Three colleagues left an established fund management company in the mid-1980s determined to set up their own firm, PRIMECAP Management (Trades, Portfolio) Co., which they would run their own way.
They did take a couple of important lessons with them when they left their employer. But more importantly, one of them was a previous associate of mutual fund legend John Bogle, and the company soon won the opportunity to advise a new Vanguard fund.
That fund has had a long string of mostly good years, leveraging its information technology and health care holdings into a number 11 ranking among all gurus followed by GuruFocus (based on 10-year results). Since starting the Vanguard PRIMECAP Fund (VPMCX, Financial) more than 30 years ago, PRIMECAP has delivered an average annual return of 13.4%.
This article is one in a semi-series examining the top 10 stock-picking gurus (sometimes individuals and sometimes teams). The other ten are: David Tepper, Prem Watsa, Bill Ackman, Seth Klarman (by Rupert Hargeaves), Chuck Akre, Vanguard Health Care Fund, Yacktman Focused Fund, Jerome Dodson, Frank Sands and the Eaton Vance Worldwide Health Sciences Fund.
Who is behind PRIMECAP?
The company was born in 1983 when three colleagues at Capital Group (American Funds) – Howard Schow, Mitch Milias and Theo Kolokotrones – decided to leave and form their own company.
About a year later, Milias was approached by a former colleague, one with whom he had had a strong relationship: John Bogle, founder of the (then) much smaller Vanguard organization. Bogle and the PRIMECAP partners agreed to start a new fund together, the Vanguard PRIMECAP Fund, with Vanguard managing the fund and PRIMECAP overseeing the stock picking. It began operations in late 1984.
Kolokotrones is the only one of the three still active in the company (Schow died in 2012). The firm’s president is 55-year-old Joel Fried, who leads a team of two dozen investment professionals and administrative staff.
PRIMECAP, the fund manager
Based in Pasadena, California, PRIMECAP describes itself an independent investment manager, which aims to deliver superior long-term results through equity investments.
In addition to Vanguard PRIMECAP and two other Vanguard funds, it also offers three funds of its own: PRIMECAP Odyssey Stock Fund (POSKX), PRIMECAP Odyssey Growth Fund (POGRX) and the PRIMECAP Odyssey Aggressive Growth Fund (POAGX). The latter fund is now closed.
As of the end of 2016, according to GuruFocus, the fund managed just over $100 billion, with about half of that amount accounted for by the Vanguard PRIMECAP Fund.
Investment philosophy
Its investments are based on four principles: fundamental research, a three to five-year perspective, individual decision-making in picking stocks and a focus on value stocks.
First, it is "committed" to fundamentals because it wants to develop opinions that differ from those on Wall Street and to have a "deep understanding" of candidate companies. This means it hunts for companies with long-term strengths that can outperform the Wall Street consensus or their existing valuations. Such outperformance might arise out of new product and service offerings, better management or structural changes in the industry—a catalyst of some kind.
The second principle is to take a long-term perspective, which it defines as three to five years. To start the process, it tries to identify good companies that are currently unpopular among investors; once invested, it says its portfolio managers then "patiently wait" for the market to come to the same conclusion. This demands high conviction by the managers; they must have fortitude to stay the course in the shorter term when the fundamentals are less promising.
Principle three involves decision-making within the company. Specifically, it tries to avoid committee or group decisions, favoring individual decision-making. Barron’s explains that PRIMECAP adopted what is called the multicounselor system from Capital; this involves several managers independently overseeing different sleeves of a fund.
The fourth principle is correctly assessing the relationship between a company’s fundamental value and its share price, arguing it will only be a good investment if it is bought at the right price. In the Vanguard PRIMECAP Fund’s Annual Report, the team offers Adobe (ADBE, Financial) and Microsoft (MSFT, Financial) as examples. A few years ago, both companies were considered "old technology" tied to legacy business models, while other "new technology" companies had adopted cloud computing and sold monthly subscriptions.
According to PRIMECAP, however, investors failed to see the potential in a transition to software-as-a-service, which both companies managed successfully and, in Microsoft’s case, led to establishment of a new cloud computing business. Adobe jumped from $28 at the end of 2011 to $107 at the time the annual report was written (September 2016), while Microsoft rose from $27 at the end of 2012 to $57 per share at the time the annual report was written.
In other words, use fundamental analysis to find stocks with good prospects three to five years down the road and are selling at prices that do not yet reflect that longer-term value.
Although there is no mention of Benjamin Graham in the reference materials, his shadow is apparent as PRIMECAP looks for value that others fail to see. It is apparent the company has a rigorous and disciplined approach, relying on fundamentals to give itself an edge.
Current holdings
As this GuruFocus overview of the Vanguard PRIMECAP Fund shows, the portfolio is heavily weighted to technology and health stocks:
Note the short positions in ETFs, options and preferred shares. The prospectus for the fund states, “The Fund may invest, to a limited extent, in derivatives...The Fund will not use derivatives for speculation or for the purpose of leveraging (magnifying) investment returns,” but does not provide any additional information in its prospectus or annual report.
Also note that while PRIMECAP has a bias to conviction stocks, it held 277 different stocks at the end of calendar 2016. Granted, there are six different funds, but they are not that diverse. Perhaps the high number of stocks might be explained by the collective size of the funds, more than $100 billion (one of its own funds already has closed to new investors).
These were the top 10 holdings of the fund as of Dec. 31, 2016:
- Eli Lilly and Co. (LLY, Financial)
- Biogen Inc. (BIIB, Financial)
- Amgen Inc. (AMGN, Financial)
- Southwest Airlines Co. (LUV, Financial)
- Texas Instruments Inc. (TXN, Financial)
- Microsoft Corp. (MSFT, Financial)
- FedEx Corp. (FDX, Financial)
- Adobe Systems Inc. (ADBE, Financial)
- Nvidia Corp. (NVDA, Financial)
- Rogers Corp. (ROG, Financial)
Like many other of the gurus followed by GuruFocus, PRIMECAP has generally done very well with timely investments in technology and health care. Observe that two of the top 10 holdings (Southwest Airlines and FedEx) are in transportation businesses.
Performance
This GuruFocus performance table shows the Vanguard PRIMECAP Fund has outperformed the S&P 500 by an average of more than two and a half points per year over the past 10 years:
The average annual return comes in at 9.5%; all but one longer-term performance measure exceeds that:
- 15-year: 9.1%
- 20-year: 11.1%
- 25-year: 12.4%
- 30-year: 12.4%
- Since inception (1985): 13.4%
Turning to the company’s in-house funds, the 10-year average annual returns (as of Dec. 31, 2016) are:
- PRIMECAP Odyssey Stock Fund (POSKX): 8.22%
- PRIMECAP Odyssey Growth Fund (POGRX): 8.87%
- PRIMECAP Odyssey Aggressive Growth Fund (POAGX): 11.75
Comparing the results from the Vanguard fund with the results from the in-house funds, and making allowance for the aggressiveness of the Aggressive Growth Fund, it appears the early years generated stronger returns for the PRIMECAP team. Perhaps the 20 years between the start of the Vanguard fund and the start of the Odyssey funds (in 2004) were more receptive to its style of investing than the last 12 years. But again, this may reflect the scale of assets under management.
Conclusion
In announcing PRIMECAP as one of its Managers of the Year for 2014, Morningstar observed, “To be sure, the Primecap approach can experience periodic slumps, but it has produced superior long-term results.”
As noted, the firm owes much of its success to investments in the right technology and health care names at the right times. Along with that, it made its entry into these names before the rest of the market discovered that value. Behind those stock selections lie disciplined and intensive fundamentals research, as well as a defined development process.
Investors can learn from PRIMECAP Management, but should exercise caution if trying to invest in the same way; past results from volatile sectors such as technology and health care do not guarantee future success.
Disclosure: I do not own shares in any of the companies listed in this article, nor do I expect to buy any in the next 72 hours.
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