Pain vs. pleasure management: An intro to our Crabtree Tech model

Author: Barry Randall, Crabtree Asset Management

Covestor model: Crabtree Technology

Ever had Steve Ballmer poke you in the ribs?  I have.

It happened in July 1999, when I was at Microsoft’s Analyst Day in Seattle. I was curious about what Ballmer thought of the upstart software movement called Open Source. A little company in North Carolina called Red Hat Software had filed to go public and they seemed likely to compete with Microsoft on some level. So while analysts (like me) and executives (like Ballmer) mingled and chatted between sessions, it was a chance to stray from the script and find out what Microsoft really thought of, well, anything.

And as we stood toe-to-toe in a hotel’s conference room, Ballmer let it rip, denouncing Linux and Open Source as terrible alternatives to real software, while jabbing me in the ribs with his finger to emphasize every point. As a professional tech stock guy, it was like a baptism. But instead of holy water and my forehead, it was Steve’s finger and my chest. God save the child. And me, of course, for thinking Linux would ever amount to anything.

I’ve been analyzing and investing in technology stocks since 1993. What was it like back then? No cell phones. No Internet. No Facebook. It may sound like hell on earth today, but really it was a lot of fun. And it still is. It’s especially fun now that I’ve been running my own technology fund for almost three years. You know it as the Crabtree Technology model on Covestor. But it’s known to me as the Crabtree Fund.  Let me introduce you to it.

The Crabtree Fund is our Separately Managed Account product that seeks to generate alpha from going long on a set of 50 tech stocks. Let me parse that for you:

• Separately Managed Account: essentially a private version of a mutual fund – it’s an industry term among Investment Advisers (like Crabtree Asset Management) that have their own investment fund, open only to their clients, or clients of a selected publisher, like Covestor.
• Alpha: the difference between the performance of the portfolio manager and the benchmark against which they measure themselves. In our case, we use the Merrill Lynch Technology 100 benchmark (MLO), while Covestor uses the Nasdaq 100. As of 2/1/12, Covestor calculates our Alpha versus the Nasdaq 100 as 33.2% since our model’s inception.
• Going Long: This just means I only buy and hold stocks – I don’t short them or use options or futures contracts to generate returns. We also don’t trade here at Crabtree: the minimum holding period is three months and about one third of our fifty stocks have been in the Crabtree Fund for more than two years.
• Tech Stocks: We have a master list of roughly 1000 companies, and we own 50 of them at any point in time. The 1000 companies can be classified in four groups: 1) traditional technology firms (e.g. Microsoft); 2) health care technology; 3) business and technical services; and 4) aerospace and defense.

So what characteristics do those 50 companies possess that earn their stocks’ inclusion in the Crabtree Fund? Every Crabtree holding needs to have the following characteristics:

1. Generate cash, via both operating cash flow and total cash flow;
2. Hold on to or gain market share; and
3. Execute on their own and Wall Street’s expectations.

In order to find companies, we use a program to filter all 1000 names in our database to find the 50 companies best demonstrating the Crabtree characteristics. We run that program in the middle of February, May, August and November, just after most public companies have filed their required financial documents with the Securities and Exchange Commission. So we’re using the freshest data available.

Now that you know our “process,” what makes the Crabtree Fund unique?

• We select tech stocks not based on their “tech” characteristics but on their financial and operational strength. It is essentially unheard of that a sector fund would ignore sector attributes in favor of a purely quantitative approach. But we have 11 years of experience using our model and are very confident in this approach, which has produced an Information Ratio of 2.63 versus the Nasdaq 100 since inception on Covestor (as of 2/1/12).
• We don’t care about valuation, per se. Sometimes a great company deserves to have a premium valuation because it reflects a great opportunity;
• We don’t invest in companies because they are part of a benchmark or index. Stocks end up as part of benchmarks because they are large, or their stock is widely traded. These factors have nothing to do with their ability to outperform other stocks;
• We think the best predictor of future success is… current success. Not someone else’s prediction of future success.
• We think it’s more important to know and analyze the five key attributes of every company in our investable universe, rather than try to know every last detail about only 15-20 companies. This leaves the balance of the investable universe unknown and thus able to out-perform us. Our method ensures we’re not getting “beaten” by a company because we didn’t make the time to look at it.

Finally, we believe we have an advantage because we’re willing to tolerate a lot of noise and volatility. Sometimes it’s excruciating to ride out a difficult time in the stock market – like the summer of 2011 – as the budget battles in Washington D.C. caused the market not only to decline, but to punish some of our holdings in particular. But we did not stray from our strategy.

Why? Because history has shown that many investors react to pain by taking action (usually selling the poor performers, down only because of market noise). And that nearly always proves to be the wrong move. The right move is to react to pleasure by trimming (though not selling completely) winners in the portfolio that are still good investments. That way, the manager captures the returns from having been correct, while continuing to own a good investment from that point forward.

And that, perhaps, is the most unique attribute of the Crabtree way: pain management, whether it’s a famous CEO poking us in the chest, or just enduring a rough stretch in the market. Either way, we’re here for the duration. Perhaps you can join us.