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PerkinElmer - >>> MFS New Discovery Fund (MNDIX) - >>> How This Small-Cap Fund Excels By Searching For Stocks With Sustained Earnings Power


Investor's Business Daily

PAUL KATZEFF

02/08/2021


https://www.investors.com/etfs-and-funds/mutual-funds/best-mutual-funds-small-cap-mfs-fund-excels-without-megacap-faang-stocks/?src=A00220


With Michael Grossman at the helm, $2.8 billion MFS New Discovery Fund (MNDIX) keeps notching a record as one of the best mutual funds. And the small-cap growth manager does it without owning any of the megacap technology stocks that have outperformed so much of the market.

He owns none of the FAANG stocks like Apple (AAPL) and Amazon.com (AMZN). Those tech giants jumped 82% and 76% in 2020.

Instead, he and his team have built a portfolio that includes names such as wood-alternative building materials maker Trex (TREX), customer-support and service software maker Zendesk (ZEN), backup generator maker Generac Holdings (GNRC) and online shipping services provider Stamps.com (STMP). Their 2020 gains outflew the FAANGs, soaring 86% to 135%.

A key aspect of his investment strategy is to weigh each prospect stock's earnings power over the next three to five years.

Further, he looks for bargains.

Best Mutual Funds: Set To Repeat As A Winner

Using those ingredients, he has cooked up one of the best mutual funds. In 2020, his portfolio's total return was 45.03%. That more than doubled the broad market in the form of the S&P 500. The big-cap bogey racked up an 18.4% advance.

New Discovery's small-cap growth rivals tracked by Morningstar Direct averaged a 38.62% gain.

Grossman's fund is a 2020 IBD Best Mutual Funds Award winner. It won that distinction by topping the S&P 500 in calendar 2019 as well as over the three, five and 10 years ended Dec. 31 on an average annual return basis.

The fund's 2020 outperformance means it will repeat as an IBD Best Mutual Funds Award winner in 2021.

Speaking from his home office in Boston, 44-year-old Grossman detailed his investment approach in conversation with IBD.

How Much Growth Is Enough?

IBD: Michael, what's the most important thing you seek in a stock?

Michael Grossman: In terms of strategy, of course we're focused on small-cap growth stocks. What we're trying to do is to identify companies that can grow at least 15% a year on average on a consistent basis.

IBD: Why 15%?

Grossman: If a stock grows 15% annually for five years, it doubles in size. I have a good chance of outperforming if the portfolio is populated with companies that double in size every five years.

What Type Of Stock Does A Best Mutual Fund Seek?

IBD: What type of companies are most likely to achieve that?

Grossman: We try to populate the portfolio with as many strategic assets as we can. We define them as an emerging growth company that has some sort of disruptive business model or technology, which enables it to take share in a very large addressable market dominated by large legacy incumbents.

That leaves the legacy players with a choice. They can cede market share to disruptive players. Or they can make catch-up investments, which cuts margins. The market doesn't like that. Or they can acquire the disruptive player. That's usually the path of least resistance.

IBD: That sounds like a win-win scenario for the fund.

Grossman: Owning stocks that include acquisition targets gives us downside support. If a stock's share price takes a near-term hit, a buyer will usually be there. That limits the downside.

We also get upside capture of the premium that an acquirer might pay for a disruptive company.

New Discovery Fund Held Takeover Targets

IBD: How has that worked out?

Grossman: The portfolio is about 100 names. In 2020 we had six companies taken over. In 2019 we had nine companies acquired. It was five takeovers in 2018. It was seven in 2017. And seven in 2016.

IBD: Do you seek different kinds of growth stocks?

Grossman: I look for two groups. The first one is about two-thirds of the portfolio. It consists of more durable growth companies. They're further along in their life cycle. They're more proven. A lot are generating free cash flow, or are close to it. I'd call them the ballast of the portfolio.

The other third is companies either in an early stage of growth or emerging growth. Their model is a little less proven.

IBD: What's an example in your big group?

Grossman: Anything in my top 10.

IBD: As of Dec. 31, that included PRA Health Sciences (PRAH), Rapid7 (RPD) and Advanced Energy Industries (AEIS)?

Grossman: Yes.

'Arms Dealers' In Biotech Help Make This One Of The Best Mutual Funds

IBD: And from the one-third group?

Grossman: Almost any biotech. I don't want to be too over- or underweight in one sector or factor. I stay roughly within 500 basis points of each of the 11 major sectors. Rather than try to guess who's going to make the next major drug, we own arms dealers in biotech.

One is Berkeley Lights (BLI). They went public in 2020. They're a digital cell biology company. They look at thousands of cells to find the best for a particular therapy. Another is Seer (SEER). They do what they call proteomic profiling. They try to detect cancer more quickly and accurately by looking at proteins.

The company sells its products to pharmaceutical companies and academia. As opposed to genomic profiling, where the analysis is of an entire set of genes, in proteomics the analysis is of proteins.

An early study shows that Seer can be used for earlier detection of non-small-cell lung cancer (NSCLC). The addressable market for proteomics is expected to be even greater than next-gen sequencing (NGS).

Another is Schrodinger (SDGR), a software company that provides physical base modeling for drug discovery. They have their own drug development pipeline for assets that they identify. If one moves through trials and hits, it can be big.

Stamps.com Has Evolved

IBD: I get that your process holds risk. None of those three names, for example, has posted an annual profit yet, although Schrodinger is expected to hit earnings per share of 5 cents by fiscal 2021, according to MarketSmith analysis.

Let's talk about some stocks that are perhaps young but better established. What's your thesis for Stamps.com? Earnings per share rallied sharply the past three quarters. They've expanded beyond just stamps, right?

Grossman: Nine or 10 years ago, it was just a stamp company. They've evolved. They do postage and labeling, but also shipping logistics.

The reason their earnings fell off a cliff, then rallied, is that they used to have an exclusive contract with the U.S. Postal Service. But they didn't renew that. They didn't want to rely on something narrow. Since then, they've contracted with multiple carriers, including UPS.

Stamps.com can buy postage or labeling at a much cheaper cost than individual small businesses can on their own. And through acquisitions, they've gotten into more shipping and logistics.

What's driving growth is e-commerce. The stock is attractively valued on earnings unlike a lot of e-commerce peers. And they're piggybacking on the same secular growth trend as Shopify (SHOP) and Amazon. We don't see e-commerce reversing as a secular growth trend.

Powering Up This Fund

IBD: Generac soared in 2020. What's your thesis?

Grossman: They dominate the residential stationary backup power generation market with over a 75% share. But that standby backup power generation market is just 5% penetrated in the U.S., so there's a long runway for growth.

They're also viewed as a clean-energy source, since their generators are run by natural gas, often replacing diesel generators.

And several years ago they got into residential solar battery storage. They made acquisitions. Now they're one of the leading solar power management systems along with Tesla (TSLA). There's an even longer runway for growth on the solar home battery side. So we see 15% growth for them for some time.

Making Money From Recycled Plastic

IBD: Why do you like Trex?

Grossman: They're a leader in composite decking. Basically, they use recycled plastic. And their costs come down as the cost of composites comes down versus lumber. Plus, they are vertically integrated. So their margins are high.

And they've benefited from the pandemic as more people are doing home projects.

Eighty percent of the decking market is wood. So Trex's market is only 20% penetrated. That penetration can rise to 50% due to superior performance of composites and lower maintenance costs.

We also own Azek (AZEK), which came public last year. They're the number two player. There's room for more than one winner in this space, given the size of the market and opportunities to take share from lumber.

Grossman Sees Growth For Diagnostic Companies Beyond Covid Testing

IBD: Quarterly earnings per share for PerkinElmer (PKI) have accelerated after slipping. What are they doing right?

Grossman: Their EPS have accelerated because they have a Covid-19 PCR test (polymerase chain reaction). But Covid-19 is not why we own it.

We've owned it for years. We have owned several diagnostics and testing companies. They have high recurring revenues and high-margin consumables.

Many years ago when we first looked at PerkinElmer, it was mainly a health-care business with newborn-baby screening diagnostics. Through internal development and acquisitions, they've diversified.

We see continued growth beyond Covid testing from their test-menu expansion and geographic expansion. We think that will drive earnings growth in the double-digit range for the foreseeable future.

Helping Financial Advisors Helps Make This One Of The Best Mutual Funds

IBD: Focus Financial (FOCS) provides support services for wealth advisory firms. What's your thesis for this stock?

Grossman: They acquire or provide an umbrella for wealth advisor groups. They are an exit strategy is for family-owned businesses or a partial exit strategy for owners who want to take equity out.

The value they provide is their platform. Wealth advisors are breaking away from wire-house banks like Morgan Stanley (MS), UBS (UBS) and Credit Suisse (CS). Wealth advisors want to be more independent. Focus Financial provides a platform for trading, compliance, back-office technology and other add-on services. They have 80 partner firms now, and that's still just a low single-digit percent of the industry.

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