Most fund managers look at price-to-earnings multiples when deciding whether a stock is cheap or expensive. However, one fund manager argues that that philosophy just doesn’t work. Robert Zuccaro of the Golden Eagle Growth Fund said the two keys to picking stocks are profit growth and new highs in their stock price rather than P/E multiples.
Background of the Golden Eagle Growth Fund
Zuccaro’s fund has $34 million in assets under management, and it’s a quant fund. The fund came in existence after the Democratic primaries one year ago because one of the proposals was to tax securities transactions at the rate of 0.5%.
If that proposal were ever adopted, it would wipe out momentum funds that trade heavily, including Zuccaro’s previous fund, which had a turnover rate of 12 to 15 times per year. He estimates that the tax penalty would have reduced the previous fund’s return by eight to 10 percentage points every year.
As a result, they introduced the Golden Eagle Growth Fund, which follows the same high profits growth characteristics of their long-standing investment style. The fund invests in 25 of the world’s fastest growing companies, and so far this year, the strategy has been working. Under the new strategy, they only turn over the portfolio once or twice a year.
Since inception on May 1 through the end of September, the Golden Eagle Growth Fund gained 80%. According to Zuccaro, in a rare phenomenon for growth funds, the Golden Eagle goes up more in up markets and down less in down markets than many other such funds. For the first quarter, the S&P 500declined 19.2%, but their model fell only 1.1%.
No shorting or P/E
Zuccaro explained that their fund strategy defies conventional wisdom. It doesn’t short any stocks, and he cites performance of equities hedge funds which use short selling as part of their strategy. He said such hedge funds have contributed just 22% of the 257% return over the last decade. Further, their cumulative return is 58%, which trails the long-only funds in the Lipper Mutual Fund Survey with a 182% cumulative average return.
He also said their research indicates that profits growth trumps P/E in stock selection. This is especially interesting because a Merrill Lynch study last year asked investors what their primary investment tool was, and the top response was overwhelmingly P/E. Conventional wisdom suggests that stocks with high P/E ratios are overvalued, but Zuccaro says his research suggests P/E isn’t a good tool to use when assessing stock value.
“William O’Neil did a study on high P/E stocks — those that sold above a P/E of 35 — and found that this group far outperformed the lower P/E group,” Zuccaro told ValueWalk in an interview. “Our own study shows that the top 10 stocks over 10 years ending 2015 (Netflix was number one with a cumulative return of 5,345%) started out with an average P/E of 64x.”
Zuccaro said when earnings reports start to come out, many investors only look at whether or not the company beat the consensus estimate for earnings. However, most companies do because they give lowball estimates beforehand, hoping their stock will go up. On the other hand, when a company increases its earnings 100% in a quarter but misses its earnings target, it will go down for a couple of days but then adjust to a higher growth rate.
How to evaluate money-losing companies
He also said Wall Street doesn’t know how to evaluate companies that are losing money, but they do.
“We strip away capital expenditures from the income statement, which are treated as a tax expense in order to arrive at true profits,” Zuccaro said. “We have several such stocks in our fund that have doubled in price but are rated in the lower half based on earnings growth in the IBD [Investor’s Business Daily] table of relative EPS. IBD makes no adjustments like many others and only considers reported EPS in their ranking system.”
The Golden Eagle investment process utilizes eight screens using12 metrics on growth rates and price change that must be met or exceeded. The last screen looks at new high history.
“We have assembled a body of knowledge on new high stock patterns,” he added. “We believe that we run the only fund that incorporates new high disciplines into its decision-making process. Our research shows that once a stock sets a first new high, it will go on to make additional new highs99% of the time — often as many as 25 or more over the following weeks or months. Half of the stocks in Golden Eagle have recorded 25 or more new highs this year.”
He noted that it’s impossible to know whether any stock will go up or down, but in the case of stocks that are constantly hitting new highs, there’s no doubt that these stocks are going up. If a stock doesn’t make a new high in 90 days, they sell it and find a new one. When they replace one of their stocks, they know exactly where to go next because they track other stocks that are making new highs that they believe will outdistance other hedge funds.
Profits growth and stock market highs
To identify the fastest growing companies in the world, their mantra is “highest profits growth leads to highest returns.” Their strategy is backed by research as well.
“We examined all stocks in my portfolios during 1985-2000 and found that the average price change was 114% for those companies that at least doubled their profits in the same year,” Zuccaro said. “In this regard, our companies reported average sales growth of 100% and average profits growth of 106% in the recessionary second quarter when corporate profits plunged 30%.”
He said 100% growth rates weren’t possible 35 years ago because U.S. companies were domestic in scope before globalization. He also believes tech companies with proprietary products or services can ramp faster than ever, which has driven growth rates for some companies higher than ever.
Focused on making money instead of risk
“The investment business is littered with funds that underperform,” he added.
He noted that data from Morningstar showed that just 12% of the typical fund which holds 60% in stocks, 30% in bonds and 10% in cash were over weighted in stocks this year, which means managers reduced their equity exposure in their portfolios earlier this year.
That also means they missed out on the stock rally as the S&P500 has surged 50% from its lows, while the NASDAQ has climbed 65%. Most fund managers were underinvested, Zuccaro believes. He said they are never less than100% invested in the market.
“Most managers are preoccupied with risk,” he added. “We are preoccupied with making money. I served on a panel a couple of months ago. The topic was ‘how do you deal with volatility?’ The three other managers on the panel replied that they diversify more. What was not said is that they reduced potential return along with risk.
Benefiting from volatility
He said volatility actually benefits their model, so they never change anything. Volatility simply means that stocks will go to higher highs and lower lows. He said the proof of this statement is that they had 38 stocks in their model over 10 years that doubled in price. Golden Eagle holds 20stocks that have doubled in price, and Zuccaro is never afraid to hold such stocks.
“This is the only way to produce hyper returns of 40% to 50% a year,” he said.
Although Zuccaro wouldn’t reveal the names of the companies that are in the Golden Eagle Growth Fund’s portfolio at this time, he did say that80% of the fund is concentrated in only three industries: internet software, internet commerce and biotech.