Quality is king

Quality is king, says Oak Value's Coats

While last year's recovery lifted low-quality stocks, this year's market will reward companies with strong balance sheets

By Jeff Benjamin
February 24, 2010

Stock picking in the current market requires a renewed focus on corporate economics and balance sheets, said Larry Coats, manager of the Oak Value Fund (OAKVX).

“After a low-quality recovery last year, now quality matters, and it's time for serious stock selection,” he said.

Mr. Coats has been part of the fund's management team since it was launched in 1993 by Oak Value Capital Management Inc.

As a portfolio manager, he describes himself as an “opportunistic buyer of advantaged businesses.” The strategy goes beyond the “implicit biases” of a traditional value investing approach, he said.

“By concentrating on price-to-earnings and price-to-book ratios, money managers are spending all their time looking at the cheapest stocks, but they're missing some valuable opportunities,” he said. “When we look at all the companies in the S&P 500, we start by looking at the businesses themselves, not the valuations.”

The highly concentrated portfolio of just 27 names has an average operating profit margin of 25%, which is about 10 percentage points higher than the S&P 500.

The fund's 30% average return on equity is almost double that of the index.

Mr. Coats said by focusing on a company's balance sheet, he has been able to build a portfolio of truly profitable businesses that aren't hampered by excess leverage.

The fund, which has a four-star rating from Morningstar Inc. and has $76 million in assets, is categorized as large-cap blend.

Mr. Coats admitted that the strategy could fit into a few different boxes.

“Some people would argue that what we’re doing is [growth at a reasonable price], but in our mind, it’s value with a quality bias, or growth with a pricing discipline” he said. “Our discipline is blend, and our portfolio is built with a growth bent.”

The strategy got high marks from Morningstar analyst Greg Wolper for the way it beat its benchmark during both the 2008 market decline and the rebound last year. The fund gained 33% last year, while the S&P 500 returned 26%. And during the meltdown of 2008, the fund lost 33%, while the index fell by 38%.

The average annual turnover of around 37% is reflective of a strategy that is based on an extremely deliberate research process. “We identify the best companies from the index, follow them, research them and then wait for the right time to buy them,” Mr. Coats said.

One stock added to the portfolio late last year is Intuit Inc. (INTU), a company best known for its TurboTax software. But Mr. Coats said the stock price was pushed down by investor concerns that an economic slowdown would hurt Intuit's broader software sales to smaller businesses.

“The stock got cheap because people were concerned about a slowdown in new business starts,” he said.

Through Tuesday's market close, Intuit shares were up 3.7% this year, which compares with a 1.8% decline by the S&P 500 over the same period.

Portfolio Manager Perspectives are regular interviews with some of the most respected and influential fund managers in the investment industry. For more information, please visit InvestmentNews.com/pmperspectives .