NEW YORK, March 14 (Reuters) - The manager of one of the best performing large-cap growth stock funds over the past five years is a value investor at heart.
Dennis Lynch, portfolio manager of the $1.3 billion Morgan Stanley Growth fund, sets out to find what he calls “emerging franchises”.
Those are businesses in the process of creating a brand or service that will resonate with customers and have a margin of safety from competition.
It’s an approach more akin to the Warren Buffet school of patient investing rather than simply buying the next hot stock.
That’s even if even if the companies in question, such as Amazon.com Inc and Facebook Inc are high-priced and technology-centered, the sort that are a far cry from the railroads and insurance companies Buffett typically likes.
“We are trying to collect the companies we think are the most unique and the most underpriced,” Lynch said.
The strategy has worked well for Lynch’s investors. His fund has returned 49 percent over the last 12 months, and an average of 29 percent a year over the last 5 years.
That performance puts him 26 percentage points ahead of the benchmark S&P 500 index. It also lands him in the top 1 percent of the 1,778 large-cap growth funds tracked by Morningstar for 2013, and led Morningstar to name him the U.S. domestic stock fund manager of the year.
Some of that out performance can be attributed to a decision to add Tesla Motors Inc to the portfolio in February 2013. It rallied more than 500 percent over the next 12 months, leading Lynch to cut approximately a quarter of his position.
More often, though, Lynch focuses on companies that rely on the Internet to disrupt established industries and establish their own brands in the process.
Roughly a third of his portfolio, ranging from Twitter Inc to Priceline.com Inc and Groupon Inc, is invested in companies tied to the Internet. That compares with 8 percent of the Russell 1000 Growth index, according to Morningstar.
When evaluating a stock, Lynch will look first at its free cash flow, and then begin building a case for where the company can be in the next five years.
It’s a process he learned while attending Columbia Business School, where investors like Warren Buffett and hedge fund manager John Griffin lectured in his classes.
He typically only adds a handful of companies a year to his portfolio of 47 stocks, and doesn’t set hard target prices to tell him when to sell.
Lynch puts less emphasis on valuation metrics like price-to-earnings and more on trying to spot advantages that don’t show up on a balance sheet.
That’s partly because he invests in large cap companies, the section of the market where it’s the most difficult for an investor to gain an informational advantage.
“We’re looking for those cases where numbers don’t tell the whole story because a company has a very significant competitive advantage,” Lynch said. “Even though there are a lot of numbers in this business it’s less scientific than you think.”
Case in point: Amazon, which Lynch first bought at between $30 and $40 a share after the dot.com crash 11 years ago.
Investors at the time questioned Amazon’s strategy of plowing most its profits back into the business and missed the fact it had the potential to up-end retailing, Lynch said.
Amazon, which closed above $371 per share on Thursday, has a similar opportunity to expand its cloud-based services for businesses, Lynch said.
Though Lynch is not worried that Internet-related stocks are in any sort of bubble, he has been filling out his portfolio with companies that have no technology aspects as well.
More recently, he’s added to his positions in luxury fashion brand Christian Dior SA and infant formula maker Mead Johnston Nutrition Co, the company behind Enfamil.
He likes Mead Johnson because hospital use and doctor endorsements of its formula gives it a unique position among childcare products and represents a recurring revenue stream that should grow as it expands into emerging markets.
Mead Johnson’s shares have slid 0.3 percent since the start of the year and trade at a forward price-to-earnings ratio of 19.5, slightly above the market average.
Given Lynch’s habit of straying far from his benchmark, investors should be prepared for some periods of underperformance, noted Janet Yang, an analyst at Morningstar who follows the fund.
But its track record suggests investors will be well-served over the long term, she added.
Investors in the fund will pay an annual expense charge between 72 cents and 97 cents per $100 invested, a fee level in line with the average actively-managed stock fund.
The fund pays a dividend yield of 0.3 percent. (Reporting by David Randall; Editing by Sophie Hares)