How One Fund Has Beaten Its Peers Despite Not Investing in a Single Mag 7 Stock

Key Takeaways

• The Independent Franchise Partners US Equity Fund has produced top-decile returns in the past year, and it only holds a single tech stock.
• The fund’s team focuses on companies with intangible assets with durable competitive advantages.
• Holdings include media names like Warner Music Group and Warner Bros. Discovery, as well as pharmaceuticals firm Johnson & Johnson.

While it seems as if every other fund is investing in the same handful of AI-related stocks, the $1.5 billion Independent Franchise Partners US Equity Fund IFPUX is something of an outlier. It’s managed to deliver category-topping returns without holding a single one of the Magnificent Seven stocks. The fund’s portfolio manager says they focus instead on the stocks “left behind,” letting other investors chase the next big AI play.

“We’re seeing a lot of opportunities in the S&P 493,” says portfolio manager Richard Crosthwaite, referring to the S&P 500 outside of the Magnificent 7. “The opportunity to invest in companies we’ve been following that have been ‘left behind’ has never been richer.” Despite a recent pullback, tech stocks have returned 21.4% over the past 12 months, rewarding investors who have piled into AI-related names.

The Independent Franchise Partners US Equity Fund holds just one tech stock, Oracle ORCL, which amounts to a 4% allocation to the sector. By comparison, funds in the large-cap blend category have a 32% weighting to the tech sector, on average. Despite this minimal exposure to tech, the fund has made it into the 5th percentile of the large-cap growth category, based on one-year returns.

Tech Is Getting Expensive and Asset-Heavy

The fund hasn’t shied away from the sector in the past, but two major factors have contributed to its tech-light portfolio. The first is the sector’s current sky-high valuations, and the second is the shifting nature of how tech companies deploy cash flow.

“We’ve owned four of the Magnificent Seven in the past. We owned Microsoft MSFT and Apple AAPL in 2011, when they had double-digit free cash flow yields,” says Crosthwaite. “The main reason we don’t own them today is predominantly the valuation.”

Crosthwaite says the significant buildout of data centers to support burgeoning demand for artificial intelligence services has changed the cash flow profile of many of the companies in the industry, and that has prompted the fund to reevaluate its position in Oracle. “[Oracle’s] free cash flow has gone negative. They’re spending so much on capex that they’ve gone from a significant net cash business with share buybacks to raising debt to fund the building of data centers,” he says.

This doesn’t mean the fund is bearish on AI-related stocks, however. “We want all of our companies to have a robust AI strategy,” says Crosthwaite. Instead of tech, the fund’s portfolio significantly overweights communication services, consumer defensives, and healthcare. Its 36.3% allocation to communication services (its largest sector holding) is more than 20 points higher than the category average.

The Independent Franchise Partners US Equity Fund Process

The fund’s tech-underweight portfolio comes from its two-step process, focusing on finding quality businesses and looking at their valuations. According to Crosthwaite, to make the grade, companies must show they have a major competitive advantage due to an intangible asset, such as a brand or a series of patents. This advantage must also have proved durable in the face of competition.

Independent Franchise Partners’ analysts start with a curated list of around 150 stocks, 100 of which are in the United States. The team then narrows that down to the 20-40 stocks the fund holds by looking at a variety of valuation metrics. According to Crosthwaite, the most important of these is free cash flow yield. He says that while the exact valuation at which the fund will pick up a stock varies, they won’t go below a 4.5% free cash flow yield, even for the best businesses.

“We get compared to a lot of these other quality funds, and I think some of them fell down in 2022, and that’s because they didn’t focus on valuation,” explains Crosthwaite. In 2022, the Morningstar US Value Index outperformed the Morningstar US Growth Index by more than 30 points. “The funny thing about valuation is that for long periods, it doesn’t really matter. But when it matters, it matters a lot, and it matters very quickly, so there’s no time to adjust,” he adds.

This approach has paid off. In 2022, the Independent Franchise Partners US Equity Fund dropped by 10.8%, compared with an average of 17.0% for funds in its category. Over the past 10 years, the fund has ranked in the 34th percentile for its category, despite having a lower standard deviation (a measure of portfolio volatility).

Warner Music: Pricing Power Is Its Strength

One example of the fund’s holdings from the communications sector is Warner Music Group WMG. The fund has a 3.9% weighting to the stock, its 10th-largest holding.

Crosthwaite says the stock has come under increasing pressure as the streaming industry has matured and subscriptions to music streaming services have begun to slow. The stock is down 5.5% over the past year, but he believes investors have underestimated the pricing power of the large record companies.

Warner is one of the three largest record companies in the US, which together hold the rights for approximately 70% of songs streamed. Warner’s share equates to just under 20% of the entire market.

Warner Bros. Discovery: Ample IP Makes it Takeover Potential

Another firm whose franchise status is based on an ample catalogue of entertainment intellectual properties is Warner Bros. Discovery WBD. The media giant owns a host of cable networks, the streaming service HBO Max, and movie and television studios.

Talk of a possible takeover by fellow entertainment firm Paramount Skydance PSKY has lifted Warner Bros. stock 147.1% over the past year. The fund had a 3.3% weighting to the firm, its 17th-largest holding as of June 30. It will likely be the fund’s largest position by market capitalization weighting when its September filing is released.

Crosthwaite says firms in the media industry are trending toward consolidation as they try to compete with Netflix NFLX, making Warner Bros. and its ample catalogue of IP ripe for acquisition.

Kenvue: Strong Long-Term Potential

Consumer healthcare firm Kenvue KVUE was the consumer products arm of Johnson & Johnson JNJ before being spun off and going public in 2023. Kenvue stock has fallen 26.2% over the past 12 months, largely due to the Trump administration’s assertion that one of the firm’s major brands, Tylenol, is associated with autism and ADHD if used by pregnant women.

Despite the possibility of significant legal liability (Texas attorney general Ken Paxton has already filed a suit against Kenvue), Crosthwaite says, “We’re not averse to increasing our positions when there are legal threats facing a company if we believe they are more short-term in nature. So we actually added to the position quite a lot recently.”

He says the fund has performed an analysis of prior payouts from lawsuits, and that he believes the stock has dropped more than the potential liability warrants. “The market typically overreacts to short-term noise,” he says. Kenvue is being acquired by Kimberly-Clark, where Crosthwaite believes its stable of brands will be better able to thrive as part of a firm that is fully focused on consumer products.

Johnson & Johnson: A Strong Roster of Patents

Kenvue’s former parent company, Johnson & Johnson, is also a major holding. The stock, the fund’s 7th-largest holding, is up 28.3% over the past year and makes up 4.0% of the fund’s portfolio.

While a major player in the pharmaceutical industry, Johnson & Johnson has been overshadowed by Eli Lilly LLY and Novo Nordisk NVO in recent years, as those firms’ GLP-1 weight loss drugs have sent their stock prices skyrocketing.

Crosthwaite says that hype is a significant reason the fund has avoided the two stocks, preferring Johnson & Johnson, whose wide stable of drugs should make it more resilient over the long term. “From a quality perspective, [Eli Lilly and Novo Nordisk] are overly reliant on GLP-1 drugs for future growth,” says Crosthwaite. “When we look at pharmaceutical companies, we really think about the durability of earnings. If you’ve got a very large concentration in a certain part of the business, that poses a risk. A drug can go off patent, or you can see changes in the market, so an overreliance on a single drug makes it difficult for us to invest, from a durability perspective.”