By Harold Goodman
August 19, 2003

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The name Mosaic Funds comes from a metaphor that likens investing to a composite picture assembled from an intricate and sometimes ornate gathering of smaller parts. In the same sense, Mosaic’s funds are an amalgamation of numerous carefully placed steps that form complete and hopefully lucrative portfolios.

Haruki Toyama, a co-portfolio manager at Mosaic Investors Fund, employs a conservative analysis strategy in which stocks can at the same time fall into both growth and value characteristics. Investors are now rewarding the fund with new assets for sticking to a defensive posture that helped protect its assets in recent bear market years when the Standard & Poor’s 500 Index lost more than 10% of its value. Since its inception on Nov. 1, 1978, the fund has endured a succession of market cycles and now boasts a 5-star rating from Morningstar.

FundEmail: The fund combines a growth-at-a-reasonable-price, otherwise known as GARP, investment style with value investing philosophies. How do you integrate the two strategies in one fund?

Haruki Toyama: We get that question a lot. In our own minds, we don’t view value and growth as mutually exclusive. The best investments have to have characteristics of both. To use the phrase value means you’re buying a security below what it’s worth, which to us is a redundancy. For example Cisco Systems in the early 1990’s was growing quickly but selling a t a high multiple. You could look back and say it was a growth investment but in hindsight perhaps it was selling for less than it was worth. Then take Coca Cola, a famous Warren Buffet investment in the 1980’s. He paid a premium to the Standard & Poor’s 500 Index, so in many eyes he made an investment in a growth stock, but given the fact that the company was growing at a decent pace it had the [value] qualities that he was looking for. I think two parties can disagree wither it was a growth or value investment, but in reality it was both-- it was selling for below what it was worth and growing at a healthy pace.

FundEmail: Can you talk about Mosaic’s metrics for identifying bargain stocks?

Haruki Toyama: I can tell you what we look for. We use an approach that looks like three-legged stool. First we look at the business model of a company. Does it have a sustainable competitive advantage? It’s a qualitative factor without a number that we can screen. What kind of cash flows does it generate and are those cash flows sustainable into the future?

The second leg of stool is the management team. We like to see a strong and proven track record of enhancing shareholder value and making intelligent capital allocations – a management team that has a high degree of integrity. There are a lot of quantitative clues here. A company with conservative accounting practices has higher degree of integrity to us.

The third leg of the stool is the valuation, which is the most quantitative, and the final piece of the puzzle. The bottom line is whether the stock is trading for significantly below what it is worth. We use PE [price to earnings], price to book, price to fee cash flow and price to asset value. At the end of the day some sort of price to economic earnings is probably the one we tend to find the most useful.

We own a company called Liz Claiborne that we bought a few years ago when the stock came down in earnings growth. At that time it was selling for a very low multiple, in the single digits, and a lot of people might say that was a value investment. To us, we saw a company that was selling cheaply that had potential to grow significantly over a long period of time. At the time we purchased the company it had characteristics of a growth and value stock.

FundEmail: This is a concentrated portfolio of 30 stocks but its beta is only .80, which means the fund is 20% less risky than the Standard & Poor’s 500 Index. How does this fund limit volatility with so few holdings?

Haruki Toyama: That’s one of the highlights of what we do. One of our underlying themes is managing risk-- we care a lot about the downside. A lot of companies are selling new product or technology that might not pan out. I think the three major legs of the stool, particularly the valuation, asks if we buy a company at a reasonable price so we have a cushion if things don’t work out. If you buy a dollar at fifty cents and it goes down to 75 cents, it’s ok.

We try to buy companies with good management. You want management you can trust to do the right thing. There are hundreds of ways to find good management. One of the best ways is to look at the cash track record of that team. As an example, we recently bought Walgreen Co. The top management team has been at the company for a long time, and during the tenure they have always made intelligent decisions – always sacrificing a little bit at the short-term for the long term. Walgreen is one of the only chains out there that has expanded through internal growth rather than acquisitions. Growing internally initially depresses your earnings in the short-term but it’s more stable in the long-term.

Also, under our business model, we look for companies with strong competitive advantages. Those could be any number of things, such as strong brand name or market share. It could be a strong balance sheet or unofficial oligopoly in the industry. We try to evaluate whether these competitive advantages are strong or sustainable because it reduces the chances of a company stumbling or hitting a permanent impairment in their fundamentals going forward.

We don’t think owning a hundred names in a portfolio reduces risk. I think a lot of people equate risk with straying too far from an index. A lot of managers like to own a lot of names because they think it reduces the chance [of underperforming the index.] To us, risk is a permanent loss in our capital. The Investors fund was flat during the bear market when the S&P was down by more than 30%.

FundEmail: More than 35% of the fund’s holdings are in the financial sector. Is the portfolio likely to increase its holdings in these types of stocks when interest rates invariably rise?

Haruki Toyama: I can’t say whether it’s likely to increase or not. It’s most definitely at a high weighting and it’s unlikely you’ll see the financial sector at 50%. We don’t look at a macro trends to make decisions. Some of the [financial] holdings will benefit from rising rates. Berkshire Hathaway, for example, has a large investment portfolio, and as the rates go up the yields on bond holdings will go higher. Berkshire is flush with cash and also it’s generating a lot of cash flow from its businesses, and as rates go up it can reinvest that cash. You can’t make blanket statements that financial companies don’t do well in rising rate environments versus declining rate environments.

FundEmail: What sectors are attractive in the remainder of this year given a recently optimistic outlook on the U.S. economy?

Haruki Toyama: No particular sector really catches our eye. I think during the last three years you saw some valuation disparities between sectors. You saw technology at high valuations versus financials at low valuations. Now the gap is closing between different sectors. Technology looks a little pricy right now as a sector. We’ve had a run-up this year and we’re lowly weighted in that sector because we can’t find a lot of opportunities.

FundEmail: This fund has managed to contain expenses by refraining from using special marketing costs known as 12b-1 fees. How important is containing costs to the fund’s performance?

Haruki Toyama: It’s tied a philosophy of ours. Our overarching goal is to give our shareholders the best returns we can, so we strive to keep our expenses as low as we can. Obviously John Bogle [founder of The Vanguard Group] has come out and is outspoken on this issue. When shareholders were getting 18% a year nobody cared. I think we [as an industry] developed a culture of shooting for the highest return and the expense ratio didn’t enter into peoples’ decisions. Going forward you’re unlikely to see the returns we had during the bull market. If you were getting 30% a year and now you’re getting 10% a year, a half a percent of fees makes a pretty big impact on the portfolio, especially over the long-term.

Our assets have grown so we’ve lowered our expense ratio over the past year. It doesn’t make sense to me that a fund company might charge 1.5% when they have $20 million and still charge the same amount at $10 billion. I think we were at 1.15% a year ago and now we’re below 1% while the fund has gone from $35 million to $110 million.

FundEmail: Tell us about yourself. What made you decide to become a money manager?

Haruki Toyama: Outside of work I like to read a lot of different things -- American history, Japanese history, novels and art history. I like music and I have played classical piano since I child. My first job out of college was at a financial planning office. We were advising clients on how to invest their money and I got more interested on the portfolio management side than the financial advice side. After a few years I went back to school at Cornell University and got an MBA. Before Mosaic I was at MFS Investments and David L Babson & Company, Inc., which is a subsidiary of Mass Mutual Life Insurance Company.

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