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Riding Trend Drivers and Enablers
Plumb Balanced Fund
Interview with: Thomas Plumb

Author: Ticker Magazine
Last Update: May 07, 11:57 AM EDT
Unlike other balanced funds, which rely on conservative equity exposure and bond income, the Plumb Balanced Fund invests in growth stocks and uses fixed income to moderate stock market volatility. Founder and portfolio manager Thomas Plumb focuses on identifying big secular trends and companies that enable or benefit from these trends, as such businesses have the potential to grow in any environment as long as they are fundamentally sound.

ďWe rely on growth stocks to generate our incremental return and we focus on companies with unlimited upside. Our approach is identifying a big trend and then looking at who will benefit from it and enable it.Ē
The enabler behind Apple Pay is Visa Card, so either Apple would have to independently develop a network that could replace Visa or it would have to buy a company. Right now, PayPal and Apple Pay use Visa and they donít have the scale to do it independently.

Also, Visa points out that the business-to-business market is about four times larger than the business-to-consumer market. It is trying to become the enabler and to eliminate the bank in the business-to-business transactions. We have yet to see that happen and it is not clear if Visa will succeed, but it is a possibility.

Q: Why do you believe growth is the best defense and offense?

A: Our view is that growth is our best offense and defense. A company that looks cheap can become even cheaper in adverse economic environments, but companies winning in the market place tend to go down less and lead recoveries. As long as the underlying trend is there, it is our friend.

We reject the idea of the return to the mean. Many blue chip companies, which had been great leaders, no longer exist. For instance, 30 years ago the second largest technology company in the world was Digital Equipment Corporation, but it disappeared.

So, it is crucial to look beyond the trends to see who is really going to ride them. One of our criteria is the profit margin of a company. High profit margins tell us that the companyís customers view the supplier as someone not easily replaced. Companies growing their top line, but without expanding their profit margins are viewed as commodity providers by their customers. The world is a tough place. Competition tries to commoditize every product or service. On the other hand, Visaís after-tax margin tells us that the marketplace sees value. Its profit margin is more than 60% at the gross level and 40% after taxes. These numbers tell us that Visa hasnít been marginalized yet.

Q: What is your buy-and-sell discipline?

A: A transition in a secular trend, or even in a cyclical trend, is always risky and volatile. In my experience, if you think you are close to the bottom but you donít really know, try not to step in. When we identify a secular transition, we let it develop a bit and pause before we grab it.

Investors are proud of picking the exact moment when a stock has bottomed, but if you are right on a long-term trend, you donít really have to wait for the bottom. Value-oriented investors often say that they would wait for a stock to come down and present a buying opportunity. However, stocks often go down because of bad news, so companies can hit a target price because of a negative development.

The difficult part is to buy a company when the stock price has already moved up. For example, we bought NVIDIA after it had gone up 40% in several months, but I am glad we bought it at $42 and didnít wait for it to get back at $25. NVIDIA has competition, such as AMD, for example, and we watch that closely. But when it is winning in the marketplace, the stock price goes up. If I had the discipline of waiting to buy the stock at $25, I would have never got the tremendous move in the stock price, which increased six times in the last two years.

Of course, we donít want to overpay, but sometimes people misinterpret overpaying. A strict buying discipline could lead to buying something inferior at a cheap price, just because you wouldnít buy the best company at a higher price.

In terms of selling, when markets or stocks go up, that creates anxiety and doubts whether the price can be sustained and grow further. Selling a stock because it hit a new high isnít always a good idea. If the fundamentals are intact and the management is still on track, these companies tend to grow longer than people think. Overall, we try to identify companies with the ability to exploit major secular trends. Sometimes the risk is selling the stock too early.

Q: What is your portfolio construction process, and what role does diversification play in it?

A: For us diversification is a function of how diversified the company is. Thatís why we are comfortable with a single company like Visa being 4% of our equities. We would consider cutting it back if it gets above 5%, because we seldom have higher individual exposure. We typically have about 35 individual stocks, but we donít invest in highly focused small-caps, so the companies themselves have diversification in their economics.

A larger number of companies wouldnít necessarily provide diversification if thereís high correlation between the macro-economic factors affecting them. For example, both utility and insurance companies carry interest rate risk. But we do believe in some diversification. For example, although we donít have any direct energy exposure, we own companies that will benefit if the energy industry recovers.

In the fixed income area, we usually donít have more than 15 bonds, so we have a total of about 50 securities in the fund. Because we avoid credit or interest rate risk, we only have one bond thatís below investment grade. We currently focus on short-term corporate bonds and floating rate securities.

Banks issued a number of securities that were fixed to variable rate during and after the financial crisis. These securities would have a fixed rate for a number of years and then, if they didnít call the security, the rate would fluctuate with LIBOR. We thought that was a good bet because rates would eventually move up, so we were able to capture a decent short-term yield. Wells Fargo, for example, did not call its security last month and now it is paying over 300 basis points over LIBOR. That will not last, because they can call in three months, but for now the principle is protected and it has provided a good rate of return.

Last year our turnover was about 29%, which is at lower end of our range. In certain environments, our turnover could go as high as 50%.

We use blended benchmark, which is comprised of 55% S&P 500 Index, 35% Barclays Capital Intermediate Government/Credit Bond Index and 10% MSCI EAFE Index.

Q: How do you define and manage risk?

A: The biggest risk is the overall economy. Although we look at the general trends, we donít get caught up in the minutiae. I believe that asset allocation does a lot to determine the risk. The balanced fund by nature moderates some of the volatility and the fear factor when things go against you. We believe that by investing in short-term bonds and structurally sound companies, we can avoid the risk for permanent impairment of capital, while the asset allocation modifies some of the volatility.

The timeframe is also important. You shouldnít invest 100% of the portfolio in stocks if youíre going to need cash flow beyond what those stocks are providing, because in that case you may have to sell stocks when they are down.

Another risk is chasing fads and trends without examining how fundamentally grounded they are. Nothing goes straight up, so making fundamentally sound choices is crucial. It is also extremely important to own companies that you understand and know well. Overall, we believe in doing what makes sense in a repeatable process.

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