You don't have to own the hottest stock on the planet to build a market-beating portfolio and top mutual fund.
Michael Schroer, manager of AMG Renaissance Large Cap Growth (MRLIX), doesn't own AI darling Nvidia. But that hasn't stopped his growth fund from racking up gains that outpace the S&P 500. This year the fund's 8.36% total return through Feb. 29 tops the S&P 500's 7.11% gain, according to fund-tracker Morningstar.
Why hasn't Schroer, who has piloted the fund since 2009 and co-manages the fund with Andy Eng, loaded up on Nvidia, which is up 66% this year and topped $2 trillion in market cap?
In a word: valuation.
Thriving Without Nvidia
Sure, Nvidia has earned rock star status on Wall Street as a leading maker of chips fueling the artificial intelligence build-out. The problem? The stock sells at more than 30 times sales. And that's simply too rich a valuation for Schroer. He prefers to buy growth stocks that have strong earnings momentum that trade at more reasonable valuations.
"In decades past, the 10 times revenue rule was, don't buy a stock at more than 10 times revenue because you will never make money on that," said Schroer. "And here we are with a stock that has been going up astronomically and is still selling for up to 30 times revenue. So that's the answer (as to why we don't own it)."
That's not to say Schroer isn't a fan of the Magnificent Seven megacap tech names that have been leading the market in the current bull run. His top four holdings at the end of January were Apple, Microsoft, Amazon.com, and Google parent Alphabet. He also owns Meta Platforms.
Asked why he owns these popular stocks and not Nvidia, Schroer said, "Their valuations are just much, much better."
Finding Growth Stocks By Top Mutual Fund
Schroer's philosophy of investing in quality growth companies when they're not selling at nosebleed valuations has paid off handsomely for shareholders of AMG Renaissance Large Cap Growth.
The fund, a 2023 IBD Best Mutual Fund Awards winner, has topped the S&P 500 benchmark in the past one-, three-, five- and 10-year periods. That's a clear sign that the fund's disciplined approach works in the short run and over time.
A Top Mutual Fund's Template For Success
Schroer says he looks for three things when evaluating a stock to buy for the portfolio, which typically owns just 50 to 60 stocks. Strong rates of fundamental growth (think high returns on capital and strong profit margins). Near-term earnings momentum (positive earnings revisions from Wall Street analysts and upside surprises when companies report earnings). And reasonable valuations (or companies selling at low multiples of earnings, cash flow, and sales). But he says he wants to see all three of those stock traits, not just one or two of them.
"If we find all three of those attributes together in a particular company, we found a good investment opportunity," said Schroer.
The fund's quantitative model scores stocks in the Russell 1000 Growth Index on all three characteristics. Schroer and his analyst team then seek out buy ideas from the companies that rank in the top 20%. The next layer of research involves what Schroer calls a "deep dive" and fundamental review of an even smaller number of companies that stand out.
Why A Top Mutual Fund Likes Stocks With Earnings Momentum
Just because Schroer prefers names with attractive valuations doesn't mean he shops for the cheapest growth stocks. No reason to tie money up in so-called value traps, or stocks that stay statistically cheap for years at a time.
And while Schroer says AMG Renaissance Large Cap Growth's current price-earnings ratio is about 20% lower than the Russell 1000 Growth Index, it's still a tad higher than prior years due to the market rally that has pushed the S&P 500 and Nasdaq to fresh all-time highs. The fund, he adds, does own some stocks selling at high multiples. But those higher valuations are offset by "extraordinarily strong earnings momentum and growth characteristics," said Schroer.
To avoid buying stocks that trade at reasonable valuations but have little upward stock price momentum potential, Schroer buys stocks with earnings momentum.
"The (profit) momentum provides the near-term kind of kicker that causes a (upward) change in the valuation of the stock in the marketplace," said Schroer. "That assures that we don't have dead money in the portfolio."
Why A Top Mutual Fund Takes An Equal-Weight Approach
AMG Renaissance Large Cap Growth doesn't make big bets on any one stock it owns. Instead of determining size weightings on its positions based on market capitalization, as the S&P 500 index does, Schroer takes an equal-weighted approach. That means all 50 to 60 stocks in the fund can move the performance needle.
This part of Schroer's strategy avoids having too much of the fund's performance riding on a concentrated handful of stocks, as the S&P 500 does now with the Magnificent Seven.
For example, even popular tech stocks that AMG Renaissance Large Cap Growth owns, like top holdings Apple and Microsoft, have much smaller weightings than the index it tracks. Schroer's portfolio has roughly 3.25% of assets invested in Apple, versus a weighing of nearly 12% in the Russell 1000 Growth Index. Similarly, Microsoft's 3% weighing is roughly 25% the size of the index's weighting.
Over the long term, the S&P 500 equal-weighted index has posted better returns than the cap-weighted S&P 500, says Schroer. "There's a performance advantage," said Schroer. He notes that last year the cap-weighted S&P 500 outperformed its equal-weighted brethren by the largest margin since the late 1990s. He says that back in the late 1990s, when the pendulum shifted after the 2000 dot-com stock bust, the equal-weighted S&P 500 index outperformed the cap-weighted S&P 500 over the next five years by 700 basis points annualized.
"I don't know if history will repeat itself, but there is precedent" for the performance of the market on an equal-weighted basis to pick up after periods in which market-cap driven performance dominates.
Stocks That Top Mutual Fund Manager Is Buying Now
While Schroer is avoiding pricey Nvidia, he's gaining exposure to the AI boom by buying semiconductor equipment makers, a bet on the recovering chip space after a post-Covid inventory build- up and continued strength in AI. "We have Applied Materials, Lam Research and KLA," said Schroer. They are all selling at mid-20s earnings multiples, Schroer says.
"We are believers in a recovery in the chip market, due in part to the spending on artificial intelligence," said Schroer. "It is a sideways way of playing the AI trend. (All the chipmakers) are going to need chips that are made by Applied Materials, Lam Research, and KLA. We think there is a long cycle ahead for these companies."
Another high-quality growth company selling at a reasonable price that Schroer is bullish on is hospital operator HCA Healthcare. The stock, which sells at a midteens P-E multiple, is benefiting from a rebound in surgeries after a sharp drop during Covid as well as easing labor costs for nurses and other health specialists. "You're starting to see more people going back for elective surgeries," said Schroer.
Digging For Opportunities
Schroer is also bullish on streaming provider Netflix. "They're showing really strong momentum in their business," said Schroer. "They added 13 million global subscribers in the fourth quarter of 2023. That was the biggest pickup in subscribers since the first quarter of 2020."
A big factor working in Netflix's favor is that they have great operating leverage. "As you add new subscribers, it doesn't necessarily cost you to provide those services," said Schroer. The company reported operating margins of 17% in the final quarter of 2023 and expect margins to increase by 24% in 2024, says Schroer.
For the market to keep up its positive momentum, Schroer says solid earnings growth must continue. He sees opportunities in pockets of the market that offer good valuation and are still lagging the major indexes. "We're trying to find companies that haven't caught up to the rest of the market, but still offer good valuation and have a good growth profile," he said.
