Timing is everything. While many investors — professionals as well as individuals — are fleeing to the perceived safety of defensive stocks amid market volatility, T. Rowe Price’s Joe Fath says he’s looking the opposite way — toward growth stocks.
In particular, Fath, manager of $45.9 billion Growth Stock Fund (PRGFX), is shopping for big, secular growth stocks whose steep sell-off is making them into attractive bargain buys, he says.
Then again, that shouldn’t be a surprise. Avoiding the herd mentality enabled Fath’s fund to outperform the S&P 500 in 2018. Its average annual return also outperformed over the three, five and 10 years before that.
That four-way outperformance will earn the fund a spot in IBD’s Best Mutual Funds Awards rankings for the latest year. That will make the fund a repeat winner.
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Fath’s time for rotating into defensive stocks was in early 2018 and the prior year. Other investors’ more recent flight to safety has helped drive up share prices in Fath’s portfolio.
Fath is a longtime practitioner of investing in three types — or buckets — of growth stocks.
His secular growth stocks are innovative disrupters. He also holds cyclical opportunity stocks. Those stocks’ fortunes ride up and down, often in sync with the broader economy. Their holding periods in the fund are shorter than his average holding.
His third bucket holds what he calls special situations, which include stocks transitioning to growth orientation from value, and stocks benefiting from a lasting industry change. They can also be roll-ups — stocks that grow stronger through industry consolidation.
Fath, who is 47 years old, talked with IBD about his investment strategy from his office in Baltimore:
IBD: Many high-multiple growth stocks that led the market up also led it back down in November and December. Have you fled those names as well?
Joe Fath: Traditional defensive areas like utilities have done well this year and lately. But secular growth characteristics are powerful and can compound for a long period of time. When you look out two or three years, the secular stuff valuation looks attractive relative to defensive stuff that’s held up but doesn’t have much long-term growth.
Usually, that dictates to me at least a slow pivot back the other way — sell down some of that defensive stuff and lean into some of the more secular growth stuff.
IBD: Have you done that?
Fath: I haven’t done a lot of that yet, but the more the market comes off, the more interesting the secular stuff becomes.
IBD: So you’ve been identifying targets?
Fath: Yeah. That’s where I’m concentrating my look.
IBD: Any similarities between now and the beginning of the bull market in 2009, when many of the year’s top performers weren’t secular growth stocks?
Fath: There are more differences than similarities with the current environment vs. 2009.
Back then we were coming out of the Great Recession driven by the financial crisis. It was first about finding stabilization then followed by recovery and then followed by economic expansion. That has been playing out now for almost 10 years.
So in 2009 we were early in the cycle where cyclicals tend to do well. Now we are much later in the cycle. I would say that durable growers (secular growth stocks) can likely perform better vs. more cyclical companies at this point.
In addition, big-name secular growth stocks are much larger and better established today, so they probably will have a bit more correlation with the overall economy.
What Makes Growth Stocks Look Safer?
IBD: Anything else make those secular growth stocks look safer?
Fath: In past downturns, a lot of those names were plowing a lot, if not all, of their profits back into their businesses to shore up their core moats and to expand their total addressable markets.
Many continue to do that but have gotten to the point where they can let a lot more flow to the bottom line because they can’t reinvest that much given how big many have become.
Bigger names like Facebook (FB), Google-parent Alphabet (GOOGL), Microsoft (MKSFT) even, they’ve got pretty good valuation support because they’re generating good profit and free cash flow.
Netflix (NFLX) is not far away from starting to generate sustainable profitability.
Likes, Dislikes About Tesla
Tesla (TSLA) has turned very rapidly toward sustained profitability. We saw that in third quarter results.
IBD: What makes up for Tesla CEO Elon Musk’s unconventional behavior, which cost him his chairman’s title and a fine in a settlement with the SEC?
Fath: I’m clearly a contrarian, and had my head beaten in. But it’s starting to pay off, given what the stock has done.
It’s a tale of two stories. The Musk side is behavior that I don’t think is becoming of a CEO and which weighed on the multiple of the stock. This summer (and fall) was the point of maximum pain, when they went through the SEC investigation and settlements. He loves to antagonize those folks, which clearly I am not happy about.
The most important part of the business is what they’re doing with products. In Q3 they were finally getting to escape velocity (reaching profitability) with their Model 3. There’s a very good chance they’ve hit escape velocity now, and sustainable profitability and cash flow.
Musk needs to tamp down the rhetoric and focus on fundamentals of the business and things will be in a good shape.
IBD: And if there’s a recession?
Fath: Even in a recession, they’re probably in a good position to ride that out, as they’ve got a deep backlog of demand. And the company is relatively small. It’ll be able to drive growth throughout that.
IBD: What’s their vulnerability to foreign tariffs?
Fath: A lot depends on that. China rolled back the 40% tariffs to 15%, and they took down their pricing, as other automakers did, so that’ll help.
They’ll start construction of their Shanghai plant relatively soon. In time they’ll have manufacturing facilities in China, Europe and the U.S.
And next year they’ll build the Model Y, a game changing utility vehicle, built on the Model 3 platform.
I’d feel better if he reduced his rhetoric. He says things on Twitter that are damaging.
IBD: You often put 50% to 60% of your shareholders’ money into secular growth stocks, 20% to 25% into cyclicals and the balance into special situations. Sounds like you’re at the lower end on secular growth, right?
Fath: Yes, more toward 50% in secular growth stocks, with 15% to 25% in each of the other two. Maybe a little more in special situations.
IBD: Give me an example of a special situation stock.
Why McDonald’s Is Appetizing
Fath: McDonald’s (MCD) is shifting from value to growth. So is Dollar Tree (DLTR). … Those are defensive companies that we also believe have offensive optionality.
IBD: Why did you introduce McDonald’s to your portfolio recently?
Fath: The company historically has done well in either a recessionary or defensive market. Tax reform, for example, has helped lower-end consumers, and they play well to that market.
And now the company is active in what I call self-help. They’re going through an intensive push to drive a better consumer experience in the front of the store.
They’re rolling out a touch-based kiosk when you walk in, so you don’t deal with a cashier. There’s a flat screen where you can put your order in. It gives you a number, you sit at a table, and somebody walks your order out to you. It’s less human capital intensive.
They’ve also embraced digital initiatives. They’ve got a partnership with Uber for delivery to your house or business. That’s expanded their runway.
Another thing is mobile order and pay, making it more convenient for customers.
We’re entering a period where digital transformation is important, and those with capital to do it will be winners.
They will also start to lever into automation in the back of the house. That will help drive margins up for franchisees and on the corporate end because of franchise fees.
We’ve seen these renovations on their international side, and now in the U.S.
Amazon Is Largest Position
IBD: Why is Amazon (AMZN) your largest position?
Fath: Most companies start with their most profitable business and evolve downward from there. Amazon has gone the opposite way. It started with their lowest profitable business, e-commerce.
Two things changed in 2018. E-commerce became more profitable, especially domestically. International should follow.
And Amazon Web Services, their cloud infrastructure business, has done well. And its margins are dramatically higher than in the core e-commerce business.
Now a third leg, Amazon Marketing Services, their advertising business, is kicking into gear.
So this company keeps building out, adding more profitable businesses, taking advantage of their platform business model.
In 2018, the company appeared to become more focused on profitability. That’s new. They’re culling areas where they can’t generate a profit. So their earnings growth is powerful. If you look out a few years, this stock doesn’t look that expensive.
IBD: Are you concerned about their top-line growth slowing at some point?
Fath: It might have to. And that won’t be a bad thing, because this is such a big business.
Obamacare Impact On Growth Stocks
IBD: Why do you see UnitedHealth Group (UNH) as an attractive managed care stock?
Fath: Health care costs have to come down, and they’re well positioned. They’re the best managed of such companies.
I also like Optum, their pharmacy benefits management (PBM) business. It’s a powerful grower.
A number of other companies are merging to achieve the combination of businesses that UnitedHealth already has.
One potential rub is the court decision out of Texas that says the ACA (Affordable Care Act, known as ObamaCare) is unconstitutional. Some rivals could be hurt more, especially the ones that are Medicaid focused. Stocks like Molina Healthcare (MOH) and Centene (CNC) are under pressure.
Others will benefit, like Humana (HUM), which gets higher rates through its Medicare Advantage program.
The ACA issue will have to grind through the courts.
Meanwhile, I expect UnitedHealth to have annual earnings growth in the midteens. They underpromise and overdeliver consistently.
IBD: You hold growth stocks Mastercard (MA) and Visa (V). Which do you prefer?
Fath: It ebbs and flows, depending on valuation. The argument for Visa is that it has more scale and is still realizing the benefits of Visa Europe, which it acquired a couple of years ago.
Mastercard has built its consulting services, which is about 20% of the business now. Mastercard grows faster than Visa because it is smaller.
IBD: PayPal (PYPL) is another beneficiary of the shift to digital payments, right?
Fath: Under the leadership that’s there now, they’ve done a good job of getting the company focused, as it broke away from eBay (EBAY) to stand on its own. They’ve made a cumbersome platform more user-friendly. They let customers choose a payment mechanism. And they’ve made good acquisitions.
They bought Braintree (which lets merchants accept payments online or within their mobile application) a while back. Another is Venmo, which they’re starting to monetize. Venmo permits peer-to-peer payments, and they made it into a social media platform.
IBD: You roughly doubled your share count in VMware (VMW) in your last disclosure. Why?
Fath: Originally, our thesis was that we were going to be in a world with just the public cloud. But what’s happened is that the world is a hybrid cloud, where companies use the public cloud but also keep (a lot of data storage and management) on-premises.
VMware sits nicely in the middle of that. You can get VMware on Amazon Web Services. It lets companies with traditional on-premise computers shift (partially) to the public cloud.
IBD: What’s your view on Crown Castle (CCI), a wireless tower REIT?
Fath: Crown Castle’s core business (involves) traditional cellphone towers. These will benefit from 5G technology deployment as new and more equipment gets added, increasing the monthly rental rates Crown gets.
But if T-Mobile (TMUS) and Sprint (S) are allowed to merge, they will consolidate towers and equipment, reducing Crown’s revenue.
The newer business Crown has gotten into is small cells. This is focused in urban areas where you need significant densification of equipment for signal strength.
The backbone of these small-cell networks is fiber. This is a big part of the reason they bought Lightower Fiber Networks. They need to get multiple tenants on this fiber and their small-cell network. This looks less likely today especially as the largest carrier Verizon (VZ) has been more vocal about going it alone and using their own fiber.
I am maintaining a position, but a smaller one, which I expect will benefit from 5G deployment. But I am finding better relative opportunities elsewhere that I believe have better longer-term risk-reward.
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