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Advisor select

Thomas Plumb is the founding Principal of Wisconsin Capital Management, LLC (formerly Thompson Plumb & Associates), which began in 1984. Mr. Plumb’s roles include Por +

Plumb Balanced Fund
Fund Family
Plumb Funds
Fund Advisor
Wisconsin Capital Management, LLC

8030 Excelsior Drive, Suite 307
Madison, WI 53717

T: 866-987-7888

Riding Trend Drivers and Enablers
Plumb Balanced Fund
May 7, 2018

Q: What is the history of the fund?

I started a balanced mutual fund called Thompson Plumb Balanced Fund in 1987, because there was interest from individual investors, who wanted to participate in the strategy of our regional institutional accounts. I was affiliated with that fund for 20 years and eventually sold it to Dreyfus Corporation. It is still in operation under the name Dreyfus Balanced Opportunity. 

When my relationship with Dreyfus ended in 2007, we started the Plumb Balanced Fund. So the fund has more than 10 years of history but the strategy is older.

Q: What is your investment philosophy? How does it differentiate you from other balanced funds?

Balanced funds tend to have conservative equity performance and they attempt to generate income through their fixed income portion, while we have a different perspective. 

We 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.

We all know that historically stocks tend to have higher returns than bonds but are more volatile. Stocks and bonds are not only uncorrelated, but in adverse situations are typically negatively correlated. So a portfolio that uses stocks and bonds should be geared to using the benefits of the underlying assets to accomplish its long-term investment goals. As you increase the stock exposure, you capture more of the incremental return of an all stock portfolio without capturing all the incremental risk until you get to about 60% or 70% in stocks. To capture the next 1% incremental return that the stock market offers over time, you have to increase your volatility or risk by over 2%.

We have found that the sweet spot for asset allocation is anywhere from 50% to 75% in stocks and that’s how we’ve built our portfolio. The fixed income investments primarily moderate the volatility of the stock market. We tend to take a little credit risk by owning corporate bonds, but we avoid interest rate risk, because in my 40 years in the industry, I still haven’t seen anyone to be really good at predicting interest rates.

Q: What type of stocks do you invest in?

We rely on growth stocks to generate our incremental return and we focus on companies with unlimited upside. We tend not to buy value stocks or stocks for which we expect reversion to the mean. Instead, we look for companies that are able to grow in a variety of economic environments, because they are breakthrough type of companies.  

The world may only show 2–3% real growth over time, but that growth is a composite of many divergent trends. Some segments of the economy can grow much faster than that for a very long time. Our approach is identifying a big trend and then looking at who will benefit from it and who is enabling it. Right now we own many companies in the financial service and technology industries, because we believe that we are still in a secular growth phase. 

For example, we focus on financial services because people increasingly make purchases through mobile and digital devices and are moving away from cash and checks. That trend is going to continue, regardless of how fast the economy is growing. Internet or digital purchasing in the U.S. is growing three to four times faster than nominal purchases in traditional stores. 

Q: What are the key elements of your research process?

We have a top-down process, but it is quite different from the process of other mutual funds. We don’t try to predict whether the U.S. GDP will grow by 3.5% or 3.2% in the fourth quarter because that has limited value for us. 

Instead, we research trends and changes. Then we identify the players in the specific industry, and then we start a due diligence process. We analyze the financials of these players, how they use their capital, how the management is rewarded and what is its ability to execute.

The next step is quantitative analysis, where we examine the recurring revenue streams and the cash flow generation of the business model. We look for growth, so we aim to find companies with accelerating top line and with the ability to increase margins. Recurring revenue streams are significant for the ability to predictably increase margins. 

Overall, we believe that the companies, which will be leaders over five or ten years, first have to be able to execute a business plan that rewards themselves and the shareholders. So, the key elements are increasing revenues and predictability by recurring revenues.

Q: Could you give us some examples of specific holdings that illustrate your process?

Currently our largest holding is Visa, Inc, which is an enabler of the digital transaction structure. If there’s a physical transaction, about 14 cents on every dollar is processed through a Visa card, while in online transactions whether through Amazon or Wal-Mart, about 42 cents on each dollar uses a Visa card.

That’s an example of a company that’s participating with high penetration in the fastest growing segment of retail. The revenue stream is recurring, because people continue to use it in daily transactions. Even people from the older generation, who used mostly cash or small checks, are now doing their purchases through cards. We can see how Visa enables the transformation and benefits from it because it provides the service to make it happen.

While we own some traditional consumer product companies, we focus on companies that allow the consumer to make purchases regardless of the outlet. We are not betting that Costco Wholesale Corp will beat retailer T.J.Maxx, for example. We are just betting that whoever goes into those stores or buys online from them, will probably use Visa or Mastercard. That’s why Mastercard Inc is also one of our largest holdings. Until we see the pattern maturing, or a significant new entry, or a new process that will change the market shares, these companies will continue to be our largest holdings. 

  • Inception: May 24, 2007
  • AUM: $50 million

We also own chip companies that enable that transformation and provide the technology backbone for financial institutions. Finally, there are companies that deal with the consumer and actually make the transactions, such as Amazon, Alibaba, or Tencent. Black Friday and Cyber Monday generated $5 billion sales all over America. Alibaba, which created its own holiday called Singles’ Day, generated over $25 billion on November 11th and 80% of those transactions were done through mobile devices. From our perspective, these are all parts of the chain.

The idea is that we don’t want to spend our time thinking whether 15.8 or 16.5 million cars will be sold in the U.S., because when we own the right technology companies, we know that every car sold will use more smart microcontrollers for safety and comfort devices. It is a question of penetration and often small products can develop significant recurring revenues.

Our equity strategy is to make sure that the companies in the portfolio have the ability to monetize that growth and are well positioned with the trend. It is not a secret that Amazon is growing five times faster than Wal-Mart, so we are watching the story, the execution, and we continue to hold them.

Q: Why is Visa considered indispensable in financial transactions?

Apple is probably the most profitable company in the world, but it is valued at 16 times earnings. That means that the market views Apple as a product cycle company and doesn’t give it the full benefit of its market dominance. When adjusted for cash, Apple would trade at a 25% discount to the market multiple. I believe that’s because it hasn’t structured a recurring revenue stream. Even Microsoft has converted to a subscription model and has developed a recurring revenue stream. Its multiple is 60% higher than that of Apple.

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 don’t 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?

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 company’s 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, Visa’s 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 hasn’t been marginalized yet.

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

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 don’t 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 don’t 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 didn’t 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 don’t 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 wouldn’t 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 isn’t 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?

For us diversification is a function of how diversified the company is. That’s 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 don’t invest in highly focused small-caps, so the companies themselves have diversification in their economics. 

A larger number of companies wouldn’t necessarily provide diversification if there’s 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 don’t have any direct energy exposure, we own companies that will benefit if the energy industry recovers.

In the fixed income area, we usually don’t 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 that’s 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 didn’t 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?

The biggest risk is the overall economy. Although we look at the general trends, we don’t 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 shouldn’t invest 100% of the portfolio in stocks if you’re 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.