In what was arguably one of the toughest tiers of the U.S. market, the 20/20 Aggressive Growth Fund easily won over all of its competitors in the U.S. small- to mid-cap category.
For the 12 months ended May 31, the $426-million fund turned in a 73.6-per-cent return, a staggering performance against the 6.1-per-cent average return of the class. The fund was also No. 1 over six months, two and three years, with a half-year gain of 63.9 per cent, and compound average annual returns of 44.3 per cent and 24.8 per cent, respectively.
What's behind the sector-leading returns of this fund? Credit momentum investing -- a strategy that focuses on firms with rapidly expanding earnings, says the fund's portfolio manager, Richard Driehaus, founder of Chicago-based Driehaus Capital Management Inc.
"Unlike growth investing, which just seeks firms with rising earnings, momentum investing demands that firms' earnings be growing at an increasing rate," he says. "Buy high and sell higher" is the Driehaus maxim.
Mr. Driehaus says he identifies winners by seeking firms that have accelerating sales as well as rising earnings. These firms tend to produce positive earnings surprises -- that is, earnings that surpass analysts' forecasts.
Such firms are often priced at relatively high multiples of their earnings. Indeed, the average price-to-earnings ratio for the fund's holdings is 45 times, far above the 28 multiple for the Standard & Poor's 500 composite index. "We pay for the fastest-growing small- to mid-caps -- and our results show that we get what we pay for," Mr. Driehaus says.
His style requires staying ahead of both other investors and companies' changing fortunes, so he's ready to sell stocks quickly when they fail to meet his buy criteria. Because the portfolio is kept fully invested, with virtually no cash, managers often have to sell stocks to buy others.
The result is a high rate of portfolio turnover -- as much as three times a year. That means large distributions of gains for investors, which can be a downside for those who hold the fund outside their registered retirement savings plan (RRSP). Such investors can face hefty tax bills for this high portfolio turnover.
The fund's recent gains have come partly because small- and mid-cap stocks have been returning to respectability. In the three months ended May 31, the Standard and Poor's 400 Mid-Cap Index was up 9.1 per cent, and the Russell 2000 index rose 10 per cent, both outpacing the S&P 500's 3.4-per-cent gain.
"The 20/20 Aggressive Growth Fund is now benefiting from returning liquidity in the mid-cap market, where [Mr. Driehaus] invests heavily, and from upward revisions to his stocks' earnings," says Dan Hallett, senior analyst with FundMonitor.com, a Toronto-based mutual-fund-research firm. "We like him as a manager."
Currently, the 20/20 Aggressive Growth Fund is invested 42.4 per cent in technology companies, including Andover, Mass.-based CMGI Inc. The Internet venture-capital firm is the fund's single-largest holding, at 3.7 per cent.
Mr. Driehaus's move into this stock shows his style, which is to seek out high-growth firms even when they are not easy to buy. To take a position in CMGI -- which had no earnings last year and a large but difficult-to-value portfolio of unlisted start-up companies -- he had to estimate a market price. To do that, he multipled CMGI's assets by an average market multiple for the assets of several other Internet firms.
Mr. Driehaus apparently got it right, because other investors have bid up the stock. Recently, CMGI has been selling for $80.13 (U.S.), far above the average $4.52 he paid in January, 1998. And the company is starting to produce earnings -- 19 cents a share in this year's first quarter.
Financial services make up another 17 per cent of the portfolio. Included here is market-leading Internet securities broker Knight/Trimark Group Inc., based in Jersey City, N.J.
The firm, which executes orders for day traders and on-line brokers, is one of the hottest Internet plays. Earnings are expected to grow an estimated 23 per cent annually, from $1.39 a share this year to $1.71 next year. The stock is trading at about $44, nearly double the $23.44 average cost at which the fund bought the stock in January, 1998.
Another 16.7 per cent of the fund is devoted to consumer cyclicals. The largest holding in this category is San Francisco-based CNET Inc. The Internet portal and content provider is experiencing earnings growth of an estimated annual 65 per cent. Mr. Driehaus bought the stock for an average split-adjusted $16.46 in December, 1997; it was recently at $42.63.
Health-care stocks make up another 12.9 per cent, including Santa Clara, Calif.-based Visx Inc., a firm specializing in laser eye-surgery machines that enable surgeons to modify focus and do away with the need for spectacles and contact lenses. Earnings are growing by 31 per cent annually. The stock, which Mr. Driehaus bought for an average price of $18.50 in May, 1998, trades at around at $71.81, a heady multiple of 114 times trailing earnings.
The rest of the portfolio is largely a grab bag of smaller, lesser-known firms, with only a minuscule 0.3 per cent in cash. Among these other holdings are Honolulu-based discount airline seat-seller Cheap Tickets Inc.
But Mr. Driehaus believes that the current obscurity of such firms is no bar to a bright future for them. "The largest-cap company in the U.S. is Microsoft Corp., which was an unknown 15 years ago. And Wal-Mart Stores Inc., in terms of growth of capitalization, is the most successful retailer in America. Thirty years ago, most people wouldn't have been able to spell its name."
There's no doubt the fund has its fans. "The fund's returns are spectacular," says Scott Clayton, associate editor of Canadian Wealth Advisor, a Toronto-based financial newsletter. "This is a fund with a hot style that invests in hot sectors. So this is a compound bet on both an investing method and a fashionable sector."
Still, in the current market, with a correction cutting the prices of technology, Internet, health-science and financial-services firms -- Mr. Driehaus's heaviest allocations -- the timing question is unavoidable.
"If growth investing or tech stocks go out of favour, this fund and like funds will be forced to sell in crashing markets," Mr. Clayton says. "The trick is to buy this kind at a bottom, not near where it is now after a year of tremendous gains."
And the fund has experienced its bottoms, especially when value investing -- which seeks out underpriced stocks -- leads the market. For example, in 1996, the 20/20 fund returned 1.2 per cent versus a category average of 16.3 per cent.
Yet Mr. Driehaus thinks his will be the prevailing style. "Small- to mid-caps are coming back to life now," he says. Despite the high multiples of many of his stocks, he contends that small- to- mid-cap prices will rise further.
"The fundamentals are so good that market sentiment is recognizing that the stool has all three legs in place: valuations in the range of historic lows, good fundamentals and favourable market sentiment coming into play."