To my clients, here is a new fund I have started adding to many of your portfolios. I have just finished my due diligence on this fund so it was not included in your year end rebalancing. I am very excited to add this fund to our stable of high quality investments.
If is difficult to find good small cap managers that have a great track record but does not have too much under management. Many small cap fund under perform because they have more than $500 million under management.
This is a no load and no commission fee fund. The annual expenses are very reasonable for a new fund. I will be sending out the Morningstar Extended Report on this fund in the next two weeks. In the meantime, enjoy this research report.
I am in Santa Fe New Mexico the rest of the week on a due diligence trip to Thornburg Management. I will report my findings when I return.
Libby Mihalka
The Financial Pragmatist
January 2007
DUE DILIGENCE REPORT : TrendStar Small-Cap Fund (TRESX)
Category: Smaller-Cap Growth at a Reasonable Price Managers: Tom Laming and James McBride
We recently completed due diligence on TrendStar Small-Cap Fund and we are adding it to our Recommended list in the Smaller-Cap Growth-at-a-Reasonable-Price (GARP) category. Our history with lead portfolio manager Tom Laming dates back to late 2003, shortly after he left Kornitzer Capital (advisor to The Buffalo Funds) to establish TrendStar Advisors. At that time we identified a number of positives, but because we felt that getting a business off the ground could create a number of distractions and divert Laming’s attention away from investing, we decided to revisit the fund at a later date. We re-established contact with Laming a few months ago with a focus on the firm’s small-cap product, an asset class where we have a limited number of Recommended investment options that are available to new investors. We have since had several hours of phone conversations with Laming and co-manager James McBride. We also met with Laming for three hours in our Orinda offices. In the end, we gained a high level of confidence that the fund will outperform an index fund over time. This report lays out the firm/team background, the investment philosophy and process, the portfolio-construction process, and the reasons for our positive opinion of the fund.
Team and Firm Background
TrendStar Advisors was formed in August 2003 shortly after Laming and McBride left Kornitzer Capital. Laming joined Kornitzer in 1993, and subsequently served as the chief equity strategist and was the lead architect of the investment philosophy and process that was used to manage the Buffalo mutual funds. Laming also served as co-lead portfolio manager on Buffalo’s small-, mid-, and large-cap funds as well as a global fund. He was the sole manager of Buffalo Science & Technology Fund. McBride was a research analyst at Kornitzer from November 2000 to August 2003, and he also worked on all of the Buffalo equity funds.
Two months after establishing the firm, Laming introduced TrendStar Small-Cap Fund and TrendStar American Endeavor Fund. Laming manages these funds with the same investment approach he employed at Kornitzer. The Small-Cap fund focuses on domestic stocks with companies less than $2 billion in market capitalization at the time of purchase. American Endeavor Fund considers only U.S.-based companies that receive more than one-third of their sales or income from outside the U.S. This fund is all-cap by prospectus but is, in fact, mostly large-cap. Both funds are co-managed by Laming and McBride, although Laming is the lead portfolio manager.
TrendStar currently manages approximately $400 million, including separate accounts.
Philosophy/Process
Laming starts by looking from the top-down for fast-growing companies followed by a bottom-up analysis that focuses on valuation. He first looks for broad industry trends, and ideas can come from trade publications, industry research, contacts, and company filings. Specifically he’s looking to identify growth drivers that he thinks will provide tailwinds for the revenue lines of companies over the next three to five years. Importantly, he only invests in trends that he believes have a high degree of predictability. For example, demographic trends have very predictable outcomes, enabling Laming to determine with good accuracy how many people are in various age brackets and what segment of the population is growing the fastest. Laming says 45- to 64-year-olds will grow by over 18 million people between 2000 and 2010. Over the same time period, companies that sell to 25- to 44-year-olds will see their end market shrink by a few million people.
This top-down portion of the process gets Laming focused on the faster-growing segments of the market. He then identifies companies that are aligned with these longer-term growth trends. Companies that do not appear to be primary beneficiaries of a trend are eliminated from consideration. For example, within the demographics trend, grocery stores would not qualify as a primary beneficiary. Although they sell to 45- to 64-year-olds, they also sell to the slower-growing (or declining) segments of the population, which dilutes their growth prospects. Instead, Laming seeks out companies such as Ethan Allen, a retailer of home furnishings that targets the rapidly growing population of 45- to 64-year-olds. This process of identifying companies that have the most direct exposure to a long-term trend narrows the investable universe (stocks under $2 billion in market-cap) to roughly 350 to 400 stocks.
Once a company passes the top-down trend qualification, Laming turns to valuation. He determines whether a stock is overvalued or undervalued using a multiple-regression model that allows him to analyze several variables that contribute to a stock’s valuation. (This is in contrast to other valuation methodologies that rely on a single variable such as a P/E multiple.) The key variables Laming looks at are profit margins, growth rates, and balance-sheet quality, although there are other less-important parameters. Laming uses regression to determine the importance of each variable for stocks’ valuations. For example, Laming’s regression analysis suggests that margins have the highest correlation to stock-price movements. So, all else equal, higher margins warrant higher stock prices. But margins are not equal for all companies, and Laming must estimate a value for each variable in order to arrive at a stock price. In doing so, Laming devotes a lot of time to studying a company’s historical profit-margin structure as well as margins within an industry to assess whether a company can maintain or improve its margins. He tries to avoid companies with declining margins, as it would translate into lower stock prices. Laming often uses a normalized margin in his model. He also estimates growth rates, which are ultimately tied to the strength of an underlying trend, as well as the balance sheet. Strong balance sheets are important to Laming because he wants to hold companies that can grow organically, not those that are dependent on capital markets for growth. The regression provides a measure of relative valuation, with the end result that roughly half of the companies in Laming’s universe will appear expensive and half will appear undervalued. The regression is only run on the companies that pass the top-down screen.
Ultimately, Laming ends up looking at a blend of high-P/E stocks and some very low-P/E stocks. But in all cases the high P/Es are associated with a combination of very high profit growth, and typically low or no debt. The low-P/E stocks are generally companies with lower margin structures (such as retailers) and they may have higher (but not excessive) debt.
Sell decisions are typically the result of rising valuations or changing business models (e.g., a company changes its business focus or makes an acquisition that meaningfully dilutes its ability to benefit from a trend). Sells generally don’t result from changing themes. This is because Laming looks for long-term trends (not fads) that can ideally persist for at least five years.
The Portfolio
The portfolio has 50 to 60 holdings, which is more concentrated than most small-cap funds. Laming doesn’t buy stocks over $2 billion in market capitalization, though they can appreciate past that level; at the end of March 2006, all of the holdings were below $4 billion. Typical position size is 1% to 3%, and position size is largely determined by valuation, although the strength of a trend and a company’s long-term ability to benefit from a trend come into play. There are no sector limitations and the fund will generally be concentrated in the health-care, technology, financial, and consumer-discretionary sectors, all areas with favorable long-term trends, in Laming’s view. Turnover has been very low at 10% to 15%. The fund is usually fully invested.
Style Analysis
As part of assessing a fund’s performance, we spend a lot of time evaluating a manager’s investment style to ensure we are using the most appropriate benchmark. We do not employ hard-and-fast rules for determining investment style. Instead, it’s a mosaic, which includes a number of quantitative and qualitative factors such as a manager’s investment objective, valuation methodology, the aggressiveness of a manager’s assumptions, investment horizon, historical portfolio and sector weightings, etc. Selecting the “best” benchmark can be a tough call if the fund has attributes of different investment styles. But this is an important step in understanding how a fund should perform in different market conditions, and it enables us to stick with a manager during an inevitable period of underperformance (provided our original thesis is still intact). After going through this analysis for TrendStar Small-Cap, we are categorizing the fund as Smaller-Cap Growth at a Reasonable Price, though it has a growth bias.
Laming’s top-down approach generally leads him to the growth-oriented parts of the market, and the portfolio’s sector weightings tend to be more in line with the growth benchmark. While there is definitely a growth emphasis, we feel that there are a number of characteristics that push Laming over into the GARP category. First, he is conservative in his assumptions. We discussed several portfolio holdings with Laming, and there was a clear consistency of using conservative estimates when it came to selecting forward-looking inputs in the regression model. Second, Laming is more valuation sensitive than most growth investors we follow. His valuation methodology ensures that he does not overpay for growth, and he will not own stocks if he thinks the future growth expectations are reflected in a stock’s price. His valuation process also leads him to own the cheaper stocks within his universe. For example, if there are a handful of stocks that he believes will benefit from a trend, he will own the stock(s) that appear most undervalued. This valuation requirement will take the fund out of the hottest-performing sectors prior to a market peak, and could cause it to underperform a growth benchmark during those periods (e.g., the late 1990s).
Performance Analysis
Laming’s track record at TrendStar begins in August 2003, which is a relatively short track record to evaluate. In looking for a longer track record to analyze, we assessed the “transferability” of Laming’s record from Buffalo Small-Cap, which he co-managed since 1998.
We came away confident that Laming was the lead architect of investment philosophy and process used to run the Buffalo mutual funds, and that he is using the same process to run TrendStar Small-Cap. However, we are only comfortable looking at the Buffalo Small Cap record beginning in 2001 for the following reason: In examining historical portfolio holdings for Buffalo Small Cap, we noticed a number of holdings that were not consistent with the long-term trend strategy that Laming uses at TrendStar. For example, energy was a meaningful percentage of the Buffalo Small Cap portfolio prior to 2001. We know that Laming will not own energy stocks because of his focus on long-term predictable trends, as guessing the price of oil is not something he’s going to attempt to forecast. There is also evidence of other stocks not fitting Laming’s current-day thematic process. Our analysis indicates that Buffalo Small Cap was initially managed using a broader Kornitzer Capital strategy (one that was used to run the firm’s separate accounts and was not confined by trends) to Laming’s current-day philosophy and process. So given that there was not a hard-start date for when Laming’s trend-based process went into effect for Buffalo Small Cap, we are only comfortable looking back to 2001. But while we believe this portion of the Buffalo Small Cap record is relevant, we put the most weight on his TrendStar record.
Since 2001, Laming’s annualized return (through November) is 11.7%, compared to 9.7% for the Russell 2000 Index iShares. This outperformance can be traced to 2001, when the fund gained 31.2% compared to 2% for the benchmark. This staggering outperformance was due to strong-performing positions in consumer staples, consumer discretionary, and financial stocks, and a lack of declining technology and energy stocks. In subsequent years, performance is mixed and Laming’s short- to medium-term numbers are trailing the benchmark due mostly to a relatively poor 2006. Looking at rolling 12-month periods, Laming has beaten the benchmark in 67% of the periods. But this number improves to 94% when looking at rolling three-year periods. We expect Laming to be out of sync with the benchmark over shorter time periods given his long-term focus.
Litman/Gregory Opinion
After numerous conversations with Laming and McBride, and internal discussions among our research team, we have gained the necessary confidence to add TrendStar Small-Cap to our short list of Recommended funds in the Smaller-Cap Growth-at-a-Reasonable-Price category. Adding the fund to our Recommended list reflects our confidence that the fund will outperform the benchmark over the long term. Below we lay out the reasons supporting our positive opinion of the fund.
On the qualitative side, Laming employs a clear discipline for investing in long-term trends and identifying companies that stand to benefit from these trends. Laming and McBride apply their process very consistently and are rigorous in how they measure trends to ensure they can persist. Laming is also very patient and he will not invest until he is highly confident that he’ll get paid over time. He is extremely thoughtful in his trend analysis, and we believe this constitutes a large part of his investment edge. Our impression is that he knows his industries as well as, if not better than, the competition. We also think he does an excellent job at the company level where he considers factors such as companies’ competitive advantages, the threat of potential new entrants or substitute products, and bargaining power with suppliers/buyers. We also have no reason to believe that Laming is missing attractive trends. We discussed a number of possible trends with Laming, but he had clear reasons for not investing in those areas. He is currently invested in 19 trends.
Laming strikes us as a very intelligent and thoughtful investor. He has clearly thought out his process and he is always looking for ways to improve the valuation model, or at the very least, understand the model’s shortcoming so that he can factor that into his qualitative decisions. He freely admits mistakes and figures out where he went wrong in an attempt to avoid them in the future.
Laming does not attempt to chase performance or pick any given year’s best-performing sector. When to buy and sell stocks is determined exclusively by the valuation methodology. Laming has clearly developed this methodology over the years. While this is noteworthy on its own, his adherence to valuation is equally important. Ultimately, owning the less-expensive stocks in his universe and carefully monitoring risks should help reduce downside.
Another positive is Laming’s shareholder orientation. For starters, he is very committed to managing asset growth. Current assets in the strategy total $390 million, of which $260 million is in the fund. Laming estimates that total small-cap capacity is between $1 billion and $1.5 billion. But, he plans to close the fund to new shareholders when assets reach $400 million. In fact, he has written this closing level in the fund’s prospectus. We applaud this decision, as capping assets is an important element in preserving managers’ ability to maintain their investment process. This is especially true for small-cap managers where asset growth can hurt performance in the form of the dilution of best ideas because they are forced to own more names, higher transaction costs, as well as higher market-impact costs from moving larger blocks of stocks. Laming is clearly not an empire builder. Another plus is the fund’s reasonable expense ratio. Considering the fund’s small asset base, fund expenses (1.39%) are quite reasonable. This is made possible by a very low (for a capacity-constrained small-cap fund) management fee of 0.7%, which means expenses have more room to decline as assets grow. Laming is also the largest shareholder of both TrendStar funds, aligning his interests with shareholders’. Laming is also tax-conscious and pays attention to tax lots, short-term and long-term holding periods to minimize tax liabilities.
We do not have any major concerns with the fund. We did question how well Laming and McBride could stay on top of their universe of stocks that they have identified as beneficiaries of trends, evaluate competitive threats, and generate new ideas. We came away confident that they are not stretched too thin, due in part to their strict discipline of only buying stocks that are beneficiaries of long-term trends, which includes significant up-front analysis that enables them to know companies within that industry very well prior to investing. They also use the valuation methodology as a prioritization tool, and have a process for reviewing portfolio holdings on a consistent basis.
While there is a clear emphasis on growth, we feel that TrendStar Small-Cap is best categorized in the Growth-at-a-Reasonable-Price (GARP) category. Investors interested in using this fund should keep Laming’s long-term orientation in mind, as there will undoubtedly be periods when his focus on long-term results is out of favor. As always, we will continue to stay in touch with Laming and provide ongoing updates.
—Jack Chee
_________________________________________________________________________________Reprinted from AdvisorIntelligence. Copyright© 2007 Litman/Gregory Analytics, LLC.
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