Morgan Stanley fund manager picks stocks the Warren Buffett way

Patient investing strategy helps Morgan Stanley fund deliver returns of 49pc over the past year

PUBLISHED : Tuesday, 18 March, 2014, 1:11am
UPDATED : Tuesday, 18 March, 2014, 1:11am

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 US$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 is an approach more akin to the Warren Buffett school of patient investing rather than simply buying the next hot stock.

Even though there are a lot of numbers in this business, it’s less scientific than you think

That is even if the companies in question, such as and Facebook, are high-priced and technology-centred, the sort that are a far cry from the railroad 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 per cent over the past 12 months and an average of 29 per cent a year over the past five years.

That performance puts him 26 percentage points ahead of the benchmark S&P 500 Index. It also lands him in the top 1 per cent of the 1,778 large-cap growth funds tracked by Morningstar for 2013, and led Morningstar to name him the United States domestic stock fund manager of the year.

Some of that outperformance can be attributed to a decision to add Tesla Motors to the portfolio in February 2013. It rallied more than 500 per cent over the next 12 months, leading Lynch to cut about 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 to and Groupon, is invested in companies tied to the internet. That compares with 8 per cent 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 is a process he learned while attending Columbia Business School, where investors like 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 does not set hard target prices to tell him when to sell.

Lynch puts less emphasis on valuation metrics like price-earnings and more on trying to spot advantages that do not show up on a balance sheet.

That is partly because he invests in large-cap companies, the section of the market where it is 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 US$30 and US$40 a share after the dotcom crash 11 years ago.

Investors at the time questioned Amazon's strategy of ploughing most its profits back into the business and missed the fact that it had the potential to upend retailing, Lynch said.

Amazon, which closed above US$371 per share on Thursday, had a similar opportunity to expand its cloud-based services for businesses, he 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 has added to his positions in luxury fashion brand Christian Dior and infant-formula maker Mead Johnson Nutrition, the company behind Enfamil.

He likes Mead Johnson because hospital use and doctor endorsements of its formula give it a unique position among childcare products and represent a recurring revenue stream that should grow as it expands into emerging markets.

Shares in Mead Johnson have dropped 0.3 per cent since the start of the year and trade at a forward price-earnings ratio of 19.5, slightly above the market average.