for expenses as the fund’s benchmark.) Looking at risk, the fund has been much more volatile than the benchmark. For example, the fund’s best and worst rolling 12-month returns are 69.8% and -56%, respectively. By comparison, the benchmark’s best and worst rolling 12-month returns are 31.5% and -45.7%, respectively. We expect the fund’s outperformance on the upside to more than make up for any underperformance in declining (or even flat) markets. Looking ahead, if Turner’s belief that growth stocks are primed to lead the market plays out, we would expect the fund to outperform.

We like that Turner uses a combination of fundamental, quantitative, and technical aspects in their investment process. We think the combination of these tools helps minimize the intuitive aspects of investment decision-making. While Turner’s process is disciplined and systematic, it is also flexible enough to adapt to changing market environments. A sector-neutral approach imposes an additional level of discipline in the stock-picking process. There are several other things to like about Turner, including the firm’s incentive/ownership structure, and a very positive corporate culture, which means that the team is likely to stick together. (There have been very few departures from the investment team.) Turner is also very attentive to asset growth and has a history of closing funds are very reasonable levels. Turner is the only firm that we know of that publishes updated asset-capacity studies for its various strategies on an annual basis. Another plus is that expenses on the fund are reasonable at 0.91%, and have declined as assets have grown.

Turner’s investment team has grown considerably since we initiated coverage on the firm in 2000. At that time, Turner had 10 investment professionals working in a portfolio manager/analyst role. The individuals were divided by sector, with each sector team covering stocks across all capitalization ranges, and making investment recommendations on stocks in those sectors. In late 2000, some sectors were covered by only one or two individuals. Over the last two or three years, Turner has grown the team and now has three portfolio managers/analysts covering each of the five key sectors (technology, health care, financials, consumer, and cyclicals). Turner is now hiring a fourth analyst for each sector team in light of the continued growth in assets (in the past three years, the firm has more than doubled its assets to more than $20 billion) and the introduction of international and global growth-stock portfolios, which are only available through separate accounts. The fourth members will be more junior, and will help with modeling, developing surveys to help gauge future earnings, and attending trade shows to gather industry information, etc. Turner says it’s possible that a fifth member will be added to each team in 2008. We should note that as the broader investment team has grown, we’ve spoken with a number of investment-team members, and we believe the process and philosophy is being consistently being applied across the team. We were also impressed with the depth and quality of the team’s research.

Turner has always had a team approach to investing, believing that collaboration leads to better decision making. We think the larger team is a positive for Turner. Having more eyes and ears on individual stocks and on each sector gives Turner a better ability to deal with the short-term “noise” in the market. Looking back a few years, Turner was more inclined to sell a consumer-related stock in the face of higher energy prices and a declining housing market. Today, a broader, more-informed team allows Turner to stick to their guns (sometimes adding to their position), and benefit from short-term misperceptions in the market. Our overall impression is that the team works very well together. A potential risk with a growing team is the increase in opinions, which can slow the decision-making process. We believe the team continues to work well together but will continue to monitor this issue.

We do not have any major concerns at this time and continue to recommend Vanguard Growth Equity for non-taxable accounts. Tax management is not an element of Turner’s investment approach, and as the fund’s high turnover suggests, there’s a potential for large realized short-term gains. We should note that Turner’s approach has been more successful among the firm’s smaller-cap products, such as Turner Mid Cap Growth and Turner Small Cap Growth and Turner Micro Cap Growth, which are closed to new investors.
—Jack Chee

_________________________________________________________________________________Reprinted Copyright© 2007 Litman/Gregory Analytics, LLC.