Q: What is the history of the company and the fund? 

Principal Global Investors is the asset management arm of The Principal Financial Group. Principal Global Equities oversees the equities investment within Principal Global Investors.

Principal Global Equities collectively manages $75 billion in assets. We have teams managing large caps, small caps, of which I am part of, emerging markets, as well as a systematic strategies team. 

The small-cap team has approximately $3 billion in assets under management. Approximately half of those are in the U.S. small-cap strategies.

Q: What is your investment philosophy? 

We want to be early identifiers of positive and sustainable fundamental change, relative to expectations, and to be mindful of the price we are paying. We like to arm our managers with in-depth information and probe market anomalies that we deem profitable. 

As fundamental investors, earnings are our primary metric of evaluation. We use a set of analytic tools, but we also embrace the principles of behavioral finance. We believe that there are exploitable market anomalies out there due to the persistent tendency of other market participants to underappreciate and react slowly to the potential value of positive change.

As humans, we are averse to change in the broad sense and the risks associated with any such alteration, but when a change is positive, that aversion clearly turns into a disadvantage. Naturally, those who are early to recognize and embrace the change have the advantage.

Our stock selection approach capitalizes and identifies these inefficiencies by focusing on the three major characteristics referenced previously.

Q: Where and how do you start? 

We generally start out focusing on the early identification of companies undergoing a positive fundamental change. The distinction between good companies and good investments involves finding companies with improving revenue or profitability, which in turn is signaling sustainable, positive earnings drivers for that company.

The underlying drivers of this change can come from a number of sources. It may be a favorable product cycle, or possible improvements to the operations and effective deployment of capital. It could also range from cost cutting on one hand to expanding the sales force on the other. There may be changes in the competitive and regulatory environments too.

We look for companies where current market expectations do not fully appreciate the future potential benefit that this positive change brings to the company. This difference in our estimate of a company’s earning potential and prevailing consensus expectations is what we consider to be the expectations gap. As we analyze companies, we want to see where sales and earnings revisions may signal a change driver that can deliver further positive surprises and close that expectation gap in our favor. 

In this process, we have seen a persistent tendency for the sell-side consensus estimates to move incrementally and slowly in reaction to positive change. That creates the expectation gap and once we recognize that, it allows us to get in at an early stage and seize the advantage to jump in ahead of the herd.

However, there are often instances when such positive changes may already have been reflected in the stock price. We do not want to overpay for these positive change characteristics and we really consider valuation as our anchor to reality.

Q: What is your investment strategy and process? 

We are bottom up stock pickers seeking to keep stock selection as the primary driver of our returns. The two things that are the foundation of our investment process are focused fundamental research and a strategic and consistent approach to portfolio construction. Furthermore, our proprietary analytical platforms provide an additional competitive advantage.

For our focused fundamental research, we leverage technology to integrate both traditional and quantitative research and align them with our investment philosophy. On the technology front, our analysts are equipped with a proprietary quantitative ranking tool that we call our Global Research Platform (GRP).

Q: How do you use the GRP and how does it help you avoid any emotional decisions? 

First of all, the GRP is a strong idea generator for our analysts and a key aspect of our competitive advantage. It provides a consistent framework for the analyst to compare the attractiveness of all the companies in the huge universe of small-cap names. We build multi-factor models segmented by economic sector allowing us full visibility into the underlying drivers.

Then, the GRP ranks companies in the database from one to 100 based on our key drivers. This ranking process is quite efficient and we find it an objective and unemotional tool that helps us prioritize our research. Consequently, that gives us a head start in recognizing positive change and helps us to make smart buy and sell recommendations.

Our analysts are at the center of our research process. They focus their attention for new buy ideas on those stocks in the top 20% of our GRP ranked universe, and our research confirms that this is where the greatest alpha potential lies.

Once we narrow our investment universe, together with aspects such as liquidity, constraints one finds in the small cap world, we typically have about 60 to 70 potential purchase candidates at any given time. The analysts will then conduct diligent research to focus on the early identification of change and expectation gaps in order to develop a valuation profile that meets our criteria.

We may see an improvement in a company’s revenue or profitability, and sometimes we even see it in improvement in the sentiment from the Street. We may start to see a small uptick in estimate revisions or companies whose shift in sentiment from consensus is becoming less bearish. People upgrade it from sell to hold or hold to buy, which could be a signal to us that there is potentially something with a positive outcome. Of course, it is important to identify these developments early on, because if you wait too long, you end up being part of the herd with no ability to deliver superior results. 

Also, our GRP tends to be such a powerful tool for us as it does not have any emotional bias. For example, it does not remember that some particular value stock used to be a very poor performing company. All it sees is that there might be a slight improvement, or at least no further deterioration, and that may translate into durable, positive changes over a long period of time.

Q: Would you share an example to illustrate your research process? 

One of our top 10 holdings in the portfolio is Rite Aid Corporation, the third largest retail pharmacy in the U.S. beyond Walgreens Boots Alliance Inc. and CVS Health Corp. The simple fact that Rite Aid was in the small cap universe tells you a lot about how the company was run. After some management changes we saw the first tangible signs of positive change with the potential to deliver more.

First, we saw the remodeling initiative Rite Aid was taking to improve the customer experience along with merchandising in the store. Until then, their stores had been cluttered with no clear thought process given to what was available there and why. Now they finally started implementing a more sensible approach to the inventory in their stores.

The complete absence of any loyalty program in the pharmacy space was a notable limitation for the company. Since we made our investment they have rolled out a customer loyalty program. Another disadvantage was the lack of a pharmacy benefit manager or any relationship to help with controlling some of the prescription-related costs. They have recently announced the acquisition of a pharmacy benefits manager to remedy that too.

Additionally, they have succeeded in cutting costs and improving profitability. By doing this, they have been able to refinance their existing debt at more attractive terms. All of that has resulted in a nice tailwind for the company.

Fortunately for us, there were a lot of areas where Rite Aid could make improvements, so this has been a long runway in terms of realizing that positive change. We will be closely monitoring the story and how it is becoming better recognized and understood by other investors. It is quite possible that there will be some change going on there and we may have to move on if the valuation becomes too rich. We hope that happens.

Q: How would the same approach work in a different industry? 

Another company we have been invested in for a while who has benefited from a favorable product cycle is Manhattan Associates, the supply chain software developer. The company, which has been consistently growing revenue, increasing margins, and reducing share count for years, is focused on warehouse management systems and omni-channel order management systems, helping companies merge their retail and online marketing efforts.

Manhattan’s technology helps enable consumers to go online to a retailer’s website and not only see a product that they want to buy, but also indicate whether that product is available in the store nearest their location. Sometimes the service will even confirm how many of those items are still available in the store. With the help of this service you can then either order online, or go to the store directly to consider purchasing the item. If you decide to order online, you can return the product to the store, if necessary, as opposed to having to send it back to the online retailer. Such features give retailers the ability to effectively manage their inventories and improve their customer’s experience.

Manhattan is very good at executing their strategy, making continuous improvements to their products and upgrading them. The positive change is not really all that dramatic but they are consistently doing what is necessary to deliver continuous improvement and positive change. It is incremental and consistent and less obvious than the likes of Rite Aid but the benefits are just as great.

I think incremental transitions can present attractive opportunities, too. For us, it may require trading off the smaller positive change with a little bigger valuation discount to account for that. When we see positive changes are much bigger, we do not have to be as demanding on how much discount we get on valuation. 

Q: How is your research team organized? 

I have a team of five analysts who support me by separating our coverage responsibilities by economic sector, ensuring we end up covering the whole small-cap universe. Since we are constantly looking for good ideas across the entire spectrum of companies, this feeds into how we construct our portfolios. We want to isolate stock selection as the primary driver of our results, therefore, we do not want to introduce any unintended top down systematic risk into the portfolio. 

The analysts on the team report to me, with four analysts dedicated to U.S. stock research, and an additional materials analyst covers materials globally, because commodities are impacted by global developments. These analysts identify the existence, sources, and sustainability of the positive fundamental change.

Once we get the signal from our GRP rankings, analysts dive into the company and, as they start doing the original research and develop insights into the company, they assess whether the market is recognizing the positive change potential. For instance, when we took the longer-term view on Rite Aid we could see all the potential changes and improvements they could make and what a big difference that could make in the company over time.

Our focused research approach extends to the meetings we have with sell-side analysts and company management teams. By gaining preliminary understanding of where the key drivers are for a particular company, we can go into those meetings with very deliberate questions to probe and challenge their assumptions as we try to understand where the upside and downside might be versus prevailing estimates.

With a more complete understanding of a company’s positive change characteristics and corresponding expectations gap, our analysts incorporate this into their valuation analysis to ensure that we are not overpaying. I have the final authority to decide if the stock goes into the portfolio or not, and if it does, how much to allocate to this position. 

Q: What are some of the factors that motivate your position size allocation? 

There are three critical factors that go into determining position sizes. First is the degree of conviction, or how much we feel and appreciate the combination of positive change, expectation gaps, and compelling valuation discount. And, if the discount is more than we think it should be, we may take a larger stake in the company. 

The second thing to consider is the risk associated with the company. Thus, the more binary in nature the risk becomes, the smaller the position tends to be. If we find what we are looking for in a company but it has large customer concentration, this may cause us to take a smaller position. While that is a risk we would be willing to take, we would want to make sure it is not so big that it cannot be diversified away.

Third, liquidity often becomes a constraint for us, and if the stock does not have enough liquidity that may limit us in how much exposure we can have. 

We seek to isolate stock selection as the driver of our results and minimize unintended systematic risks. In doing so, we monitor those risks and how they might be creeping into the portfolio through our selection approach. If an unintended characteristic is emerging in the portfolio, we are going to be careful in the position size we have in those companies. For example, if the beta – a measure of risk – in the portfolio is approaching the limits of our comfort zone, we may need to adjust the size of positions.

Q: Would you elaborate on portfolio concentration and expected turnover? 

We typically aim for about 150 companies. What is most important in our process is that we find companies that have the criteria we are looking for. Our process allows us to efficiently monitor the entire small cap universe, and diversify our portfolios into the best ideas across all industries.

As mentioned earlier, another factor of stock count are decisions we have to make such as conviction, liquidity, risk, and just accommodating the ideas we are generating.

We use the Russell 2000 Index as our benchmark. You can expect our annual portfolio turnover to be 60% to 80% in a normal market environment. If our average holding period for a company were one year, our turnover would be 100%. That said, this level of turnover suggests a holding period of about a year and a half.

Q: What drives your sell discipline? 

Our sell discipline is driven by our philosophy. Once a stock becomes a holding in the portfolio, we are continuously monitoring it to make sure it has the characteristics we are looking for. This always poses the question of positive change, or whether the expectation gap has closed, and if the valuation discount has disappeared. If we see the change has moderated or reversed, we will remove those companies from the portfolio.

We may have companies that still have the characteristics we are looking for but the magnitudes may have diminished over time, hopefully because the stock prices have performed well for us. But if we find a better idea we will replace that company with a company that has a greater abundance of those characteristics and a greater upside potential.

We will not sell for short term disappointments or temporary drop in GRP rank. With the Rite Aid example used earlier, we have had occasions where it has come in short of where our expectations were. The market reacted negatively, but we had taken the longer view as to how the positive change plays out, and we would rather use those stock price dips as opportunities and increase allocation.

Q: How do you define and manage risk? 

We want to maximize rewarded risk and minimize unrewarded risk. We focus on bottom-up stock selection and taking the right kind of risk. Striving to generate returns that are consistently superior to the benchmark, we recognize that to do so you have to look different from the benchmark, and that requires taking on risk. 

We want to look different from the benchmark at the stock level itself with the individual companies we own and with the characteristics we are looking for. Are these stocks in abundance in our portfolio relative to what they are in the benchmark itself? We then want to minimize the risk we view as being unrewarded, such as top-down, systematic risks.

We do not make calls as far as which industries and sectors are going to come in and out of favor. We let our company decisions influence which sectors we are overweight or underweight relative to the index. We tend to stay within narrow bands relative to the index and do not make calls on what direction the market is going in. Also, we stay fairly beta neutral and uninterested in the direction of interest rates, oil prices or other market impacting factors. Those are, in effect, the risks we want to remove from the portfolio.