William Chester, manager of the $39 million Westcore Select fund, has the same dream as many other growth-oriented investors: Catch a company at its key point of growth inflection—when its earning growth rate stops being flat and starts to climb.
How does one stay ahead of the market and find those gems before everyone else? Chester says that there's no one secret ingredient. But he thinks it helps to narrow his sights on a very small number of stocks. His portfolio usually consists of about 20 to 30 picks. Is Westcore Select "the little fund that could"? Its numbers are more than respectable. The fund is up 17 percent so far this year vs. 7 percent for the Standard & Poor's 500 index. The fund's average annual return over the past three years is 15.9 percent, and 15.8 over the past five—that's 6.4 and 2.9 percentage points over the S&P, respectively.
While an inflection point in earnings growth is what catches his eye, Chester says that forecasting a stock's future performance ultimately determines whether or not he buys. And that forecasting couldn't be done, he says, without a close knowledge of individual sectors, generated from his team of analysts. They combine those industry-specific insights with the company's projected revenues and earnings to come up with a price target of where the fund would sell the stock. Chester will buy only if that target is 20 percent higher than the current price. He says its "typical" for a stock he's interested in to be generating 20 percent return on equity, the company's efficiency at making profits from every dollar of net assets.
One such stock was St. Jude Medical, a manufacturer of medical defibrillators and other medical devices. In an example of the industry-specific research that drives his stock-picking process, Chester says he observed a number of "technical problems" afflicting St. Jude's competitors in the defibrillator market. He also liked the high barriers to entry in that market, another quality he looks for when picking stocks.
Chester understands that some investors might be intimidated by the highly concentrated nature of his fund, which contains only mid-cap stocks. "When people think concentrated, they think higher risk. They focus on large-cap because they're perceived to be of lower risk." But Chester tries to eliminate excess risk by maintaining a well-diversified portfolio to hedge against market volatility. Right now, the portfolio has 25.2 percent of assets in the information sector, 56.6 percent in services, and 18.3 percent in manufacturing. The service stocks are fairly evenly divided between healthcare and consumer, business, and financial services. His information technology picks mainly come from hardware and manufacturing mainly from industrial materials.
Chester also doesn't allow individual stocks to dominate the portfolio. No single stock can be more than 7 percent of the fund. Apollo Group, which runs the for-profit University of Phoenix, is his largest holding at 5.5 percent through the end of October. The rest of his top three holdings are BE Aerospace and the T. Rowe Price Group, both at 4.8 percent.
So what are some recent growth stories Chester is excited about? As video game industry-watchers debate about who will win the latest round of the console wars, Chester thinks the real victor will be the company who has positions on all fronts. That's why over the last year he has emphasized Electronic Arts in his portfolio. They have a strong "ability to provide product on a variety of consoles," he explains The limits of that ability will be put to the test this holiday season as Electronic Arts releases its much-heralded rock-star simulator Rock Band on all the major platforms.
Before Rock Band wowed audiences at the major video-game conference E3 this July, Chester was already a believer in EA at a time, he says, when others doubted the company. EA had a relatively large amount of games coming out for the Sony Playstation 3, which has underperformed compared with the other new consoles. Chester says this exposure to Sony hurt its immediate outlook. It now has a bright future with the predicted sales success for Rock Band. Chester explains what he saw what others didn't with another ingredient for growth investing success: "the ability to look past the short term."