Morgan Stanley's Dennis Lynch looks for small companies that he can buy and hold for years as they grow into bigger businesses. His search has led to investments from Pandora Media Inc. to Twitter Inc.
Sometimes he is willing to pay prices that look expensive by traditional measures.
Mr. Lynch's picks made the $2.2 billion Morgan Stanley Institutional Fund Inc. Small Company Growth Portfolio (MSSGX) the top performer among U.S. stock funds over the past year on a risk-adjusted basis, according to the Bloomberg Riskless Return Ranking.
The fund surged 69% in the 12-month period ended Nov. 18 for the highest absolute return among 686 equity funds with at least $1 billion in assets, helping to offset above-average volatility.
ROOM TO GROW
Mr. Lynch, who invested in Facebook Inc. and Twitter when they were still private, said that early-stage companies with room to grow can command multiples of earnings and cash flow far above the norm for established firms.
For example, the Morgan Stanley fund has invested in Internet radio station Pandora (P) and real estate data provider Zillow Inc. (Z), which sell for estimated price-earnings ratios of more than 900.
The trick is to compare the current price to what businesses could earn five years into the future, Mr. Lynch said.
“It may look like you are paying a lot at the time, but if a company has a large enough potential, you may look back and find you got in at a cheap entry point,” he said.
The stocks in the Morgan Stanley fund trade at an average of 113 times earnings and a price-to-cash-flow ratio of 26, compared with 49 and 18, respectively, for the Russell 2000 Growth Index, a benchmark for small-capitalization growth-oriented companies, according to data compiled by Bloomberg.
Shares of Pandora sell at an estimated 958 times earnings, and Zillow trades at an estimated multiple of about 2,029, according to data compiled by Bloomberg.
Pandora and Zillow shares more than tripled in the 12-month period ended Nov. 19.
Bloomberg's risk-adjusted return is calculated by dividing total return by volatility or the degree of daily price swing variation, giving a measure of income per unit of risk. The returns aren't annualized.
Morgan Stanley's small-cap fund produced a risk-adjusted return of 4.6% in the 12-month period ended Nov. 18. Its volatility was 15.1, compared with 13.5 for the peer group.
Mr. Lynch said that he doesn't target low volatility, citing Warren E. Buffett's statement that large, lumpy returns beat smaller, smoother gains.
Although acknowledging Mr. Lynch's strong long-term returns, Janet Yang, an analyst for Morningstar Inc., wrote in a note last month that shareholders have “had to endure some stomach-churning periods of performance to get there.”
The fund lost 42% in 2008, trailing 60% of peers, and 9.1% in 2011, behind 91% of rivals, according to data compiled by Bloomberg.
The fund gained 28% on an annualized basis over the past five years to beat 89% of peers, and returned 9.8% when adjusted for volatility over the same stretch, the data show.
The $4.6 billion Primecap Odyssey Aggressive Growth Fund (POAGX) gained an adjusted 4.2% over the past year, with the second-highest total return and above-average volatility. The $1.2 billion Teton Westwood Mighty Mites Fund (WEMMX), which ranked third, combined higher-than-average returns with lower-than-average volatility.
Mr. Lynch, 43, runs the growth team at Morgan Stanley Investment Management, a 17-member group within the bank's money management unit that oversees $30.3 billion in stocks of all market values.
His group also runs the Morgan Stanley Institutional Fund Trust-Mid Cap Growth Portfolio (MPEGX), which beat 87% of peers over the past five years and the Morgan Stanley Focus Growth Fund (AMOCX), which invests in large-cap stocks and beat 98% of rivals over the same period, according to data compiled by Bloomberg.FEWER STOCKS
Morgan Stanley's small-company growth fund owns less than half as many stocks as the typical small-cap-growth fund and has lower fund turnover, trading its stocks about one-fourth as often as peers, Morningstar data show.
Mr. Lynch's largest holding as of Sept. 30, Corporate Executive Board Co., has been in the portfolio for more than a decade.
The firm, which sells research on best practices to large companies, has many of the qualities that he looks for: It dominates a niche market, it can grow at a good pace over time and has what Mr. Lynch considers a sustainable competitive edge.
In this case, that advantage is the relationships that CEB has built with Fortune 500 companies over time.
CEB and his second-largest holding, Advisory Board Co., which provides similar research to the health care industry, were both spinoffs of the same private company.
Mr. Lynch calls spinoffs “a good place to go fishing,” because they aren't always well-scrutinized by other investors.
The biggest contributor to the fund's performance over the past year, according to data compiled by Bloomberg, is another company that was split off from a bigger company: Fiesta Restaurant Group Inc. (FRGI). Fiesta broke off in 2012 from a company that owned Burger King Worldwide Inc. franchises.
Fiesta has two restaurant chains, one of which, Pollo Tropical, has the potential to grow much larger, Mr. Lynch said.
Fiesta shares have more than tripled in the past year. The stock sells for a multiple of 87, compared with 34 for the Russell 2000 Growth Index.
Mr. Lynch isn't concerned.
Investors often are put off by the high prices commanded by early-stage retailers and restaurants without appreciating how big the companies can become, he said.
Chipotle Mexican Grill Inc. (CMG), throughout its history, has sold at higher multiples than rivals, Mr. Lynch said.
“Knowing what we know today, it probably should have traded at multiples so high they would have seemed absurd at the time,” he said.
Chipotle shares have climbed about 13-fold in the past five years, trading at a multiple of 54 times earnings.
The Morgan Stanley fund has a heavier concentration of consumer discretionary and information technology stocks than its benchmark index, according to Bloomberg data.DIFFERENT MODELS
Many Internet stocks in the portfolio shouldn't be thought of as a bet on a particular industry, because the firms have different business models and compete in different businesses, Mr. Lynch said.
“What they share is that they use the Internet to disrupt industries,” he said.
Mr. Lynch said that he doesn't invest based on any particular view of the economy or the stock market, because that doesn't work.
“What we try to do is identify companies in which we have confidence, regardless of what happens to the economy,” he said.
