The Golden Touch : California Fund Manager Thinks Capital Appreciation

L.A. Times Archives

Jan. 28, 1997 12 AM PT

The Golden State has truly been golden for Conrad Herrmann: The Franklin California Growth fund, which Herrmann co-manages with Nicholas Moore, has posted tremendous returns by investing the bulk of its assets in stocks of companies either based in California or doing most of their business here.

The $212-million-asset fund has gained 124% over the last three calendar years, versus a 54% gain for the average U.S. growth stock fund.

Herrmann, 36, grew up in Connecticut and is the son of Lacy Herrmann, who heads the Aquila family of single-state municipal bond funds. Conrad spent his early career in a non-investment capacity at Aquila, went on to earn an MBA degree from Harvard, then headed West to join San Mateo-based Franklin. He and Moore have co-managed the California Growth fund since July 1993.

Herrmann was interviewed by Russ Wiles, a mutual funds columnist for The Times.

Times: Franklin California Growth started as a passive fund--just buying and holding stocks in a California index--then was changed into an actively managed portfolio. Why the switch?

Herrmann: Egos were involved. We thought we could do a better job with active management.

Before, when we rebalanced the portfolio on a quarterly basis, we often would look at some of the companies in the index and say, ‘My gosh, this or that stock is overvalued.’ At the same time, we wanted to participate in emerging-growth companies that were not part of the index. The IPO [initial public offering] market was beginning to heat up again.

Times: Does your California focus give you enough companies to choose from?

Herrmann: It gives us plenty. There are 1,383 [publicly traded] companies headquartered in California. If you aggregated the capitalizations of these companies, California would rank as the fourth-largest stock market in the world, behind the U.S., Japan and the United Kingdom.

Times: What are you looking for when you buy stocks?

Herrmann: Broadly speaking, capital appreciation. But there are four strategies that we employ to get there. First, we seek companies that we can hold long-term as core buy-and-hold positions. These are truly outstanding businesses--com-panies with high or dominant market share, very high returns on capital, reasonably predictable earnings and signs of managerial excellence. Many also operate in industries with high barriers to entry. Companies that fall into this category include Intel [the semiconductor leader] and Cisco Systems [a computer networker].

Times: What’s your second strategy for selecting stocks?

Herrmann: We want to identify companies that are leaders. They might not have the No. 1 market share, but they certainly have a large market presence, along with some control over their own destiny. We want to invest in these stocks at a favorable point in the company’s life cycle or a key product’s life cycle, and we try to buy them below what we consider the fair market value.

One example: Mentor Corp., a leading maker of medical inplantable devices such as breast and penile implants. One of their newer products, which doesn’t yet have FDA approval, is called ultrasonic liposuction and is used in cosmetic surgery with little invasiveness.

Other examples include Mattel, the toy company, and Xilinx Inc. and Altera Corp. [The latter] are both in the programmable logic-device marketplace of the semiconductor industry.

Times: How about the third strategy?

Herrmann: Here, we want to identify stocks that have become severely undervalued, for whatever reason. We want to use market volatility as an advantage. We’ll buy these stocks when they drop to our price objectives.

Granite Construction fits that bill. It’s one of the largest heavy civil engineering and construction companies in the nation. It benefits from a lot of the public- and private-works projects around California. It has been building its backlog as the state’s economy has picked up, yet is trading for only 40 cents for every dollar of sales.

The stock’s price-earnings ratio, based on estimated 1997 earnings, is less than 11, and it has been growing at a 15% annual clip. Investors just aren’t aware of what’s going on with them.

Another would be K2, which people might just think of as a ski-equipment company. It was formerly known as Anthony Industries, a pool maker, and from those original roots has become a diversified recreational/sports products company. It has good brand recognition with a lot of products--skis, in-line skates, snowboards, fishing rods, backpacks and more.

This is a good, stable company that historically has been able to grow at a 15% to 20% annual rate, yet its shares trade at less than 16 times 1997 estimated earnings.

Times: And the fourth strategy?

Herrmann: Emerging-growth companies. We want to participate selectively in the new-issues market. Netscape is an example of a company we bought as an IPO. When it reached an excessive valuation, we sold it. Then we repurchased it last summer after the market sell-off and still own it. But in general, IPOs are a small part of the portfolio.

Times: Technology is almost synonymous with California, and that sector has clearly helped boost the fund since 1993. How big a stake in tech do you hold now?

Herrmann: Technology is 33% of the fund right now. It has varied from 25% to 40%.

One reason we created this fund was to tap into the entrepreneurial spirit that lives on in California. Certainly within Silicon Valley, there are a lot of investment possibilities. We have identified a formula for success in the region, what we call the Three Ss: for Silicon Valley; the school system--a reflection of universities like UC Berkeley and Stanford; and Sand Hill Road, a venture-capital area of Menlo Park that helps finance many of the new companies coming to market.

These three factors coming together have created some interesting new companies.

Times: Obviously many California companies operate on a global scale, but have you been able to play stocks whose fortunes have improved as the state has come out of recession?

Herrmann: Sure. For example, a year ago we saw signs of the California economy beginning to recover, so we wanted to look for companies that would benefit from this. Examples are some of the REITs [real estate investment trusts] we own, like Bay Apartment Communities and Irvine Apartment Communities. We bought those stocks more than a year ago and still own them. Job growth has been solid, and these companies benefit from that.

Times: What’s your current outlook on the state’s economy?

Herrmann: It’s still very favorable. Various forecasts indicate the economy will be on a roll for several years. Plus, the state government is showing renewed fiscal responsibility. Revenues are picking up again, and the state received an upgrade in its debt rating last July. We think California is hitting its stride.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Franklin California Growth

Strategy: Seeks long-term appreciation by investing mainly in shares of California-based companies.

VITAL STATISTICS

Year to date total return: +1.1%

Avg. general stock fund, YTD: +3.0

5-year avg. annual ret. through 1996: +22.7

Avg. general stock fund, 5-year return: +14.0

Five biggest holdings as of Dec. 31:

1. Computer Sciences 2. Mentor 3. Integrated Systems 4. Netscape Communications

5. Bay Apartment Communities

Max. sales charge: 4.5% Assets: $212 million