Q: What is the history and the core mission of the fund?
I inherited the Alger Growth Opportunity Fund in February 2015 when I joined the company. That particular fund dated back to March 2008. Alger Small Cap Focus Fund started after I took over, with a complete overhaul. The core of what we do is to identify and invest in what we believe are exceptional small companies that have the potential to become successful large companies.
We define smallness in terms of revenue. I think that revenue is a better indication of size than market cap. We want to look for a company early in the corporate lifecycle, but not a startup. A company that has a dominant position in a particular area, but really has a small penetration, so that they can gain market share, but also the market is growing with them and there is significant top-line growth potential. At the initial point of investing, we generally look for companies with operating revenue of less than $500 million. In many cases, a lot less.
Also, we are benchmark agnostic. I do not manage the portfolio by overweighting or underweighting the benchmark. It is all about bottom up fundamental stock selection. The companies we have are not really household names. On a one-year basis, as of the end of February 2017, our beta was 0.83 and our standard deviation was less than the benchmark (Russell 2000 Growth); 13.64 versus 13.87. So even though the focus strategy is less than 50 names, our volatility overall is less than the market and we tend to have really good down-side capture at 70.78 and our up-side capture is 100.3 for the same one-year period.
We spend an inordinate amount of time understanding our companies. Our companies typically have a rare combination of high top-line and earnings per share (EPS) growth, strong growth margin, operating margin, a lot of cash, generally have no debt and strong cash flow generating capabilities. Our holdings generally have a lower debt to capital ratio compared to the benchmark, and higher revenue and EPS growth.
We also have a long-term investment horizon, 3-5 years. Many times it is beyond that. Small cap investing requires a patient mindset. Benjamin Graham had a famous concept, “in the short run, the market is like a voting machine--tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine--assessing the substance of a company.”
Over the long term we are confident that by utilizing our stock selection skills we can generate attractive risk adjusted returns, and outperform the benchmark in the long term.
Q: How do you define your investment philosophy? Are there any underlying principles that you always gravitate to?
We look for companies that are on the cutting edge of innovation, those that can transform an industry. Maybe they have a disruptive technology, they can improve efficiency and productivity, or turn data into actionable information, hence saving time, money and headaches. In the healthcare area, many of them also save lives. Alger’s investment process is about investing in companies driving positive dynamic change.
In terms of investment criteria, the characteristics we look for are companies with sustainable top-line growth and a durable revenue stream, a high-quality, solid balance sheet and profitable growth, not just any growth. I want our companies to be able to fund their own growth and not rely on the financial markets. A lot of companies have recurring revenue, and a strong competitive position that they can defend over the long term.
Most of our companies are science-based companies where the core technology can be applied in adjacent markets or verticals over time. We spend a lot of time with management, understanding what their long-term vision is, instead of short-term earnings. We want to see leaders that really want to build an exceptional company over the long term.
Q: What is your investment process?
We invest in technology, healthcare, industrial, some consumer discretionary, and financial, mostly fintech. It all goes back to innovation. We wouldn’t look at utilities, or consumer staples, the non-growth sectors. Our forte is about analyzing companies from the bottom up. We don’t go with the herd mentality. We would rather understand our companies well. The road less traveled. Performance should derive from stock selection.
Revenue is our initial criteria, typically less than $500 million in revenue at the initial point of investment. What we try to do is qualitative thinking. Is it the kind of company we are looking for? When we have an idea, I will evaluate it with our small cap analysts or sector analysts. They would do a basic analysis, 1-2 pages, including competitive and market analysis.
If an idea is worthy of further investigation, and I make that decision, we’ll do a thorough analysis, using a proprietary model and process, with five-year historical and 5-10 year projections. We’ll look at competitive forces, market structure, penetration, saturation, source of revenue. It’s really a combination of qualitative and quantitative analysis.
We’ll do a stress test and scenario analysis, and establish our bear/base/bull prices, understanding upside potential and downside risk. I particularly pay attention to bear price. Bear is not about the world coming to the end. It’s the worst case scenario for company-specific factors, a realistic bear. We typically would buy at 10%-15% above our bear price. A bull price is if the stars are lined up. We also do a weighted probability of bear/base/bull cases. For a growth company, it’s extremely important that we understand the downside, and have a solid bear case.
We also do a lot of channel checks with suppliers, customers, partners, competitors. And we do a lot of management interviews.
At Alger, we have deep talent in our sector analysts. I also have on my team three dedicated small cap specialists—each of them with different industry experience. One of them has significant consumer, industrial and fintech experience. The other two have very strong healthcare and technology experience.
Q: Can you share an example of a company that highlights your research process?
Veeva Systems (VEEV) went public in 2013. They provide SaaS solutions for the pharmaceutical and life sciences industries. The company started with customer relationship management (CRM) and has a strong long-term partnership with Salesforce.com in the life science vertical. That was their core business initially. Veeva is the market leader in the SaaS space for CRM life science and that business niche alone is about $3 billion-plus. They already have more than 35 of the top 50 global life science businesses as customers and more than 450 clients overall. Their CRM business has strong cash flow generating capabilities and can support new growth engines.
Soon after their IPO, Veeva invested in Vault, a content management platform for the life sciences industry. A lot of people were skeptical if Vault can be successful. We started investing in the company in 2015 and felt that they had the potential to be a dominant player in the content management space. Since then, Vault has grown very rapidly, and has continued to do so.
Veeva has the rare combination of high growth and sound profitability and we think they can have a very strong top-line compounded annual growth rate and EPS. They also have a very high GAAP operating margin, about 20%. And that is the highest for any pure play SaaS company. They don’t have any debt. They have over $500 million in cash on the balance sheet.
Their content management solutions can be used for any regulated industry. And now that they have this success with Vault in life science industry, last quarter Veeva announced that they are moving to a new vertical for quality systems for chemicals, manufacturing and cosmetics. They will start with North America and Europe, and already have two Fortune 500 clients, global chemical companies. It’s a fragmented, paper-based market waiting to be disrupted with robust cloud-based software. They are big companies with money to spend who aren’t leveraging technology. We are confident that they can expand to more verticals in the future. It really is a formidable weapon. And no one else is doing this in regulated industries. The potential is very large. Today, Veeva’s total addressable market has expanded to $7 billion-plus, and the company’s revenue for the last 12 month was only $544 million.
Veeva exemplifies what we look for in what we believe is an exceptional small company. When we run our bear/ base/bull cases, we think the stock is still attractive over the long term.
Q: When you build a concentrated portfolio, do you pay close attention to price? What are your views on diversification?
We run a concentrated portfolio but also believing in diversification in terms of business risk. At a single security level, the limit is typically less than 6% at market value. Industry limit in our portfolio will typically be less than 33%. We also are generally fully invested for cash. If you look at our top ten holdings, it is fairly diversified in terms of end-markets served. For example, we have one company that is a leader in infection prevention controls. Another is a leader in machine vision software, and we also have software companies that focus on state and local governments.
I absolutely care what we pay for our stock, which is why the bear price is so important. But we invest in growth companies. Price-to-earnings ratio, the popular measure of stock is not a good measure for most of our companies because a lot of companies are just getting to the inflection point for earnings. For small companies, we believe the most misused measure is PE, because earnings are not normalized yet.
Q: How do you manage portfolio risk?
We don’t invest in unicorns, hyper-growth companies. The most important factor for us is sustainable growth. We always use volatility to buy on weakness, especially when there is a big disconnect between fundamentals and stock prices.
I would say none of our top ten holdings are hyper-growth companies. It’s about high quality growth. We do invest in some emerging growth companies, but they tend to be smaller positions. They’re growing a lot, but they’re not that profitable yet. This is why the buy point is very important for our risk control. If you understand the solid bear case, that can serve us very well.
For example, Cvent Inc. (CVT), a leading cloud-based enterprise event management platform that seeks to simplify the management of event functions such as registration, e-mail marketing, and web surveys. You could have called it an emerging growth company when we initially bought it in 2015. It became one of our top contributors that year. They were clearly a dominant player, as the crux of its competitive advantage is the proprietary Cvent Supplier database built over the years to provide detailed, up-to-date accurate information of all hotels in a given vicinity; and we believed the network effects associated with the proprietary database would continue to result in accelerating revenue and profitability as the company continues to gain scale, and customers continue to sign up for additional functionality on both the event and hospitality side. The company had no debt and strong cash flow generating capability.
The stock declined significantly in February 2016, due to broad multiple compression across the SaaS software space and the company’s decision to make 2016 a year of increasing investment spend, pressuring earnings in the near term. However, given the improvement across business fundamentals, we viewed this as a transient headwind and believe the company will continue to improve its competitive position over the long-term. We view the event planning space as a fairly underpenetrated opportunity; with an estimated addressable market opportunity of $5 billion, Cvent only has 4% market share with revenue of just under $200mm, despite being the market leader in the space. We added on weakness during that period.
In April 2017, the company was acquired at 69% premium at $36 by Vista Equity Partners.
Was Cvent an emerging growth company? It was. Therefore, understanding the intrinsic value of the business was extremely important. Because we had a solid bear case, at the end, it delivered attractive results.
