Q: What is the history of the fund? Could you give us some background information?
JAG Capital Management, based in St. Louis, has assets under management and advisement of about $1.3 billion in total. JAG Large Cap Growth Fund is a traditional open-ended mutual fund, which exists since 2011. It is important to note that we manage the fund and our separately managed accounts the, and the strategy itself has been in existence since 1990. I have been the co-manager of our Large Cap Growth strategy since I joined the firm in 1999, and the lead manager for the last 10 years.
Q: What core beliefs drive your investment philosophy?
We are unapologetically active managers, who run a focused portfolio of between 30 and 40 individual securities. We strive to be fully invested and we aim to maintain high active share of at least 80% compared to our benchmark index, the Russell 1000 Growth.
Philosophically, we try to capture big moves over a long period of time in big companies. In terms of the companies we own, we look for superior and sustainable growth characteristics, solid fundamentals, and compelling price appreciation potential. One of the ways we identify compelling price appreciation potential is through price momentum, which is a component of both the security selection and the monitoring processes. We also look for fundamental momentum, in the sense that we want to own companies with superior top and bottom-line growth rates that we believe that good potential to persist in the future.
We also focus on sustainability in our process, both in terms of a company’s business model and their corporate citizenship. We want to own companies that with business models that can continue to succeed in the future. Therefore, we look for companies with large and growing addressable markets. Within that cohort, we want to own leaders in their served markets, because leaders tend to have the most pricing power and the widest moats.
In terms of the broader concept of sustainability, we want to own companies who are good corporate citizens, selling quality products and services in a transparent and ethical manner. We avoid owning tobacco companies, hard liquor distillers and producers of offensive weaponry. These are legal products, and one could argue that offensive weaponry is a necessary component of national defense. But as allocators of our own and our clients’ capital, we choose to avoid investing in these types of enterprises.
We also consider environmental, social, and corporate governance (ESG) factors in our security selection process. We want to own companies that treat all their stakeholders ethically and transparently, including their employees, their investors, and their shareholders. Investing in equities is hard enough as it is. Why put capital at risk in shares of companies that have opaque business models, shoddy disclosures, or harmful products?
Overall, we are believers in innovation, the arc of human progress and the advancement of technology. But we are also cognizant of the fact that we live in disruptive times. Technological disruption creates huge winners, and everyone loves to talk about winners. But, by definition, disruptions also result in big losers. From a portfolio management perspective, we want to own the “disruptors,” while avoiding the “disruptees.” We seek multi-year holding periods for the positions that we own, but our focus on the power of disruption compels us to maintain a proactive sell discipline.
We are long-term investors and definitely long-term optimists. At the individual company level, we don’t start with the premise that we’ll hold the stock forever. Rather, we will continue to hold a stock as long as it exhibits the attributes that attracted us initially. When these attributes deteriorate or disappear, or when we see a change in our original investment thesis, we will step aside.
It is easy to buy companies that are doing well and to become emotionally attached to them, especially if they have significantly appreciated since they were purchased. It’s much harder to admit that the situation has changed. We own many companies that operate in dynamic, competitive, growth-oriented industries and markets so, by definition, we need to be watchful if our thesis is still intact. That’s why we monitor the developments in each position and in the broader market. We use a disciplined and unemotional process to monitor our holdings, which helps us to side-step emotion-driven blind spots.
Q: What are the key steps in your investment process?
We are bottom-up investors. Our investment universe is comprised of the top 40% companies in terms of market cap in the Russell 3000 Index. We exclude master limited partnerships, REITs, tobacco companies, hard liquor distillers, and producers of offensive weaponry. The result is an investable universe of approximately 700 securities.
In lieu of a more traditional screening tool, we use a proprietary factor model that sorts, scores, and ranks these 700 securities daily. We have selected these factors over the years and optimized them through back testing both independently and together. We focus on the top quintile of scores, which amounts to around 140 individual securities. Our team continuously curates that to build a Focus List of approximately 80 securities, which includes our 30 to 40 holdings.
Focus List securities are subject to fundamental research. Our fundamental research process is similar to the research of most investment managers. We review earnings calls, company presentations, corporate filings, trade literature, external research from third-party sources and the news flow. We accomplish our own valuation analysis, which considers historical valuations at the company level, peer comparisons, and projected growth rates.
Next, we conduct proprietary qualitative analysis on all candidate securities. We believe this component of our research process is unique. It consists of an 18-question survey that is completed out by the responsible analyst. The survey is designed to address areas of analysis that are not typically captured by traditional quantitative or fundamental research techniques. The questions are designed to compel the analysts to assess each company’s Market, Moat, Management, Messaging, and Momentum. Analysts select their recommendations from the pool of candidate securities that have the highest qualitative scores. These recommendations go into our so-called bullpen, which is typically comprised of names that are vying for a chance to get into the portfolio.
Typically, we don’t interview managements, but we participate in earnings calls and we view how the management interacts with investors. We try to establish if the management is transparent and whether it offers conservative and achievable forward guidance. We also see how the analysts perceive the company and the management. We assess if the company is gaining business momentum and if the owners are facing challenges. Although we rely on publicly available information, we may interpret that information differently. That is how we seek to generate excess returns over a full market cycle.
Q: Why have you decided not to interview management teams?
First, in a post- Regulation FD world, we don’t see a way to legally or ethically gain an edge from the time and expense of interacting directly with corporate management teams Second, we do our best to keep emotion out of our investment process, because unemotional investors are more likely to be successful. Developing a personal relationship, or having an emotional investment in a management team, can be an obstruction to building the desired portfolio. We like to keep emotion out of the process and we don’t want our purchase or sale decisions to be potentially contaminated.
Q: Could you illustrate your process with a couple of examples?
One of our largest holdings is Adobe Systems (ADBE), which we have owned since the summer of 2016. It is a well-known company which our factor model has consistently scored in the top quintile. Prior to our investment, the company was converting to a subscription-based model from selling software on a unit basis. That was a tumultuous change. The transition caused disruption in several quarters in terms of earnings surprises and gross margins. But we viewed the company’s transition to a subscription model positively, because recurring revenues tend to be less lumpy and more valuable than transactional revenues in most industries.
We purchased the stock in June 2016 at under $100/share, while today it trades at over $250/share. Everything that we had expected and most of what we had hoped for has happened in the last couple of years. The subscription approach has grown their addressable market, and the company has solidified its leadership positions in content-creation and marketing-related graphical software. The company continues to outperform on fundamental metrics, relative strength, and momentum. I believe it is good example of what we try to do.
Another example is Intuitive Surgical Inc. (ISRG). We purchased our shares in January 2016, when we noticed a perceived an impending positive inflection point in a new product cycle. The company originally went public in 2000, and they produce sophisticated surgical robots. Their first innovation was a robot used primarily by urologists for prostrate-related procedures. It has continued to expand into other surgical applications in urology, gynecology, cardiology and, potentially, to orthopedics.
Intuitive Surgical not only generates revenue from robotic software, but also from the consumables needed for operating the robots. It is a classic “razor, razor blade” model, which we like. The company’s products, compared with traditional invasive surgery, reduce costs of care by reducing time patients spend in the hospital and rehab. It also results in smaller incision and less trauma to the body. We believe that the company has a sustainable business model because it helps to reduce the total cost of treating certain disorders.
Q: Do you consider Adobe’s subscription model to be sustainable?
Subscription models exist in a variety of different industries, and investors tend to value recurring revenues higher than non-recurring revenues. We always have to monitor the company, the competition, the market leadership and the pricing policy. Once we own a position, we get an opportunity to analyze results, pricing, guidance and performance in various markets. Since we bought the stock, Adobe has expanded into adjacent verticals, applying the same subscription-based approach. I believe that we, as investors, benefited because the company continued to grow not only its original market, but also adjacent served markets.
In another example, we’ve owned Amazon for about three years. We’ve actually owned it several times over the last 19 years, but we most recently got a position in the summer of 2015. As a consumer, my Amazon membership goes back to 1998, when the company was a just an online bookseller. It is a well-known story now, but Amazon has consistently expanded its addressable market and leveraged its internal technology to enterprises in the form of services. Their subscription-based Prime memberships continue to provide their customers with more reasons to buy products and services from Amazon, which has created a flywheel effect over the last couple of decades. These types of growth stories are rare, but we think it is our job to identify them.
Q: What is your portfolio construction process?
We run a focused portfolio of 30 to 40 individual positions. Because of the concentration, we need high conviction to enter a name and that’s embedded in our process. Our buy discipline begins with our factor model, followed by the fundamental research and the qualitative process. When we buy a position, we typically start with 2% weight in the portfolio.
We don’t want to be overly diversified; as active managers we view over-diversification as a potentially negative factor. We cap our individual sector exposure to 150% of that sector weight within the Russell 1000 Growth Index or to 15% of the portfolio. Our largest position typically is about 6%. An exposure of 10% to a single stock would be a rare occurrence, but we do have the flexibility to hold a particularly large weighting in an individual name. We also cap our industry exposure to 30% of the portfolio.
Overall, we have a bottom-up process that results in a focused portfolio comprised of our best ideas. Over the years, the main driver of our excess returns has been security selection, not sector allocation. Of course, we like to be in the right sectors but we don’t have a top-down overlay that dictates the sector weightings. The construction of the portfolio stems from individual security selection.
Q: How do you define and manage risk?
We are not big believers in some of the standard volatility-derived measures of risk, such as standard deviation. The primary risk in growth equities is the permanent loss of capital. That’s the type of risk that we aim to assiduously avoid. Situations like those in Enron and WorldCom in the early 2000s can be catastrophic to portfolios, particularly if an active manager becomes stubborn in his view of the fundamentals or intrinsic value. So we keep a close eye on permanent loss of capital. Portfolio diversification, sector-specific, industry-specific and security-specific exposure limits represent another layer of our risk management.
As we discussed earlier, price momentum is a significant component of our investing process. It is incorporated in our buy discipline, sell discipline and risk management. Since positive and accelerating momentum is a component of our buy discipline, we incorporate negative and decelerating momentum into our sell discipline. When stocks exhibit negative divergences or deteriorating momentum as measured by our internal tools, they become candidates to be reduced or eliminated from the portfolio.
Another area related to risk management is opportunity cost. It can be summarized by the question, “what are we missing?” As growth equity managers, we know that every day and every month there are innovative companies that are poised to do incredible things for their shareholders and customers. Although this concept is not typically included in risk management discussions, we think a genuine risk for active managers to miss transformative stories and companies that are doing great things. We do our best to guard against that risk, and our process is designed accordingly.
