Visitation Rites : For Mid Cap Growth Fund, the Emphasis Is on Price Discipline--and Meeting Company Executives Is Key

L.A. Times Archives

Nov. 19, 1996 12 AM PT

After seven years with J.W. Seligman, where she ran the high-performing Seligman Growth Fund, Suzanne Zak joined Minneapolis-based Investment Advisers Inc., where she has run the IAI Midcap Growth Fund since July 1993.

Focusing on companies with market capitalization averaging between $1 billion and $3 billion, Zak has produced some of the strongest returns in the field but with lower risk than the typical growth fund. She spoke from her office with Times staff writer Thomas S. Mulligan.

Times: For a growth fund manager, you place a lot of emphasis on price discipline.

Zak: It’s an old-fashioned concept, but we do think price makes a difference, as well as growth.

Times: Your approach is bottom-up--that is, you look for individual stocks rather than first trying to identify promising sectors?

Zak: Sometimes you can come to the same conclusions either way, but I think you have a lot more conviction if you come from the bottom up and you’re hearing it directly from corporate management as opposed to making some grandiose projection for the economy.

Times: How important is talking with management?

Zak: That’s a key. We visit the managements of all companies before we’ll invest a dollar of our clients’ money. It ties in with our valuation model. Free cash flow is great to have, but it is critical how that money’s going to be reinvested. We need to know whether the returns on that investment are going to help the company grow.

Times: Isn’t there a certain amount of “noise” in discussions with management, since executives may try to present only the most positive interpretation?

Zak: You’re so cynical! Yes, sometimes it’s amazing what lengths companies will go to to put a positive spin on things, but that’s just human nature. I think that my undergraduate studies in psychology have done me a lot more good in the investment business than my MBA in finance. There will be a lot of spin control, but what you also have to realize is there are people behind all those numbers, and if all you’re going to do is just look at the raw numbers, I’m not sure how you’re going to get much insight from that.

Times: Has a road trip ever cooled you on a stock that looked good on paper?

Zak: There was one that we sold earlier this year after digging a little deeper--American Greetings Corp. If you just looked at the numbers, they throw off lots of cash, but the acquisitions they’ve made outside the greeting-card business have not produced satisfactory returns at all. Spending more time with management convinced us that they really didn’t have expertise in anything other than greeting cards. But they were reinvesting and making acquisitions, so on the surface it looked OK.

Times: The fund describes itself as aiming at long-term investors. What’s considered long-term these days?

Zak: We usually hold stocks for two to three years. On average our turnover will run between 30% and 50% annually, and looking around at the competition these days, that seems to be on the low side.

Times: We’ve discussed your discipline in buying. Do you follow the same rules in selling?

Zak: Yes, when we buy a stock, we do set a target price for what we think the appreciation potential is over the next 12 to 18 months. But it’s not an automatic sell rule. It’s a guidepost that raises a yellow flag so we can revisit to make sure we’re up to date on what’s going on in the company, whether anything has changed, whether that target price is still valid.

For example, with HFS Inc. [franchiser of Days Inn, Ramada and other hotels], which we’ve owned for several years now, they’ve made so many acquisitions you have to keep revising that target price.

Times: You seem to like business services. Danka Business Systems and Alco Standard Corp., for instance, are among your largest holdings.

Zak: It’s one of the few industries out there that’s driven by technology yet doesn’t have inherent technological risk, because they don’t make the equipment, they just supply it. New color copiers and digital copiers are starting to be incorporated into networks in offices, and it’s a highly fragmented business. Alco and Danka are the two big players apart from Xerox Corp., which dominates the high end.

All the Japanese manufacturers distribute for the most part through independent companies, and so Danka and Alco are able to buy these smaller operators at very reasonable prices because they’re the only logical buyers. They’ve run into each other in acquisitions, but so far they haven’t beat each other to death over them.

Internally, the growth of the business looks like 8% to 10% for these companies. So you have got double-digit internal growth, you’ve got acquisition growth, and now Danka just bought the servicing division of Kodak, which gets them into the high end, which is going to have huge potential for them.

Then there’s Lexmark International Group Inc., the old IBM printer company that was bought by management. It looks like they can continue to grow at about 20% a year, and they’re increasing capacity--that’s how they’re reinvesting their cash flow.

And all they need is a few points of market share. They don’t have to take on Hewlett-Packard Co. head-to-head. They’ve got about a 5% share of the laser-printer market and they’ve just started to get into inkjets, where if they can get that same share it’ll be huge for them, although it’s nothing to Hewlett-Packard.

These guys are sharp, they’re motivated, they come out of the environment of an LBO, so they have extraordinary financial discipline. Free cash flow was initially used to pay down debt; now it’s being used to expand capacity. The stock has recently perked up quite a bit, but it has not done anything since they did the initial stock offering last November.

Times: It’s a big factor that Lexmark originated in a leveraged buyout?

Zak: Hey, if your mortgage all of a sudden tripled, you’d get a lot more discipline too.

Times: For a growth fund, you have a pretty small position in pure technology stocks.

Zak: We moved away from technology last year. With 20-20 hindsight, it looks like it was maybe a little bit early, but it’s just where our valuation discipline led us at a given time. And some of those stocks have come back down to earth in the corrections we’ve had since then, especially in July.

Times: You’re fairly concentrated in heavy industry, maybe 10% of your holdings. Where’s the excitement there?

Zak: Well, look at Tyco International Ltd. Their main business is sprinkler systems and all the piping and fittings that go into that. They’re in very mundane businesses, but these guys are just incredibly efficient manufacturers. They’re set up so that their divisions are operated fairly autonomously, yet the bonuses they can get if they produce the bottom-line numbers are substantial. And it’s worked for years--I mean, they just crank it out!

I’ll give you an example. [Earlier this month] I took a tour of a foundry they have down in Pennsylvania. It looked like it was 1,000 years old, melting down steel, making fittings and things. When they bought that foundry it was losing money. Now it’s making--in round numbers--$40 million in operating profit on a revenue base of $130 million.

There’s nothing that really jumps out at you as obvious, but it’s doing 1,000 things 1% better, and that’s what gets you there in manufacturing.

The other thing is--let’s face it, the best and the brightest are not going to want to go out and run a foundry for the most part, so sometimes it’s easier to be a growth company in a business that isn’t attracting huge competition. These guys have something like 40% or 50% market share in the pipes that go into chain-link fences. You can’t get much more of a commodity business than that, and in order to dominate you have to have a cost advantage. The concept is simple; the execution is difficult.

Times: Are there common themes among your portfolio companies?

Zak: They’re not the flashiest companies; generally they’re not the big momentum stocks. They just make money. And the one thing you can count on in the stock market is, over time, if the company continues to grow at a high rate, other investors will find it because stock prices follow earnings growth.

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IAI Midcap Growth Fund

Category: Mid-sized stocks

Strategy: Seeks long-term capital growth by investing in shares of companies whose market capitalization is between $1 billion and $3 billion.

VITAL STATISTICS

Year to date total return: +17.7%

3-year avg annual return (through June 30): +20.5

Avg growth fund, 3-yr avg annual return: +15.1

Five biggest holdings as of Sept. 30:

1. Danka Business Systems

2. HFS

3. Alco Standard