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   Interview

    Guest Interview:

   Equity Assets Mgt.

    1875 Ski Time Square Dr. Ste. 1
    Steamboat Springs,CO 80487

    Telephone: (800) 879-1189
    Fax: (970) 879-1272
    E-mail: info@jahi.com

 

    Interview Quarter: 1Q1996

 W. Howard Cammack Jr.,

 President

Q: Please explain the various products offered by EAM.

A: EAM is a specialty equity manager with a single area of investment emphasis - small cap growth stocks with a market cap of up to $500 million at time of purchase. A recent study estimates that 75% of all U.S. stocks have a market cap below $300 million. This presents an enormous supply of opportunities. But, with opportunities comes confusion, so we enforce a stringent process to weed out problem areas and focus upon that which we consider to hold the greatest potential. We invest in companies with at least 20% earnings growth but never pay over 15 times earnings so as to purchase growth at a 25% discount (for the past several years we have been able to purchase growth at a 70% discount to growth). We eschew extremes such as concept stocks (bio-tech), economically sensitive areas (banks, utilities, gold and oil stocks, etc.) and market timing. We don't believe anyone can successfully time the market, and, in fact, studies too numerous to mention here handily support that guessing the market is a risky, risky proposition. When it comes to the broad economy, there are just too many industry specialists, strategists and economists attempting to gauge the next tedious morsel tossed about by the Fed or trying to hash over some piece of extraneous minutia provided by the government, which will only be restated in the next 30 days. Instead, we prefer to invest where the information is less competitive, where we can be ahead of the information curve. That is, we look for companies where an internal change is dramatically increasing earnings growth. We only invest in companies with real products and identifiable earnings flow in order to verify our research through cross-checks with distributors, suppliers, competitors and customers. We do this because there is little availability of public information on these stocks, because they are less well known, and we don't want to rely solely upon the word of management. Accordingly, we-cross check information with an outside source who is in a position to know something about the particular company of interest - usually someone doing business with that company. Typically, we prefer to talk with a distributor of the company's products, a supplier, a competitor and when possible a customer Our experience is cross checking leads to new ideas and to new resources of information.

Q: How did EAM get started as an investment management firm?

A: EAM was founded by Frank Inman and Ward Cammack when the two were introduced by a mutual friend. Both had entered the investment business in 1979. Ward had been an equity analyst for Equitable Securities, an employee owned equity research investment banking firm with emphasis on small cap growth investing. Frank had been Head of the Institutional Equity Department for another regional firm. What were the greatest influences in developing your investment strategy? The greatest influence in developing our investment strategy was our attraction to and understanding of the small cap arena. But, the catalyst was our mutual consternation in seeing so many small cap managers mess up great operations by way of three factors - (1) too much money under management, (2) too many stocks in the portfolio and (3) too many people in the process. Accordingly, we put in place three tenets which serve as the foundation for our investment process. We vowed to limit our client growth at $300 million, to own a limited number of great companies and to manage using a tight team of professionals recognizing that research should be complementary, not competitive, within the firm. Small cap investing is not improved by staffs of industry specialists with self interests not consistent with a generalist effort. The straight-forwardness of our operation augments our philosophy of investing in easy to understand, well run companies combined with the recognition that 75% of all U.S. companies have a market cap below $300 million. This is the end of the market where new stocks enter public ownership so we don't want our research segmented. Within this universe are a virtually endless selection of well run, fundamentally superior companies with committed management teams and employees operating within defensible operating niches. By comparison, the large cap end of the spectrum is dominated by Wall Street and its legions of analysts, economists and corporate finance minions competing for deals and opportunities to recommend stocks with lots of shares outstanding. We believe this transaction oriented mentality is too competitive and at odds with achieving superior returns. In fact the focus of the Street really limits most research to the largest 10% of stocks, which by their size alone, are more cyclical and more complicated because they are multi-divisional, macro-economically exposed and thus less predictable.

Q: Could you please give us a brief history of EAM?

A: EAM was formed in 1989. We allowed the performance to incubate with a select number of accounts until a five year history was established at which time a broader marketing strategy began. Now we have over seven years of performance which has annualized at a rate of just over 30% as compared to 13% for the Russell 2000. The same investment process and discipline has been employed throughout. Initially, we managed a handful of accounts for individuals. Today our client base is comprised of individuals, family offices, private and national foundations and several significant pension plans. We also manage a small cap fund which is our largest account. Recently, in order to maintain the quality of our effort, we raised our separate account minimum to $3 million.

Q: Who are the major principals in the firm and what are their backgrounds?

A: The professional team is comprised of four people: Frank Inman, Ward Cammack, Brian Sites and Eve Robinson. As we mentioned Frank had been head of the institutional research area for Interstate. Frank is the Chief Investment Officer of the group which means he is has the final say on all investment decisions. While we all have a voice, we believe one person must be accountable. This contrasts to some firms where voting is the means of decision making. That's political and may be inconsistent with making the best decision and it may slow the process. Ward had been an analyst, and he also has a good deal of experience in the fiduciary arena. Today much of his time is spent running the firm and making sure we are in compliance on federal and state levels. He also oversees the systems from information technology to trading. Brian Sites had been a technology analyst for Robinson Humphrey. Brian spends a good deal of time on the road visiting companies and talking to managements. Eve Robinson had been with Morgan Keegan. She is our head trader, responsible for order entry and execution with various brokers and fourth market trading systems. We have complimentary backgrounds that provide an enormous amount of synergy. In addition, we all get along well and feel comfortable in challenging each other which we think is essential, because if we don't take each other to task, the market will.

Q: What does EAM look for in determining future earnings and revenue growth?

A: EAM seeks companies with real earnings, companies that are creating and shipping real products with an identifiable earnings stream that we can cross check with outside sources such as distributors, suppliers and competitors. Within this stream, we seek internal factors that are generating an acceleration in earnings per share such as a new product, a new manufacturing technology, a new distribution strategy or a new application of technology. This growth is slow to be recognized because of low analyst coverage and the quants typically miss out in the early stages because their screens tend to be reactive rather than proactive, which is what our process is all about. We want to benefit from the dual determinates of stock price appreciation. We expect positive earnings surprise to combine with magnitude of earnings growth to create multiple expansion in addition to earnings growth. Just as importantly, we never invest in sectors of the economy because of some macro forecast, we don't sector weight and we avoid economically sensitive companies. In other words, we would not load up on bank stocks because somebody thinks interest rates are going to decline. What if we were wrong and had bet a large part of the portfolio on such a hazy scenario? Similarly, we avoid banks because their revenues are sensitive to economic growth and interest rate fluctuations. What's more, they seem to restate their earnings every four to five years, so we cannot depend upon them for real growth anyway.

Q: Could you please explain what you mean by seeking companies that are insulated from broader economic forces?

A: Because we are seeking companies growing because of internal factors, we avoid like the plague companies sensitive to macro-economic events such as interest rate changes, swings in oil prices or other commodities. This pretty well rules out banks, utilities and gold stocks. We don't think anyone can consistently predict the course of the economy or the market, that's a loser's game which history shows is risky business anyway.

Q: What is the average capitalization of the companies found in your portfolios?

A: All other things considered, we will invest in a company with a market cap below $500 million. However, our average market cap tends to run around $250 million, which is where we like to be.

Q: How important is the internal financing capability of a company in your selection process?

A: Consistent with our search for internal events driving growth and our disdain for economic sensitivity, we prefer a company capable of financing 80% plus of its growth in order to further insulate it from macro-economic forces, particularly an increase in interest rates. Also, the window for Wall Street financing is fickle and banks aren't that dependable either. Accordingly, a company financing new earnings out of excess cash flow seems to provide some defensible qualities.

Q: How much emphasis do you place upon the quality of management?

A: Quality of management is imperative. We depend a great deal on the word of management and what customers and other industry sources say about that management and the people they attract. Despite competitive forces, competitors are forthright in their opinion of others in the same industry because that reflects upon everyone in that industry. Companies don't run companies, people do.

Q: Please give us some examples of the types of proprietary technologies you look for.

A: Proprietary technology is something we seek in the application rather than in pure technology. We are less interested in a product that browses the Internet and very interested in a technology that reduces costs and allows companies to compete more effectively. For example, we are invested in a company that creates a product that enables manufacturers to anticipate machinery break-downs in order to schedule maintenance so that in many cases plants improve operating capacity, improve profitability and receive an almost infinite pay-back for their investment in that product. We like this because it makes their customers more cost competitive, so they have a real reason to be in business. This is a product with huge market potential and really no competition. While this particular stock is valued at about 12 times earnings with a growth rate exceeding 30%, we believe it deserves a multiple well in excess of what it currently has. This turns us on more than the next Internet play which is far less predictable but with higher expectation hurdles.

Q: In your investment strategy, how important are momentum and valuation?

A: Momentum is a tricky word. If you are referring to magnitude of earnings growth, we like that. As for this momentum game that everybody's playing, that is just greater fool theory. But, we think its good for us that so many investors have switched to these computer screening technologies to pick stocks. It means that other investors know less about individual companies. In addition, if they are investing in momentum, they are investing in a trend after it has occurred. We seek change at the inflection point. In fact, we consider EAM to be a pre-momentum investor. Accordingly valuation, in conjunction with magnitude of earnings progression over consensus expectations, is important if we are to receive multiple expansion. We will not pay over 15 times forward 12 month earnings and will sell automatically any stock reaching 30 times our forward 12 month estimates. Usually, when divesting, we are selling to the momentum players who are reacting to information we have already researched and from which we have benefited.

Q: How do you minimize risk in your portfolios?

A: We minimize risk by avoiding that over which we have no control such as the economy or market volatility. We manage fully invested portfolios that we consider to have fundamental characteristics superior to both the economy and the market at much more attractive valuations. Over time, we expect this superiority to provide above average returns. We also attempt to mitigate risk through our harsh sell disciplines which include forced displacement by a better idea, selling any stock that reaches 30 times our forward twelve months estimate, selling any stock for which the P/E exceeds the growth rate and selling because of deteriorating fundamentals.

Q: Under what conditions would you consider selling a stock?

A: We own a limited number of stocks in the portfolio so we must sell a stock in order to add a new position, i.e., forced displacement by a better idea. Essentially, this discipline is a wedge for prying apart our maximum P/E of 15 at purchase and minimum growth rate of 20%. At this time our earnings estimates indicate an average P/E of 13 with an average earnings growth of 50%. We also sell any position reaching 30 times our forward twelve month estimate. We automatically sell any stock where the story changes by way of a negative development. All these factors keep us focused on our best ideas. Our observation has been that many managers are lured into owning that next idea so that pretty soon they have a hodgepodge of things which they know less about. We want to keep the portfolio as fine tuned as possible all the time.

Q: Is there a particular price earnings ratio which you favor?

A: Oh yes! We use a maximum purchase P/E of 15 times our forward 12 months estimates because that has been an average P/E for the market over time and thus can be justified. Conversely, we sell at 30 times earnings because that is a P/E which is unsustainable. We recognize that a stock valued at 30 times earnings, no matter how much we like it, somebody owns more of it than we do, they paid a higher price than we did, they have higher expectations than we do and they are more susceptible to disappointment. We don't want to bear the brunt of somebody else's mistake when they rush to sell a stock by which we may have already made a significant return. Portfolio management, despite all talk of reward, is really about controlling risk by not doing something stupid. In the investment markets, that is often related to becoming emotionally involved.

Q: What are the sources from which you get your research?

A: Research is conducted internally though we continue to expand upon a proprietary network of sources over the past seven years. This network consists of venture capitalists, financial restructurers, a handful of exceptional analysts at remote regional firms (definitely not in New York) and managements in many of the companies in which we have invested.

Q: Is your approach based upon a mathematical formula? If not, how does your decision process arrive at your final stock selections?

A: You might say that because we never pay over 15 times earnings for at least 20% growth, that we attempt to purchase growth at a 25% discount. Currently, the market is affording us 50% growth by our estimates at an approximate discount of 70%. By this measure, the larger indices have valued their stocks at a premium exceeding 100%, based on next years earnings. This seems rather ridiculous given that large cap companies tend to be multi-divisional, so they have more facets exposed to the broad economy, they are more complicated to operate and certainly to research. Our approach is based on fundamental analysis, that which we can see and test. We build earnings models that may go out as far as 18 months which is as far as one can reasonably predict. We think three year models typically used by Wall Street are fairly useless. The problem with most research is that it attempts to forecast too far into the future, this process takes too long to construct, is too uncertain and therefore risky in both a business and opportunity sense. We prefer to learn what we can in the most efficient way possible and get on with it by way of a mosaic which can never be 100% complete.

Q: What kind of turnover do you have in your portfolios?

A: Turnover has averaged 75%. Delving deeper, we find that we tend to hold winners and sell the losers fairly rapidly. Why do you favor small cap stocks over mid to large cap stocks? We favor smaller companies that are easier to operate and understand than multi-divisional companies that never seem to hit on all cylinders and tend to be more cyclical because of their broader exposure to the economy. Small companies have an average of two analysts providing some coverage, which translates into greater opportunity for us, in comparison to large cap stocks which often have 15 to 30 analysts conducting very intensive research so there is less chance of an information edge but a greater chance of an unpredictable problem. It's basic risk/reward.

Q: At which point would the asset size of your firm begin to negatively impact your investment strategy?

A: We could have difficulty managing if we exceed $2 billion under management, but we think that is one of the great challenges of small cap - big assets and small stocks are not congruent with superior performance That is why we plan to close our doors to client growth as we approach $300 million under management. Simple math tells you that a manager with $2 billion under management and 70 positions not wanting to exceed owning 5% of any company must have an average market cap of at least $600 million. This means a manager that size may have difficulty investing in most of the stocks we own. We would rather appreciate to that point than simply add clients and run a greater risk of disappointing our investors. We think we have room to grow and we are very enthusiastic. This appears to be a good time to be investing because of the values and growth rates we are finding that meet our criteria. So we are really pleased to be doing what we have been doing all along!

 
 
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