Funds’ Holdings Bust Their Britches
Tom O’Halloran’s goal is to buy stocks that will bust right out of his category.
O’Halloran, portfolio manager of Lord Abbett Developing Growth Fund, buys small-cap growth stocks. But he doesn’t want them to stay that way.
“We want the small-cap stars that can become mid- or large-cap stars within one to seven years,” O’Halloran said.
He has had a few of those lately. The fund sold solar power company First Solar () last year when it was near $20 billion in market cap. The stock rocketed nearly 800% last year. Another solar company, SunPower, () reached $10 billion in market cap when the fund started cutting it back.
O’Halloran starts small. His universe typically ranges from $500 million in market cap to $2 billion when he first buys.
He wants companies that are growing sales at least twice as fast as the economy. In a normal environment of 3% growth in the economy and 3% inflation, he’s seeking at least 12% sales growth.
Financial strength is another key. Developing Growth seeks a strong balance sheet and it prefers profitable companies.
He and his team of five small-stock analysts dig into the company’s fundamentals. A good business model is vital, and favorable industry forces help, O’Halloran says. They look for competitive advantages and strong, credible management, too.
“If a company is good on all four of those, we consider it a very fine business,” O’Halloran said.
That narrows the 3,000 or so stocks that fit his size criteria to about 250. He trims that to about 120 holdings at any one time by focusing on growth characteristics.
He’s not only hunting for powerful growth, but also a trend in the right direction. He sold former highflier Crocs () last year when it said profit growth would slow from about 200% to 40% this year.
Stick To The Process
O’Halloran won’t stray from the fund’s process. “We view the process like the U.S. Constitution. It’s unchangeable,” he said.
The fund will sell a stock when the reasons it bought it have changed. The business model or management might have weakened, or the company could be losing share. Earnings or sales growth might have peaked. He’ll also sell if valuation reaches an extreme.
The fund has beaten its small-cap growth peers tracked by Morningstar Inc. for three straight years. That includes the fund’s whopping 35.9% gain last year that trounced its peers’ 7.6% gain and the S&P 500’s 5.5% return.
Developing Growth has beaten its peers and the S&P 500 over the past three-, five- and 10-year time periods, too. The fund’s 16.53% five-year average annual return tops peers’ 12.50% gain.
Last year’s outsized gains, he says, came mostly from “unusually good stock picking.” The bear market that started last year hasn’t been kind to many of these highfliers. Going into Wednesday Developing Growth was down 16.13% vs. 13.52% for its peers and 10.67% for the S&P.
New Oriental Education, () which teaches English to students in China, was an example. The stock soared 140% last year. Now a smaller holding, it plunged through its 10- and 40-week moving averages the past two weeks and is about 45% off its November high.
Sectors played a big part, too. The fund was heavy in consumer and tech stocks last year. It was light in health care and industrials. And the fund hasn’t owned banks for nine months, he says.
This year, that has changed. The fund is now overweight in health care, whose stable growth looks good in a slowing economy. Tech is about equal weight vs. the market, while O’Halloran is steering away from consumer stocks due to economic concerns.
Illumina () recently became the fund’s largest holding. The maker of genetic testing gear fits O’Halloran’s health care theme. Its sales have been growing in triple and high-double digits, it posts strong profit margins and it just settled a rival’s lawsuit. “That’s a major overhang that’s been lifted,” O’Halloran said.