Why Our Investment Horizon Is Long

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Published September 20, 2012

| Covestor

For Crabtree Asset Management and the Crabtree Technology model, August was relatively quiet. Was it the calm before the storm? Or maybe everyone was on vacation. Heck, even we took a few days off…

The “earnings season” that began in July reached a conclusion in August. The following Crabtree Model holdings reported earnings during the month:

TNS, Inc. ; Catamaran ; Measurement Specialties, Tetra Tech, Cambrex, Hickory Tech, Amdocs, Anika Therapeutics, Accelrys, NIC Inc., EPAM Systems, Nippon Telephone, Astronics, MAXIMUS, GSI Group, Zillow, Magic Software, Photomedix, XO Group, OSI Systems, KongZhong, Mentor Graphics, Perfect World and American Software.

As is usually the case, most earnings reports showed that the companies were doing well. Most notable were the positive reports from Cambrex, Anika Therapeutics, EPAM, MAXIMUS, Photomedix and KongZhong. However, some of our holdings under-performed, including GSI Group, Zillow and Perfect World.

As Crabtree clients and regular readers know, we generally don’t react to company news – not even earnings – but we made a rare exception for Zillow, upon the release of its second quarter earnings on August 7. The company met Street expectations of $0.04 per share in quarterly earnings. However, three things troubled us:

Zillow’s revenue growth continued to decelerate rapidly, from well over 100% in Q1 to 75% in Q2 and a company-guided estimated revenue growth of 60% in the current third quarter;

EBITDA margins were guided down from the 19% achieved in Q2 to around 16% in the current quarter; and the company announced the registration of shares in advance of a secondary offering (this occurred in early September).

So all of a sudden, we found ourselves holding a company trading at a forward PE ratio of roughly 80, that was no longer handily exceeding estimates and guiding future earnings higher.

And one whose supply of shares might soon be growing: the September offering turned out to be 575,000 shares being sold by insiders and 3.425 million shares offered by Zillow itself. This latter number is over 10% of the 29.3 million shares of Zillow already issued and outstanding and represents an immediate dilution of future earnings.

Anyway, our experience is that when companies carrying premium valuations stop showing the characteristics that supported those valuations, re-valuation to a lower price occurs rather quickly.

So we sold our Zillow after-hours on August 7, after the release of the printed earnings announcement, but before the associated conference call. Only time will tell if our decision was wise, and as we write this in early September, Zillow stock is trading at roughly the same levels as when we sold the stock one month ago.

Also in August, we began our quarterly rebalancing process, commencing with the running of our quantitative model after the market close on August 17. Our model process yielded 78 technology companies that met all five of our Crabtree criteria. However, our model process was slowed by an unusually large amount of “data cleansing.”

Thus, although we had a working model in only a few days, it took us until early September until we created a trade blotter; the necessary trades were executed without difficulty on September 5. We’ll have more to say about the new composition of the Crabtree model in our September manager letter, but we’re very happy about the 13 new names in the fund.

Lastly, the Crabtree model performance for August was similar to that of July: mostly quiet and in the vicinity of most of our benchmarks. For the month, the Crabtree model rose 3.76%. This compared favorably with the S&P 500, which rose 2.0%, and unfavorably with the Nasdaq 100 benchmark 4.9%. Our model also slightly underperformed our internal benchmark, the Merrill Lynch Technology 100, which rose 4.5% in August.

But whether good or bad, even monthly performance is considered “short-term” at Crabtree Asset Management. We are investing with a time frame of quarters and years in mind and even as summer turns to fall, that won’t be changing anytime soon. Next month, we’ll discuss the quarterly re-balance in more detail and we’ll look back at our first full year as a Covestor model manager.

Disclosure: The investments discussed are held in client accounts as of August 31. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or that investment decisions we make in the future will be profitable.

Performance discussed is net of advisory fees. Also, any investments discussed in this presentation are for illustrative purposes only and there is no assurance that the adviser will make any investments with the same or similar characteristics as any investments presented. The investments are presented for discussion purposes only and are not a reliable indicator of the performance or investment profile of any composite or client account. Further, the reader should not assume that any investments identified were or will be profitable or that any investment recommendations or that investment decisions we make in the future will be profitable.

Covestor model: Crabtree Technology

Covestor Ltd. is a registered investment advisor. Covestor licenses investment strategies from its Model Managers to establish investment models. The commentary here is provided as general and impersonal information and should not be construed as recommendations or advice. Information from Model Managers and third-party sources deemed to be reliable but not guaranteed. Past performance is no guarantee of future results. Transaction histories for Covestor models available upon request. Additional important disclosures available at http://site.covestor.com/help/disclosures.

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