Q: Brian, let's begin with a short overview of Coventry Capital Management. Briefly, what do you do and how do you do it?
A: Coventry manages common stock portfolios primarily for individuals. The objective is to outperform the S&P 500 over a three to five-year period. For the most part, growth-oriented issues are emphasized. The starting point is to pick issues with projected earnings growth rates in excess of the S&P 500. If a client has a need for current income, high-quality fixed-income issues are used to provide current income. The common stock portion is kept intact for growth in a balanced account format. You look for fast-growing large companies that dominate their markets.
Q: Please describe what you are looking for in one of those companies.
A: Large capitalization growth companies have been the emphasis during the last several years and have performed very well. In the past two years, I have been adding medium-size companies to client accounts. The reason for this shift is that the medium-cap companies are good candidates for strong appreciation based on the prospects for above-average earnings growth on a two to three year basis relative to larger-cap companies. Regardless of the size of the company, I look at revenue and earnings growth, return on equity, new products that might be coming along and the company's price-earnings ratio relative to the estimated growth rate.
Q: How do you achieve high returns when your holdings are closely followed by everyone else?
A: I prefer to use issues that are followed by several analysts. I use a range of earnings estimates to construct a price range associated with those earnings expectations and develop a target price. There are several other factors which contribute to the price range, but earnings trend is the starting point. The target price can move with the upward or downward direction of earnings expectations. The return is a function of the projected earnings expectations. The direction and magnitude of interest rates and the growth of common stock earnings in the aggregate are the key areas of my focus. Stock prices move with the change in earnings growth, and that growth is affected by a change in the interest rates, which are the discounting factor in equity prices. In recent years, inflation has been low. As a result, we have had a stable discount factor during a period of very strong corporate earnings growth. Recent volatility has come from external factors such as the concern for the stability of foreign economies and their impact on the US economy. Of course, if US economic growth is stronger than that with which Federal Reserve is comfortable, there is always the likelihood of intervention by the Fed to slow economic growth.
Q: What individual factors do you look for in accessing the potential of a company as an investment?
A: Other individual factors include price to sales, price to earnings, price to cash flow, relative market multiples and earnings growth. These factors all converge to develop a trading range for individual issues relative to the S&P 500. I watch these factors on a forward rolling basis. Typically, these are the elements that I look for in the research that I use to build a working list of stocks.
Q: Of these factors, which is the most important?
A: When building a working list of common stocks for client accounts, I look at issues from a comparative stance. First, I look at the historical earnings growth for the past five years and then the projected earnings growth for the next two to three years. The objective is to determine what the future growth rate will be and how much of that growth will flow to the expected stock price. The projected earnings growth of the stocks on my working list average is 15% as compared to 6% for the S&P 500. Issues in the 15% plus growth category are medium capitalization issues that I have added in recent years. These issues are some of the "new" growth issues of the market place. Shifts in consumer preferences to the products of the medium-cap companies are the driving force behind this category.
Q: Would you describe your strategy as bottom up or top down?
A: From an issue-selection viewpoint, the approach is bottom-up. With the bottom-up approach, the emphasis is to select individual companies that are expected to outperform the S&P 500 and other companies in their respective industries. From a sector viewpoint, top down helps to sort out the overall areas of investment. During the next few years, areas of growth emphasis within the U.S. economy will evolve around health care and technology products. Consumers need health care and technology products. Consumers also use energy and are active participants in the retail sector. Broad sector opportunities present themselves from a top-down view and top-down considerations serve to focus on the sector diversification within a particular account. The bottom-up view provides investment opportunities in new areas that may not receive much attention from a broad sector approach. If 25 to 30 issues are equally weighted in an account, each issue has to stand on its own numbers. I believe diversification of a common stock portfolio is a key discipline in money management.
Q: How much of your investing is determined by numerical analysis and how much by instinct?
A: Numerical analysis comprises about 80% of the input. The balance is judgment which comes from integrating all the factors into a model of past experiences. I have been managing money for about thirty-five years for equity and balanced accounts. In an equity account, the objective is 100% market performance. In a balanced account the market performance objective is tempered by the client's need for current income from fixed income investments. In the balanced account, the common stock segment is a only a portion of the account, but this segment is expected to provide principal and income growth to offset the effects of inflation on the fixed income segment. The starting point of the balanced account is the expected current return of the client. I have found over the years that a client with high current income needs should seek the current income from fixed-income investments and not stocks. The reason for this is that the income requirement pushes the equity segment toward high-yielding issues and the result is there is no capital appreciation in the equity sector. The judgment factor is important when determining asset allocation or changes in asset allocations. From a broad conceptual point of view, expected returns of common stocks must be compared with the expected returns of competing instruments such as bonds. Although several factors have been discussed here, it is important to note that in reality the weighting of factors will vary with the client's objectives. Each client has a different set up circumstances and objectives. When a client wants a 100% equity growth account, the judgments to be made are clear and well-defined. When a client has a growth objective with no asset allocation parameters, the manager has to be right in terms of the allocation and the issues selected. Something we have not talked about is quality of investment vehicles. I think investment quality should be high. I don't think anyone wants to compromise quality for additional unrewarded risk. Good judgment needs to be coupled with discipline.
Q: Does macroeconomics ever enter into your analysis?
A: From the trend standpoint it does. The direction and magnitude of interest rate changes are important because the consumer is impacted. The consumer is important because consumer spending represents 2/3 of GOP. From a sector standpoint, I look at overall consumer trends. Important trends evolve gradually and effect consumption. In the US economy, as consumers make new consumption choices, markets and investment options change. Opportunities in investment come from changes in consumer habits. The consumer has the financial power to support new products. For example, a few years ago during the period of gasoline shortages, consumers paid the pump price and then shifted to smaller cars. Consumers want and pay for mobility. As consumers got weary of the small car and believed the large car was desirable they shifted back to larger cars. I am a big believer that history moves in cycles. The popular sport utility vehicle is a case in point. These cars have replaced the station wagon because they are more versatile, safer and can carry more cargo than the old station wagons. The point is the American consumer has the financial strength to dictate changes in the products offered. In the beginning, only a few companies offered SUVs. Now the consumer has many choices of SUV manufacturers. Housing is another example. At one point people only lived in the suburbs and worked it cities. With the next trend change people lived in one suburb and went to work in another suburb. Maybe people will shift back to cities as suburban living becomes less attractive. Consumers want mobility and housing. If you add demographics and technology to these consumer trends, the strength of the consumer is more evident. Technology provides computers, telephones, and many other products of convenience. State of the art communication products are a third solid consumer demand. The population is aging and needs health care products. New drugs are available for a host of illnesses. Health care is a fourth consumer demand area evident in the current U.S. economy. Retailing has changed dramatically in the U.S. Retailers use income and age data to target their customer base. The internet is changing how people make purchases. There is a baby boomlet in process in the US, which augurs well for housing and retailing companies.
Q: What is the average cap size of the companies you typically buy and how high is your turnover?
A: The range of capitalizations is $400 million to $300 billion. Eighty percent of the issues are in the big cap range and the remainder in the medium-cap range. In addition to size, I need to mention domestic versus foreign issues. Many large U.S. companies derive sales and earnings from overseas economies. My preference is to invest in domestic companies for participation in overseas growth. The advantage is that the exposure to overseas economies varies from company to company. I would estimate turnover to be about 20 percent. Since most clients are individuals with tax consequences, I try to keep the turnover rate low.
Q: Do you ever buy smaller companies?
A: Not really. Comfort level is an important factor with clients. Clients like to be able to recognize most of the names in their accounts. Investing in emerging companies is a skill which takes great analytical ability. There are always opportunities in the small cap area and the best way to play small caps is to invest in a fund that concentrates on this area. The same could be said for investors looking for straight foreign-equity investment opportunities. A fund is the best investment vehicle. How many stocks do you typically hold and in how many different industries? Mr. Spengemann: In larger accounts, 25 to 30 issues is about the maximum number held. These issues would be in nine major sectors and roughly 15 industries. I have about 40 issues on my working list, which has been expanded slightly in the past two years. If you put 25 stocks in an equity account, each stock equally weighted is about 4% of the account. The account is well diversified with issues which have good growth prospects. The number of issues held and the industries emphasized is industries is the major consideration in money management. Attention to the sector and industry weightings of the S&P 500 is also important. Discipline becomes a major player after all the statistical work is done. I began a career in the investment business right out of college almost 35 years ago. During the past 20 years, financial markets have undergone considerable change and have become fiercely efficient. I still find this business exciting because I like to forecast change.
Q: What resources do you use for your research?
A: I buy research from two Wall Street firms and read several financial newspapers each day. I receive fax reports three times each day from my primary research source. Company and industry reports are brief and to the point. Economic and financial market commentaries are also covered in these reports. Your volatility is just a little above the S&P.
Q: How do you find growth-oriented companies with such low volatility?
A: It really depends on the method used to build a working or buy-list population. The equal-weighted beta of my population is 1.05 and the estimated earnings growth rate is 15%. There are stocks in the list with a beta less than the market and earnings growth greater than the S&P 500. If the price-earnings ratio is close to the market, there still is room for growth. I believe that a stock can be attractive if the price-earnings ratio is less than the forecasted rate. High-growth issues sometimes experience relative underperformance in the short term. In the long run, a growth-oriented account will fare better than the other disciplines. High-growth issues experience period of relative underperformance in the short term. In the long run, a growth oriented account will fare better than other disciplines. Your performance seems very consistent.
Q: How do you keep it that way?
A: With the objective to outperform the market and the investment markets being efficient, I have found from my experience that a 1.05 beta stock population works. Solid growth companies tend to keep earnings flowing at a favorable rate. In many cases, the worst that happens is that growth may slow down a bit in a recession. That is why a shift to more defensive issues would occur because market conditions require a shift in the asset allocation. By all measures the stock market is now in record territory.
Q: If we hit a bump in the road will this affect your investment strategy?
A: A gradual shift to more defensive areas would be the strategy shift. If you are monitoring the gains and the issues are at their targets or above, the idea of locking profits is a good idea. The S&P 500 is selling at 22x 1999 estimated earnings. From the current level the S&P 500 could move ahead by at least another 5%. You really have to look at the individual issues on a daily or weekly basis. The larger equity accounts get priced daily in relation to target prices. Next, the issues get sorted top down by rate of return on cost. Performance is calculated for several periods relative to the S&P 500 and the projected target composite account value. At this point, judgment and discipline are needed. A major part of the battle is getting the working list right. The rest of it is getting the issues in the client's account and monitoring the account. Everything comes into place here: the criteria, the objectives, the numbers, the judgment, the diversification and the discipline.
Q: How do you find undervalued stocks when the market is trading at lofty price-to-earnings multiples?
A: The value is a function of where the stock price is relative to the target price. There appear to be issues in the energy area that would fit in the undervalued area. Even though oil prices are down , the oil companies are expected to experience earnings increases next year. Maybe oil companies stocks don't fit in to a growth category for some people, but their products are needed by consumers. Consistent moderate growth is better than no growth.
Q: Do you ever time the market or build up cash when you think the market is overbought?
A: Yes. One of the things I consider is the competitiveness of an expected bond investment rate of return compared to expected equity rates of return. ln a nutshell, one must link the dividend yield with the growth rate of equities investments. If the dividend yield is 2% and the growth rate 6%, the forecasted rate of return for equities would be 8%. If on the other hand, U.S. Treasuries are yielding 5.50%, then it would appear equities have the edge. Earlier, I mentioned the magnitude and direction of the change in yields. If we were to move toward a more inflationary environment with yields rising, it is likely that equities would lose their most favored status in current markets. This type of environment would suggest a trimming of equity positions is appropriate. Although there are many factors to watch, equity investing is about earnings growth rates and the discount rate applied to earnings.
Q: Tell us a little bit about your background and why you founded Coventry.
A: My background began in research and evolved to portfolio management. Along the way I learned from people with a lot of experience. I founded Coventry because I wanted to start an investment management firm that would reflect what I learned at Mercantile Trust as an analyst, at Harris Trust as a portfolio manager, and at Brown Brothers Harriman as a portfolio manager. I have been fortunate to have learned disciplines from some of the best investment thinkers in the US. In my mind, Coventry reflects a combination of these principles.
Q: Why is Coventry different from other firms?
A: Coventry is different because the firm reflects experience drawn from past experience during bull and bear markets. Tailoring this expertise to the needs of the particular client is our primary vocation.
Q: What kind of investor would be most comfortable with your investment style?
A: The investors most comfortable with the investment style of the firm would be those investors who want to put a growth-oriented investment management philosophy in place in their accounts. In addition, investors with a three-to-five year investment time horizon and $500,000 or more in investable funds would find the Coventry style suited their needs.