Picking Stocks: Top

When it comes to picking stocks, Putnam Core Equity can seek out gems in every corner of the market. Megacap growth names? Check. Value stocks priced right? Check. Small caps with big dreams? Check.

Portfolio managers Jerry Sullivan and Arthur Yeager run a "go anywhere" fund. That means Putnam Core Equity (PMYYX), a 2023 IBD Best Mutual Funds winner, can shop for virtually any stock in any aisle of the Wall Street supermarket. These managers aren't handcuffed by having to buy a specific type of stock that fits snugly into a style box, such as large-cap growth.

The $3.6 billion portfolio, which holds around 100 stocks, has a personality of its own.

"The style is pretty eclectic," said Sullivan. Any stock with a compelling story in the Russell 3000, an index that tracks the entire stock market, has a chance at gaining entry into Putnam Core Equity's portfolio. "We'll play them if we find them interesting," said Sullivan.

Sullivan and Yeager have worked together for 30 years. They have a knack for identifying best-in-class companies — and snatching them up at good prices.

Putnam Core Equity has topped the S&P 500 in the past one-, three-, five- and 10-year periods, according to fund-tracker Morningstar. The fund posted better returns than 96% of its peers in the 10 years ending July 31.

The fund's 21.6% gain in 2023 is outpacing the S&P 500 by roughly a full percentage point. Owning the right stocks has resulted in market-beating returns. Putnam Core Equity owns all the "Magnificent Seven" tech stocks that are leading the market higher.

As of June 30, the fund's Top 10 included Apple (AAPL), its No. 1 holding, as well as Microsoft (MSFT), Alphabet (GOOGL), Amazon (AMZN), Nvidia (NVDA) and Meta Platforms (META). It also owns a smaller stake in Tesla (TSLA).

IBD caught up with Sullivan and Yeager to learn more about the fund's unique strategy.

IBD: How does the fund differ from most funds?

Jerry Sullivan: It's a multicap fund so it can go anywhere. Its benchmark is the Russell 3000, which is a little less large cap than the S&P 500. It has more small and midsized companies. But we tend to lean the fund just a little bit large cap, just as the Russell 3000 does.

IBD: You don't have to invest in one style of stock?

Sullivan: No. All styles. Growth. Value. Even small caps are of interest to us. If they can get liquidity, we'll play them. We'll also do all kinds of special-situations stocks. We've seen a lot of stocks work in different years and different time periods. Whether it's low quality, high quality, spinoffs, cyclicals, turnaround situations, fast growth. They all have their periods, so we try to put out a product that responds to the era that we're in.

IBD: Are there common traits of stocks you own?

Arthur Yeager: They generally have low leverage and are not dependent on the capital markets to finance their business. They tend to be number one or two in their category and have very good, deep management teams.

IBD: Where do you get stock ideas?

Yeager: We have a consistent process with an eclectic investment style. In a nutshell, we're trying to find securities that are mispriced. The market is rife with psychology and moving parts, and very frequently there's an opportunity that's got good, defined downside risk and good, defined potential upside. We get ideas from three buckets: legacy companies, smart-money indicators, and special situations. We're looking for best-in-class companies and patiently wait for an opportunity.

IBD: What's a legacy company?

Yeager: Legacy just means that we have followed the company for a long time and think we know them pretty well. So, the key ingredient for us is: Are we going to get a chance to buy it opportunistically? We wait around a long time (if necessary). If there's a secret sauce, it's just patience.

IBD: Give me an example of a legacy company you've bought?

Yeager: (Before joining Putnam in 2017), I worked at Raymond James Financial (RJF) for 14 years. It is a very well-managed, high-quality financial firm with a strong culture. So, knowing the company well, when we got an opportunity to buy it, we started to build a position. We generally won't trade around it. But we will add to it when things go sideways, or the valuation becomes temporarily depressed.

IBD: You like to buy opportunistically. Any examples?

Yeager: Lowe's (LOW), the home improvement retailer. We bought it (a few years after) the 2008-2009 housing debacle. (Lowe's commanded a 1.3% position in Putnam Core Equity as of June 30.)

We were looking for a way to play the inevitable turn in housing. The housing stocks had been plundered, and Lowe's was a less-cyclical, higher-quality way to play it. Lowe's was sufficiently cheaper than Home Depot (HD).

Our initial position was around $25 a share and it's now $234 a share. So, it's been a 10-bagger over 10 years. We've added to it occasionally when people got nervous about either their profit margins or comparable sales or (competition from) Home Depot or the housing cycle.

IBD: You are a low-turnover fund. Why do you hold stocks a long time?

Yeager: You have to hold them. Our turnover tends to be lower because we're buying high-quality companies that we think have long runways. You have to believe the runway is sufficient to provide the growth necessary to drive the story. We want sales growth, good profit margins with upside potential that we can get with lower capital intensity. We also want a good ownership culture. If we can get three of those four things, then we want to get the stock at an attractive price.

IBD: Fortunately, you own the seven megacap stocks that have been bull market leaders.

Sullivan: They are dominant. One thing you know about them is that they're not going out of business. And they started off the year so depressed. They got crushed last year. So, we added to a few of them. Some people might criticize us (for owning all of them.) Well, thank God we do. It just keeps you in the game sometimes. You get that right (and it helps performance).

IBD: How do avoid selling holdings early?

Yeager: It would have been a mistake to sell the legacy tech names every time they (ran into trouble). Microsoft, (the fund's second-largest holding through June 30), flatlined for about 10 years despite earnings growing fairly consistently and being a dominant player in its category. Apple, the same thing. It just became more clear that there is no way their position in smartphones was going to get (supplanted). And they were consistently building ecosystems around that.

It would have been very easy to get out of these stocks several times over the last five years because they got temporarily expensive. But it would have been a mistake every time. We look beyond short-term issues like valuation. We try to always look out two, three, five years and say, "OK, is there still opportunity here?" That's why our turnover is low and why we have low-cost positions in a lot of these companies because they've proven their business models successfully over many years.

IBD: You invest in companies that try to bounce back from challenges. Share one.

Yeager: I'll give you a special-situation stock: Pacific Gas & Electric (PCG), (the California utility that declared bankruptcy in 2019 due to liability resulting from wildfires caused by its faulty wires and equipment). They went through the wringer when they burned up the state of California. And the company arguably had a fairly mediocre operating performance.

IBD: So why take the risk?

Yeager: The bankruptcy basically catalyzed the board to go out and find a best-of-breed operator. And they did that (when they named) Patricia Poppe as CEO in January 2021. That piqued our interest. We've got a good utility analyst in-house and he said she's a best-in-class operator. So, we started looking at the stock and we realized that the earnings power was reasonably significant relative to the stock price. We thought (Poppe) could turn it around.

At the time, I think the stock was $10 or $11 with very little sponsorship (stockholders with conviction). Everyone hated it. But PG&E had two things (working in their favor): they brought in Patty Poppe and they had the governor behind them because, basically, it had to work. Otherwise, California is in a world of hurt. We didn't think the state wanted to take ownership. So, the setup was good. The stock was cheap relative to earnings power. You had a very good management team with a well-articulated plan. We started buying at around 10 bucks and got a pretty good position on. Now it's an 18 stock.

IBD: You often get ideas by tracking the "smart money," right?

Sullivan: Yes, we watch the smart money, and look at company insiders who are buying shares. Following (legal) insider buying can be very powerful. It gets us thinking: What do they know that we don't?

IBD: Any holdings you bought at a good price due to patience?

Yeager: Arch Capital (ACGL) (a specialty insurance company) is a stock we had on our radar for a long time. When Covid hit in the spring of 2020, we were sifting through the wreckage and looking for companies that we were familiar with that were high quality and we thought had a lot of downside protection.

(ACGL) was trading slightly below book value. It's well-capitalized. And they have compounded book value since they came public 20 years ago at a ballpark midteens rate. It's an example of something we have had in the back of our mind for a long time, and we finally got a chance to buy it at an attractive price. And that's what we try to do.

IBD: What's your take on Nvidia, the mega tech stocks and the AI boom?

Yeager: I think it's probably overplayed short-term. I've sat in on 50 AI calls over the last two months, and I'm clearly not smart enough to decipher how this is going to roll out and what it really means. At first blush, it's going to be an incredible productivity tool.

The other thing that seems obvious is that the GPU (computer chip) is the center of the AI universe. And that's Nvidia. And frankly, we should own more of it (the fund had 2.2% of its assets in Nvidia on June 30). We will find out more over the next two to three years who the real AI winners and losers are.

Sullivan: AI is more than a buzzword. It's a reality. And just like the dot.com stock era was super-explosive in its infancy, it's the same with AI. Some of these stocks are overpriced. And as we pointed out earlier, Microsoft flatlined for 10 years, so you have to be aware of that. But the AI stocks we own are not at the high valuation levels like the dot-com stock era.

IBD: Can AI stocks like Nvidia go higher?

Sullivan: Yeah, we could go higher. But I think we will hold on here. We don't want to get married to any short-term move because it can kill you once this thing rolls over. It will roll over because some of them get overpriced. But the reality is, AI is a real technology that's going to be with us until long after I'm dead.

IBD: What's your take on the bull market? Can it last?

Yeager: The big driver unequivocally on a short-term basis has been this AI phenomenon. It's driven the biggest stocks which drive the market. But the other thing that's driven the market is that, remarkably, a very aggressive Federal Reserve tightening has not derailed the economy yet.

The second thing is there's still a lot of fiscal stimulus out there like the Inflation Reduction Act and the CHIPS Act. There is also a significant amount of excess savings built up. So, all those things have conspired to keep the economy better than expected. And to some extent, you can argue that the last four months have been a combination of a relief rally because things haven't fallen apart.

IBD: Do you see the rally broadening out beyond megacap tech?

Yeager: We both think the market can broaden out if inflation continues to roll over and the economy continues to chug along. This reminds me a little bit of the mid-1990s when the Fed was raising rates and Orange County, Calif., blew up and (filed for bankruptcy). But the economy remained resilient through that period. The Fed kind of stopped raising rates after Orange County, but they didn't become easy. In the end, the economy chugged along and guess what? Earnings grew, sales grew, people were employed, and it was kind of a Goldilocks environment. It's very plausible that we have that kind of environment over the next year or two. And there will be more people looking for stocks outside of the Magnificent Seven.

IBD: What risks remain?

Yeager: The thing that worries me a little bit is that the Fed doesn't seem to be interested in stopping (raising rates) really, and I'm worried that the political environment as we roll into 2024 is going to potentially upset confidence again. Those are the clouds out on the horizon.

IBD: What types of stocks will benefit from a broadening of the rally?

Sullivan: In a soft landing, small-cap stocks will look better. Cyclicals and domestic stocks, too.

IBD: What small- and midsize stocks do you own that could benefit?

Yeager: We like U.S. restaurant chain First Watch Restaurant (FWRG). It is a unique story with a breakfast- and lunch-only offering. They close the restaurants at 2 p.m. We think they have a long runway for growth.

We also like (enterprise technology company) NCR (NCR), which has a special situation. The company is splitting into two different companies (one focusing on digital commerce for retail, restaurants and digital banking, and the second focusing on ATMs). That would make the sum of the parts worth something in the low 30s and the stock is in the mid-20s.

And Tex-Mex restaurant Chuy's Holdings (CHUY) is a long-term compounding play that we bought in the depths of the Covid crisis. I think our cost is, you know, in the midteens and it's now a 41 stock. It's not remarkably cheap at this point. But it kind of falls into that category of good operators that we think has got a long runway of growth. We'd be more inclined to buy it on weakness than we would sell it at current levels. If inflation continues to come down, you're going to see the small caps and midcaps catch up as the market broadens out.

IBD: Any other secret sauces you want to mention?

Sullivan: We're always looking for an edge. That's the edge. We don't get too comfortable. And we care about valuation. Sometimes people forget that valuation matters.

IBD: So, when do you buy-and-holders sell?

Sullivan: If a company disappoints, the question is: Why did they disappoint? Is it structural or is it transitory? That's what we have to figure out. If we think it's structural, that's it. We've made a mistake and we move on. And if it's transitory, we'll probably add to the position.

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