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North Growth U.S. Equity

Over the last five years, as the S&P500 Total Return index's expansion and collapse yielded only a modest average annual gain of 1%, the North Growth U.S. Equity fund yielded an impressive 20.7% average annual return. During the bear market of the past three years the contrast is even more striking, with the fund returning 13.2% annually to the index's 10.1% loss. Such performance helped to place the fund in first and fourth place in its asset class over both three and five year time horizons.

Founded in 1992 by Rudy North as a niche specialty fund under the Philips, Hager & North banner, the fund has been managed by North Growth Management since 1998 when Mr. North retired from PH&N. Rudy North describes the fund's raison d' etre with the following words: "The Fund was to be an uncompromising exercise in the application of investment practices, which I personally had become comfortable with over a long-period covering all types of investment conditions." It is worth noting that the bulk of Mr. North's own assets are invested in the fund.

At present the fund is managed on a day-to-day basis by a team that includes Rudy North's son, Rory, and Erica Lau, who was with PH&N until 1998. Rudy North remains a senior manager for the fund and is involved in all investment decisions. The fund's investment style is bottom-up growth-at-a-reasonable-price (GARP) with decisions based on in-house research. Preference is given to companies that are growing through operations rather than acquisitions. Rory North describes the ideal company as one that has solid prospects for a consistent 15% return on equity, a price-to-earnings ratio of about fifteen, and no debt.

The fund invests exclusively in U.S.-based businesses but operates under few constraints otherwise. For example, there are no hard limits on stock or sector exposure. However, the fund will not invest in tobacco stocks. This practice reflects Rudy North's long-standing policy born of perceived unethical behaviour by tobacco companies during the 1970's. A stock that is chosen for the portfolio will remain as long as it maintains its attractiveness relative to other stocks. The managers will readily substitute better stocks for old ones, and the fund's high 78% turnover reflects an active approach.

Taken as an aggregate at the end of the third quarter, the fund's portfolio reflects its GARP style. It sports a low dividend yield of 0.5% and an earnings yield of only 4.3%, which translates to a price-to-earnings ratio of 22.8. Its price-toearnings ratio is about on par with that of the S&P 500 index and the DJIA, but its dividend yield is significantly lower. The fund's high price-to-book ratio of 2.9 is also similar to that of the indices. From a value perspective this is, of course, an expensive portfolio.

At the end of the third quarter the fund held thirty-nine distinct stocks, which accounted for 99.35% of its assets. Cash rounded out the remaining 0.65%. The top three sectors represented in the fund were technology, health care, and industrials. The fund's top three stocks were Nextel Communications, Chesapeake Energy, and Cardinal Health. Together, these holdings accounted for just over 18% of assets. The fund's significant technology exposure, at over 30% of assets, is about twice the market weighting for tech stocks. It was built up a little over a year ago as the fund saw many attractive tech stocks and began deploying what had been a 30% cash position. The fund previously held significant tech positions until about 1998 when, in Rory North's words, companies such as Oracle, Cisco, and Sun Microsystems became "growth-at-any-price" stocks and were sold.

The fund has been a net buyer recently. Cisco was reintroduced into the portfolio about a year ago, and the fund also added to its holdings in Chesapeake Energy. A notable acquisition during the first five months of this year was The Gap Incorporated, which, at 3.82% of assets, is the fourth largest holding. On the sell side, the fund has been less active. St. Jude Medical was replaced by Guidant, and a position in Clayton Homes was reluctantly tendered to Warren Buffet's takeover.

Rory North's favorite stock continues to be Nextel Communications, which the fund also held between 1994 and 2000. An aggressive position in Nextel was established anew in the fall of 2001 on a firm belief in the company's strong fundamentals, despite rumours of doom and gloom. Out of prudence the Nextel position was trimmed somewhat during a stormy 2002, but the initial move has paid off handsomely with Nextel gaining over 140% since the stock was purchased.

The 2001 and 2002 annual reports included warnings from the fund's managers that the Canadian dollar might be undervalued relative to the U.S. dollar. Although their argument focused on the strong fundamentals of the Canadian economy instead of the weakness currently seen in the U.S., the fact remains that the Canadian dollar's rise so far this year has had a negative impact on Canadian investors' U.S. holdings. The North Growth U.S. Equity fund itself is unhedged. Its one year return to September 30th was 29.9% in U.S. currency, but the Canadian dollar's sharp rise cut the fund's return to only 11.2%. To address the currency risk, North Growth now offers its largest clients the North Growth Currency Hedge Limited Partnership. This partnership is designed to eliminate Canada/U.S. currency fluctuations for investors in the North Growth U.S. Equity fund.

Unlike most of the funds on the Frugal Funds list, the North Growth U.S. Equity Fund is sold by offering memorandum instead of by prospectus. This means that it is mainly directed towards so-called sophisticated investors. Indeed, on the first of May the fund's minimum investment level was increased from $150,000 to a high $250,000, which makes it inaccessible to smaller investors. However, for those who have the means, the fund is available with no load directly from North Growth management. If the fund is to be held in a registered account then you will have to go through a broker.

Over the long term the North Growth U.S. Equity fund has outperformed all other funds in its class, returning a ten-year average of 16.9% annually. This should be compared to the 6.8% average annual return of U.S. equity funds over the same period. Such a superb long-term record of performance coupled with a rock-bottom MER of 1.22% makes the North Growth U.S. equity fund an excellent choice for conservative frugal investors who can meet the admittedly high minimum investment.

FF: Q3 2003

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