Q:  What is the history of the William Blair Mid Cap Growth Fund? A : Robert Lanphier was one of the three co-founders of the William Blair Mid Cap Growth products in 1997, and David Ricci joined the firm in 1994 and has been a Mid Cap Growth team member for six and a half years. The Mid Cap Growth product became a more broadly available mutual fund on February 1, 2006. Our goal is to build a portfolio of companies that are enjoying sustainable earnings and sales growth and are valued between $1.5 billion and $18 billion. Currently, the mutual fund has $135 million and the midcap investment strategy has $2.7 billion in assets under management. With the help of the investment philosophy and stability of the organization, we have managed to attract and retain talented analysts over the last 14 years, many of whom are focused on the same strategy and market sector. In addition, our network of contacts in the industry and the strict adherence to our philosophy have helped us develop our investment knowledge. Q:  What are the advantages of investing in midcap companies? A : Over the last three decades, the midcap sector has been a source of outperformance vis-à-vis the broader market on the back of superior earnings growth. We believe that on average midcap companies have opportunities to grow at a faster rate. Midcap companies can be great investment vehicles for investors seeking a fund with above-average return possibilities without bearing the risk of small caps. Also, the midcap space can provide them with returns that are higher than large companies or broader market indexes. What is more, midcap companies generally have a breadth of management and can have strength in the balance sheet. Small caps have binary fates. For instance, a small biotech company may be dependent on any one event such as a successful phase III clinical trial in order to move to commercialization and prosper, or it may go out of business if the trial fails. Midcap companies, on the other hand, tend to have a diversified customer base and tend not to be dependent on a specific product. They generally have a broad presence in many parts of the United States or in some cases even worldwide. Q:  How would you describe your investment philosophy? A : We are traditional quality growth investors. We look for companies that can not only grow at a faster pace than the average company, but also sustain that earnings growth for a longer period. There are three places where we find opportunities to generate additional returns by exploiting market inefficiencies. First, we look for companies that are growing but where investors are not focused on earnings beyond the current year. Second, we search for companies that are out of favor as a result of short-term issues. And lastly, we aim to discover companies that are on the cusp of becoming more well known to Wall Street as quality growth investments. As a general rule, Wall Street is obsessed with the earnings growth in the next quarter and at the best in the next 12 months. However, we believe that it is much more important to focus on the earnings growth over the next three to five years, especially starting from the second year onwards. In our opinion, investors pay less and less attention to the longer-term sustainability of earnings, which we call a time horizon inefficiency. Thus, while Wall Street is focused on short-term earnings, we are more concerned about the durability of the earnings in the medium to long term. We can exploit this inefficiency in the market by focusing on companies that have durable franchises rather than looking at the current darlings as perceived by Wall Street. To better illustrate how we consider the long-term sustainability of earnings, I would like to cite an example of a company called Netflix, Inc. It is an Internet subscription service streaming television shows and movies. When we looked at Netflix a couple of years ago, we were very impressed with its highly differentiated DVD-by-mail rental model and the way the company was aggressively addressing the shift to online digital streaming. Still, we were not impressed by the sustainability of the model once it got to streaming, because we were concerned about the new competition from Amazon.com, Inc., Google Inc., and Microsoft Corporation. We felt that Netflix would not have a differentiated offering and ultimately the cost of its content would be bid up as the company started facing more competition for content. On the whole, we were not convinced that the profitability of the streaming model was sustainable. As far as out-of-favor companies are concerned, we generally scour our investable universe for names affected by temporary issues that put off investors. We strive to find companies that have a durable franchise but are suffering from transient issues related to markets, products, or customers. However, if we believe that the long-term viability of the franchise is intact and the valuations are favorable, we will often purchase them. Lastly, we also look for quality growth companies that are not only likely to sustain their growth in the next few years but may enjoy accelerated earnings growth as well. Since such companies either have undiscovered catalysts in place or are not that well understood by investors, they happen to be on the cusp of delivering higher earnings growth. We will certainly follow this kind of company and try to learn the hidden strengths that the market has not discovered or understood yet. Q:  How do you identify a durable business franchise? A : We define durable business franchise as a business with strong management, a sustainable business model, and solid financials. When evaluating the management team, we look qualitatively at management’s record of success, its alignment with shareholders, and whether it has significant equity ownership. We assess qualitative aspects of that management team in terms of its proven ability to reinvent the company, whether there are signs of a solid corporate culture that will sustain it in good and bad times, and whether it is building a leadership team below the top executives that should be able to execute against those growth goals. Those are the types of characteristics we take into account when assessing a management team. In terms of the business model, we look for a very open-ended market opportunity. We prefer companies that are leaders or emerging leaders that have clearly differentiated and value-added products and services, preferably with high barriers to entry, which permits the company to have some flexibility on the pricing front. And then, within financials, we scour for high returns on capital, superior cash flows, and recurring revenue models. We have a preference for more predictable earnings. In addition to the balance sheet and low debt, we also look at high return on capital invested before putting all that together to make a qualitative assessment of whether this company has a truly durable franchise that can sustain earnings over the long haul. Q:  What is your investment strategy? A : First, we start out with about 900 companies that fall in our preferred market-cap range of between $1.5 billion and $18 billion. We also speak with analysts, both in house and on Wall Street, who help us identify potential quality growth investments or durable business franchises. In addition, we have a quantitative team that helps us in identifying names that could have slipped through the cracks. Within several hours of speaking with our experts in the industry and looking at select public filings, we will be able to decide whether a certain company deserves a closer look or a company visit. We initiate our formal research process from then on to learn more about the industry, competitors, and the company. The process continues to an in-depth dive, which can take weeks or months or in some cases even more than a year depending on the level of knowledge that we have of the industry. We will conduct an exhaustive review of the company, which usually involves a visit by either of us to the company along with one of our analysts. While on location, we try to meet with as many people as we can in the organization to get a complete understanding of how they think. Once that due diligence is completed, David and I will talk through the merits of investing in a company. After a thorough discussion, we will ultimately decide if the company deserves a place in the portfolio. Both of us must agree that a name needs to be dropped, trimmed, or added to the portfolio. What we have in place is very much based on a consensus approach. In summary, our analytical work, investment analysis, and company visits, further aided by our collaborative key issue approach, will determine our stock selection. Q:  How do you execute your research process? A : Let me start with an example. One major holding that has been part of the portfolio since its inception in 1997 is Fastenal Company, based in Winona, Minnesota. The company, which distributes nuts, bolts, and various industrial supplies, went public in 1987. What makes it different and such a big part of this portfolio is that the company meets so many of the criteria of a durable business franchise. The management team is very much aligned with us as long-term shareholders. Management team members’ wealth and ownership has been created from the stock that they purchase themselves outright. Another aspect of management is the culture that it has created. At present, the company has more than 2,500 branches around North America, and every branch has its own profit-and-loss statement. Fastenal’s revenue and earnings per share growth has exceeded 20% on a compound annual basis since 1987. Moreover, with more than 2,500 branches around North America, the company has the unique ability to service the local client in a way that nobody else can. Needless to say, that, in turn, allows it to have on the financial side 51% gross margins, 21% operating margins, and fabulous returns and cash flows. It is important to note that the company has achieved this incredible growth of less than 100 stores at the time of its IPO to 2,500 without any debt or acquisitions. It is all organic growth. So, we can see the power of this management, business model and financials that are driving very sustainable long-term cash flows and earnings growth. We also believe that the company’s internal growth initiatives, such as industrial supply vending machines, will enable it to sustain earnings growth well into the future. In our view, this is a quintessential William Blair type of company that retains its people, penetrates existing clients, and expands into new accounts. Q:  When do you decide to sell a stock? A : As bottom-up, fundamental stock-pickers, we spend most of our time looking at the individual security and developing a level of conviction not only in the sustainability of the business franchise, but also in the valuation. Consequently, the most important criterion in an outright sale would be a change in the fundamental investment thesis as it relates to the durability of the business franchise. That could be a change in management or competitive position or a change in how we view the operating metrics and balance sheet. Next, it comes back to the three pillars of the durable business franchise—management, business model, and the financials—and if one of those pillars is compromised, it could lead to a sale. For instance, the CFO of one of our portfolio companies announced that he is departing for reasons that we find difficult to understand. It does not necessarily translate to selling the company on the same day, but it certainly raises a flag for us to go back and take a hard look at whether that is an indication of a problem. Therefore, management change is an obvious reason when we evaluate the situation closely. A less obvious reason to sell would be the competitive environment. Those subtle factors may include indications that a company finds it more difficult to gain share or retain the pricing flexibility that it previously had. Since these developments could undermine the sustainability of growth, such a company can clearly become a candidate for a sale. There are times when even great companies can be overbought and may become unattractive from a valuation standpoint, and that can lead to an outright sale. Whenever that happens, we could come back to the same company when the valuation becomes more attractive again. Q:  How many names do you have in your portfolio? What role does diversification play? A : We have a range of 40 to 60 names that can be in the portfolio. Currently, the number of securities in the portfolio is 56. No company in the portfolio would ever be more than 5% from a market value standpoint, so we control position sizes. An average position would be a little less than 2%. The top 10 holdings of the portfolio tend to represent about 28% of the overall portfolio. The weighted average market cap of the portfolio today is about $7.4 billion, which compares with $7.7 billion for the Russell Midcap Growth Index. As for the turnover in the portfolio, about half of that is probably related to trims and adds around existing positions. Our name turnover would be probably about 35% or so in a given year, so the average holding period of a given name is approximately three years. We put some parameters in place for those economic sectors that represent a double-digit percentage of the benchmark. We will be no less than half and no more than twice that of the benchmark. We use the Russell Midcap Growth Index as the benchmark for the fund. Q:  What kinds of risk do you focus on? A : We think of absolute risk control in three different ways. From an absolute risk control standpoint, our goal is to know our companies as well as or better than anyone else on Wall Street. The second aspect of an absolute risk control is the valuation discipline. We pay a lot of attention to the price we pay for a company. If that risk/reward profile is not favorable or attractive, we will monitor it but we will not feel compelled to own it. Number three is limiting risk and position sizes to no more than 5%. Positions start between 1% and 3% of the portfolio and are scaled back if they hit 5%. There are also benchmark relative risk controls. We start with looking at third-party analytical tools, which are very important to us from a portfolio construction standpoint. They help us understand the decisions we are making, and the risks we are incurring, the intended as well as the unintended. Another risk control examines behavior in the marketplace that is inconsistent with what we perceive to be the fundamentals of the companies. Oftentimes there are external events or factors we want to understand. We build certain custom risk tools for a better analysis of the markets and individual holdings that standard risk tools fail to measure appropriately.