Just Say Know

The Milpitas, Calif.-based Interactive Technology Value Fund, the top stock mutual fund over the last two years, according to Lipper Analytical Services, is a good example of what can spring from the right investment club.

Co-managers Kevin Landis and Ken Kam first started buying stocks together as part of a five-member club in Silicon Valley. Each brought a unique combination of work experience and educational background to the investment table.

Landis, 36, studied electrical engineering and computer science at UC Berkeley, then earned an MBA from Santa Clara University. He worked in the semiconductor industry before co-founding the fund in 1994.

Kam, 37, helped to establish and manage a medical device company called Novoste before entering the mutual fund business. He earned degrees from Santa Clara University and from Stanford University’s graduate business school.

As managers of the Interactive Technology Value Fund, Landis concentrates on technology stocks and Kam pursues medical companies. They thus adhere to one of Peter Lynch’s guiding principles: Invest in what you know. They were interviewed by Russ Wiles, a mutual fund columnist for The Times.

*

Times: It’s been a roller-coaster ride for technology stocks over the last year, but your fund still gained 61% in 1996 and is up nearly 18% so far this year. Has it been difficult to manage a tech portfolio, under the circumstances?

Landis: With technology investing, you’ll always be operating in an environment full of surprises, which are driven by business developments that can be good or bad. And, of course, stock markets fluctuate. Wait until more quarterly earnings releases come out--that’s when you’ll really see some volatility. Every three months, we go through this.

Volatility is stressful, but it doesn’t mean it’s bad. It’s like the old cliche of crisis representing both danger and opportunity. That’s why we do our homework: So that we can make sure we know the companies in our fund really well.

Times: Recent news reports have speculated that a weakening in sales growth of personal computers may be a long-term trend. Are you concerned about a fundamental flattening of demand for technology products?

Landis: It’s possible. Slowing growth happens periodically in the PC market. It seems to vacillate between growth that’s anemic and robust. Yes, we could be heading into an anemic period. But I know that for every anemic period, there will be a robust one. And the anemic times give us a chance to pick up stocks at better valuations.

If there turns out to be a technology sell-off this summer--and I’m not saying there will be--I can guarantee we’ll do our best to take advantage of it.

Times: How would you describe your basic investment philosophy?

Kam: Our investment heroes are Warren Buffett and Peter Lynch. We have learned a lot from them--primarily that it’s best to invest in what you understand. What we understand are the industries from which we came. There’s no substitute for the perspective you gain building a successful career for helping you analyze that industry. The contacts you make and the experience of competing tell you a lot about who’s a threat and who isn’t.

Our fund is meant to build off those experiences. We have developed a network of contacts from those industries.

Times: How did you two meet?

Landis: We met doing community service work for an organization called Junior Achievement. We were on a team that was advising a group of high school students who formed their own company, back in 1985. By 1987, five of us decided to launch an investment club, using the Peter Lynch model of investing in companies you know, because we were all high-tech professionals.

As a club, we went through the initial school of hard knocks. Parallel with that, Ken and I were gaining experience as analysts, so there was a convergence and maturation of our investment skills. We realized we had a similar investment philosophy and nearly an identical vision of what we wanted to do, which was to form this fund. Our club was wound down two years ago, but the other members are now investors in the fund.

Times: You claim to be the only technology fund based in Silicon Valley. How does that help?

Landis: Particularly for my portion of the portfolio, which is electronics, we feel it’s an advantage to be here. I can’t think of a better vantage point from which to follow this industry. It’s easy for me to, say, take a chip designer to lunch so I can understand sub-micron layout methodologies and have him explain what exactly is parasitic extraction. It would be tougher to do that if I had an office in Manhattan or Boston.

We like to surround a company, talking to its suppliers, customers and competitors. I like to get impressions and opinions from everybody who interacts with that company, and I want them all to be investors in our fund so they will be eager to give me a frank opinion. During our first year, we told our industry contacts that they now had a way of participating in our success. That locked in the industry network. It has grown since then because other industry professionals have heard about us and wanted to participate.

Times: And you bring the same grass-roots research to the medical side of the portfolio?

Kam: Yes. My primary contacts are cardiologists and physicians. Other parties would be operating-room technicians and nurses. In this country, if you want to bring a new medical device to market, you have to conduct clinical trials first. With just about any product for which I want an honest opinion, I can schedule to see a procedure, and talk to the nurses, doctors and operating-room techs who are trying out the products. This happens long before the product is approved and long before there are any sales, much less earnings.

Many people don’t know this, but about 50% of the people who die in this country every year die because of heart disease, or some complication related to it. So if you understand the cardiac markets, then you’re covering about half of the medical device and health-care market, and probably the richest part. That’s where I focus my efforts, and that’s where our network is strung.

Times: With such early exposure, do you tend to buy a lot of initial public stock offerings?

Kam: I don’t think we’ve bought a single one. When a company does an IPO, it’s at a time of maximum hype. It’s not a time when we have an advantage over anyone else.

Landis: The investment bankers do an excellent job of telling a company’s story at those IPO road shows. We want our cake and we want to eat it too, which means owning great companies at great prices. The only way we can do that is to identify these firms and wait for them to become misunderstood. For example, when a company has missed a quarter [in terms of good earnings] and people are scared, that’s when the great opportunities arise, not at the IPO stage.

Times: Since you have both a medical and a technology slant, how do you allocate the portfolio? How do you decide or negotiate what to own?

Landis: We don’t try to artificially constrain ourselves. We don’t have an asset-allocation limitation. We give ourselves maximum latitude to go after our best ideas.

Kam: We have to be able to look each other straight in the eye and say, ‘I think this stock can double in two years.’ I trust my partner on the high-tech calls, and I feel comfortable presenting my case for the medical stocks. But the opportunities almost never are split equally between the two sectors.

Times: Keeping with one of Warren Buffett’s tenets, you maintain a small number of holdings.

Kam: That’s absolutely right. We don’t think our shareholders pay us to invest in our 50th-best idea. It’s more important that the investments we do make work out, rather than that we make hundreds of investments.

Times: How many stocks do you normally own?

Kam: About 36 or 37.

Times: Are you a diversified fund, in the regulatory sense?

Landis: No. We’re a non-diversified fund, which means we can have 50% of our portfolio in concentrated positions. But we are limited to not taking any single position over 25%, and it’s rare that we even come close to that.

Times: What are some of your major holdings?

Landis: One [favorite] is a company formerly known as Sierra Semiconductor. This was a San Jose-based semiconductor firm that had evolved into a company without clear direction. They had a mixed bag of products, without being the clear leader in any one thing. They had lost the lead in modem-chip technology.

Then they purchased a little company in Vancouver called PMC, for Pacific Micro Circuits. This was a group of engineers who were clear leaders in providing the chips that implement ATM, or asynchronous transfer mode, which is the best new solution for Internet-backbone communication. If you send me an e-mail, it may go over a modem or local area network for the first mile. But for most of its journey, it goes over a high-speed ATM backbone. PMC is the leader in that.

Sierra purchased the company when ATM was still new. Last summer, Sierra announced they were getting out of their main business, the modem-chip business, and that they would phase out various other product lines. PMC since then has brought along several other interesting chip product lines. Sierra has moved its headquarters to Vancouver and changed its name to PMC-Sierra [$26.25 on Monday on Nasdaq]. Now they’re clearly focused as a communications-chip company. This is our biggest position, at about 8% of assets, and my favorite stock.

Times: What are some other favorites?

Landis: Another is IKOS Systems [$21.375, Nasdaq], based in Cupertino. They verify chip designs. Imagine you’re a chip designer and you’ve just completed several months of work on something that has literally millions of transistors. You’re about to spend several hundred thousand dollars and six weeks or more building a prototype. You know the design is complicated enough that your prototype will have bugs in it. But you don’t know if there will be five bugs or 100, which is important because you don’t want to go through many generations of prototypes--that’s expensive, and, more important, it can cost you weeks on the calendar and your market window.

You need to do something analogous to proofreading your design. So you use software and hardware to simulate the chip before you actually build it. This is called verification. IKOS delivers accelerated verification. They’ll sell you the software you need to simulate your design and specialized hardware to accelerate that process, so you can do it overnight. It’s a great little company that’s building a dominating position. Its customers, the chip makers, gain a real advantage by using these products.

Times: How about a favorite medical stock?

Kam: My story’s about a company called Arterial Vascular Engineering [$32.19, Nasdaq]. They produce something called a cardiac stent. They’re the No. 2 player in the world in this, after Johnson & Johnson. A cardiac stent is a little coil that a cardiologist will put into your artery to physically hold it open and prevent it from collapsing. Until about two years ago, stents couldn’t be implanted safely. In a high percentage of cases, blood would clot on the stent. When the clots broke off, some would travel to the brain and cause strokes.

About a year and a half ago, a doctor in Italy found that he could solve that problem by using a different device, and stents since then have become a $1-billion-a-year industry. Arterial Vascular Engineering is a little company up in Santa Rosa. Medtronic and Boston Scientific are among the companies behind them. I have a lot of respect for anyone who can beat Medtronic.

Times: But it sounds like the competition is keen.

Kam: When it was announced that 12 other companies were going to enter the market, Arterial Vascular’s stock dropped from $20 a share to $9 in about a week. On those days, I didn’t want to come into work. What drove the stock down was fear that the increased competition would hurt earnings.

But what most analysts on Wall Street don’t appreciate is that once physicians get used to the feel of a device like this, they’re reluctant to change products. The other 12 companies have failed to take market share because none of the doctors wanted to go back through the learning curve. So when the stock was down between $9 and $11, we quadrupled our position. Since then, it has become one of our winners this year, and it’s the largest medical position we have, at 6% of fund assets.

Times: Any other favorites?

Kam: Remember when I told you that doctor in Italy discovered he could safely implant the stent by using another product? There’s only one public, pure-play firm that makes this product. It’s called EndoSonics [$10.875, Nasdaq], and it finally broke into profitability last year. I know from having managed one of these companies that once you do that, your incremental sales become extremely profitable. EndoSonics’ sales are growing by about 76% a year. So you can imagine that if sales continue to grow at that rate, they will drop some heavy coin to the bottom line.

Times: What does this product do?

Kam: It’s an intraluminal ultrasound catheter. It allows the physician to look at your arteries from the inside. By using this device, a cardiologist can tell if the stent has been fully opened or deployed. When it is, the risk of blood clots is dramatically reduced.

Times: Do you spend much effort trying to time or forecast the stock market?

Landis: No. We really view time spent pondering which way the Dow is headed as time that could be better spent researching our best ideas. Just as we won’t waste a lot of time on our 50th-best idea and won’t add those marginal stocks to the portfolio, we won’t waste time trying to guess the Dow.

Times: What do you see as some of the dominant themes in the medical and technology areas these days?

Landis: There are two enduring truths about both medical and technology investing. The first is that we know over the next five to 20 years, these two industries are going to be real growth engines. You’re going to see industrywide expansion. Nobody will argue about that.

Second, these businesses are easy to misread. They’re highly technical, and the competitive landscape can shift suddenly. While that may scare a lot of people, it means there are opportunities to invest in great companies and to get them at good prices when they are misunderstood. Here in the middle of Silicon Valley, we’re in the right place to take advantage of that with this fund.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Interactive Technology Value Fund

Strategy: Buys a combination of compu-ter-oriented and medical stocks using a bottom-up research approach.

*

VITAL STATISTICS

Year-to-date total return: +17.9%

YTD total return, avg. technology fund: +7.3

3-year annualized return, to May 31: +55.9

3-year annualized return, avg. technology fund: +28.4

Five biggest holdings as of June 19: 1. PMC-Sierra 2. Cisco Systems 3. 3Com 4. Lattice Semiconductor 5. Arterial Vascular Engineering

Sales charge: None

Minimum Investment: $10,000 (less through discount brokerages)

Phone: (888) 883-3863

Morningstar risk-adjusted performance rating, 1-5: HHHHH

Sources: Lipper Analytical Services, Morningstar Inc.