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Artisan's Andrew Stephens: Growth stocks for barren times

August 1, 2012: 5:00 AM ET

Innovative companies and strong sectors can trump shaky markets, says the Artisan Mid Cap fund manager.

By Amy Feldman, contributor

Andrew Stephens, manager, Artisan Mid Cap Fund

Andrew Stephens, manager, Artisan Mid Cap Fund

FORTUNE -- When the economy is stagnant, says Andrew Stephens, manager of the $6.3 billion Artisan Mid Cap Fund (ARTMX), only companies that innovate or operate in a thriving sector are likely to rise. Those are the qualities he's seeking these days. Stephens, 48, is a growth investor, though the description doesn't quite fit him. Yes, he seeks expanding profits, but he doesn't ignore valuations; he aims to buy stocks at 70% or less of their private market value. Stephens focuses on where companies are in their profit cycle and the strength of their management. His track record suggests he knows what he's doing. Under his leadership since its 1997 inception, the fund (closed to most new investors) has returned an average 13.3% a year, vs. 6.3% for the Russell Midcap Growth index. Fortune spoke with Stephens about his strategy, where he's finding innovation, and why he views Discover Financial Services (DFS) as a growth play. Edited excerpts:

Q: Why do you think growth stocks will do well now?

A: In the developed world a lot of the machinery for growth is broken. Spenders have turned into savers, there's massive deleveraging, and the banks aren't lending. GDP in developed markets is just not going to grow as it has in the past. When growth is subdued, the only way to put up the numbers is to have some secular driver. What will work is innovation. Those companies are not only going to surprise people with earnings, but their multiples will also be valued up.

You're overweight in technology and health care. What do you see there?

We've found a lot of innovation in health care and information technology. We've also found it in the industrial sector and in consumer discretionary. Health care has been good overall, and good for us, so it's a little like talking about the best stocks after they've already been good. Regeneron Pharmaceuticals (REGN) has a drug for macular degeneration, Eylea, that's been a runaway hit and the big driver. But the real story is Regeneron's drug-development platform. The stock has doubled this year and gotten close to our valuation, so it doesn't warrant being as big as it was, but it's still going to grow. We also have a lot of capital in health care information systems. You cannot improve anything until you can measure it, and so much of the system is tied up in administration. The stimulus package three years ago had incentives for hospitals and health care providers to move to automated health care information systems. By 2015, if you don't have a system in place, your Medicare reimbursements go down. That's been a big driver for companies such as Cerner (CERN), which is a leading provider of health care information systems to hospitals and doctors' groups, and Athenahealth (ATHN), which is trying to sort out all the back-office billing and coding.

I was surprised to see Discover Financial in your top holdings, since I don't think of financials as growth stocks now. What's your thinking?

From the mid-'90s to about 2008 was one of the biggest boom times in consumer credit. But credit cards lost market share to home-equity lines of credit and second mortgages. That has all gone away. The consumer took a breather from accumulating debt, and the savings rate went up dramatically. Still, this is America, after all, and we're seeing people take their credit back up again. The credit card business has become a better business. Losses are lower, fee income is higher, and receivables are growing again. And I think it's going to be a while till the banks come back and compete for the consumer.

What's a stock you're getting excited about?

IPG Photonics (IPGP). Some people consider it a boring industrial name. It used to be an optical component supplier for telecom networks. It continued to invest in R&D and developed high-powered fiber lasers that are used in welding and cutting applications and are far more precise and efficient than the traditional processes. They are taking share, quite rapidly, with all the big assemblers, the automakers and aerospace companies. While we worry somewhat about the industrial economy and what's going on in Europe and in China, we know they're at a very low market share in welding and cutting, and that will grow over time. Our primary metric is their share of installed lasers, and as long as that continues to go up, we know we're onto something.

That's an interesting area to find innovation.

We spend a lot of time traveling around outside the U.S. It's very clear to us that the Chinese need to, and want to, automate their economy, not only because labor costs are rising, but also because if you want a quality supply chain where people trust your products, you need to have the same standards that other parts of the world have.

So we've got a pretty big exposure to Agilent Technologies (A), which does testing and measurement for food quality, and Mettler-Toledo International (MTD), which does weighing and testing, and Rockwell Automation (ROK), which does automation and robotics for the factory floor, and Trimble Navigation (TRMB), which does GPS-guided agriculture equipment.

This story is from the August 13, 2012 issue of Fortune.

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