Q: What is the history of the fund?
The original fund, at the time called Scudder Capital Growth, was incepted in July 2000 and was managed as a blend portfolio with a slight growth bias relative to the S&P 500. Deutsche Bank acquired Scudder Asset Management in 2002 and a new portfolio management team took over in 2003. They added a top-down macroeconomic analysis, using as benchmarks both Russell 1000 Growth and S&P 500 indexes.
In 2009 another team took over and emphasized a mix of top-down and bottom-up views by taking a more thematic and high-quality focus to investing. I began to manage the fund in October 2016 and, until then, had regular interaction with the previous analysts and the portfolio manager. We had a strong overlap in terms of assessing individual companies from a bottom-up perspective. That guaranteed a natural progression of fund management.
Q: How is the fund different from its peers?
The obvious differences are the low turnover, which is a result of our long-term thinking, the emphasis on risk balancing as opposed to momentum-led investing, the diversification across sectors, market cap and growth life cycle stages, as well as the fact that performance and risk are driven almost exclusively by stock selection.
More important are the method and, in particular, the mindset we apply to investing that help us make sense of today’s world, which has become increasingly dynamic and more influenced by intangibles given the rising service and intellectual property share of GDP. Therefore, we think of ourselves as students of change and its dynamics, aiming to understand and identify the right type and mix of growth stocks for the portfolio. We consider ourselves not only portfolio managers, but also innovation analysts. That helps us build conviction in the durability, magnitude and pace of change, while financial markets appear influenced by short-term flows.
Q: What is your investment philosophy?
We believe that the companies undergoing positive dynamic change offer the best investment opportunities, because they represent a scarce asset. Therefore, they are expected to earn a premium, irrespective of the economic conditions, and should outperform across the market cycle. We believe that we can capitalize on that change better than the market by identifying positive change early and by systematically studying and understanding its nature, drivers, and sustainability. The market usually acts more on short-term news and is typically slow to recognize the potency of change.
So we focus on high-quality companies that exhibit positive change, which is long-lasting, sustainable and especially explainable, while not being priced into the stock. We look for companies that are in the sweet spot of superior growth, driven by distinct competitive advantage and strengthening or superior fundamentals, while operating in secular growth-driven market segments.
We believe that growth is typically misunderstood and gets underappreciated. From our perspective, the key is to remain disciplined in terms of the investment timing and time horizon, especially when temporary market dislocations or overreactions to short-term news provide compelling opportunities. Consequently, we are strong believers in a consistent, yet adaptable investment process that lets us take advantage of these situations and learn from past mistakes.
We also recognize that investment decisions cannot be made on numbers alone. Competitive advantage is based on effective business strategy, and the creation and exploitation of tangible and intangible assets, so it cannot be measured but must be assessed. Aspects like corporate culture, brand power, stakeholder relations and innovativeness are hard to directly quantify, but they are important, especially as the economy becomes more driven by ideas and creativity. This in turn requires the development of insight, judgment and intuition through deep thinking and research, not just acting on the obvious.
Q: What is your investment strategy?
Our strategy centers around two concepts to identify and invest in the right mix of growth stocks. The first concept focuses on the growth dynamic and divides growth into a pyramid of two categories that fit our criteria for long-lasting, sustainable and explainable growth. “Stability” represents about 80% of the mix and includes gradual or consistent high level of growth. The other 20% represent “fancy” growth, where change is described as disruptive, inflecting or accelerating.
The latter is associated with higher risk for business failure, because it involves younger and less proven business models and organizations. The stability portion is therefore the intended base layer of outperformance, while the fancy portion represents higher optionality for upside reward.
The second concept is based on the premise that companies, similar to products, follow the path of a life cycle from the initial start-up phase until they grow and eventually mature. We define this path by dividing it into three relevant growth stages with distinct characteristics: early, core and established. The core segment is the bulkiest one, representing 50% to 70% of the portfolio; the established companies represent 30% to 50% and the early stage portion accounts for less than 10% of the portfolio.
We combine these two concepts with our principle for diversification and we manage the risk-reward profile of the portfolio by taking into account the degree of a company’s growth dynamic subject to its life cycle maturity stage.
Q: Would you describe your investment process?
Our process is guided by a fundamental-oriented investment framework: The four Cs. The first one is Conviction, which we capture in a business thesis through fundamental assessment of each individual company and its growth prospects. The second is Comfort, which addresses our risk tolerance to the most impactful threats to the business thesis that we know and want to learn more about. Building a bridge from whether the company can be a good stock, in this step we also pay attention to the stock characteristics of the firm. Confidence then looks at testing various scenarios of future business outcome resulting in an understanding of likely risk-reward, while identifying deviations from consensus. In a final step, which we call Competition, the overall context of the portfolio including its construction parameters is taken into account to select and hold only the best ideas.
Overall, we spend a significant amount of time building conviction in the long-term growth prospects of a business. The critical step is then translating this view effectively into the investment decision, which is what the other Cs help us do.
It is a collaborative process but it is the portfolio manager’s ultimate investment decision and responsibility to include a name in the portfolio or not.
Q: How do you generate ideas?
The best ideas come through observation, reading, listening and, importantly, making the connections. Screening cuts out a lot of the noise and directly leads to companies that meet certain criteria, but the human aspect also plays a role. I believe that outperformance is the result of a differentiated skill set that is the result of learning, experience, judgment and even the intuition that we develop over time in a collaborative environment where we look to connect and extend our knowledge in an attempt to cut across traditional barriers of research as trends converge and innovation spreads across industries.
Q: What is your research process? How is the team organized?
DWS represents a platform with more than 900 investment professionals with local presence around the globe. This provides an informed global perspective, which is extremely valuable in our investment process as we assess secular trends, investigate shifts in competitive landscape and try to gain an early read along global supply chains. We have also built long-term relationships with industry experts, business leaders and sell-side research analysts outside of our firm.
We interconnect on a formal and informal basis. That helps us stay aware of bottom-up asset class, sector and regional perspectives and cover blind spots. Within our team, we regularly meet with the analysts and other portfolio managers to share and elevate each other’s knowledge and understanding.
The process can be best described by starting with the idea generation, which is followed by further reading, listening, debating and asking questions at management meetings, conferences and expert panels. Building a conviction requires understanding the distinct competitive advantage and its sources such as intellectual property, brand power, network effects, management capability and corporate culture. It also involves analysis of secular trends as well as the company’s specific fundamentals and contemplating if they are staying superior or getting stronger over time.
For that reason we spend most of our efforts on understanding a company’s business and business strategy. Combining the fundamental insights with a rational view on valuation and stock-specific sentiment factors will then lead us closer towards the investment decision.
Q: How do you measure the investment worthiness of a security?
Applying traditional valuation techniques for growth businesses can be tricky or even not applicable. The change they create, facilitate, embrace or benefit from cannot be simply referenced to or extrapolated from the past or the present. However, we employ financial models, which emphasize the exploration of the future for possible outcomes, not just determining the company’s worth. Through that exercise we get a relatively good idea whether the dynamic of the business model allows for a certain level of stock appreciation and favorable risk-reward.
Furthermore, depending on the company’s growth life cycle stage, we look at valuation multiples, which we evaluate relative to the peers and to the firm’s own growth metrics. To form a complete picture, we extend the definition of “peers” not only to companies within the same industry, but also to companies with similar quality.
Importantly, we do not believe in determining specific price targets to avoid anchoring and selling out of winners too early. Instead we embrace the idea of price target ranges.
Q: What types of investment metrics do you focus on and why?
In addition to the frequently used metrics for growth and profitability, we focus on quality operating metrics to gain an appreciation for the firm’s competitive strengths and its ability to stay in control or become stronger under varying economic conditions. For example, the churn rate provides insight into the stickiness of customer relationships and visibility into the upselling opportunity and recurring revenue growth.
Other metrics include pricing power, which represents a sign of a strong market position, innovation leadership and branding. Gross margins are a good indicator for the general value added of the products or services a company provides. Among the more traditional metrics, we closely track those that give us a sense for downside protection: low balance sheet leverage, high FCF generation and conversion, strongly rising or superior capital returns, and stable to falling share count. If a company is not profitable today, we definitely would like to see a strong pull towards profitability, which would materialize over the next 12 to 24 months.
Q: What is your buy-and-sell discipline?
It is related to our investment framework with the idea for competition among the new idea, stocks on our candidate list and existing holdings in the portfolio to lead us to the ultimate decision node of buying and selling. Depending on changes in the absolute and relative attractiveness of these stocks and the overall portfolio fit, we determine the best names to be held in the portfolio. This involves constant monitoring and regular recalibration of our views.
Q: How do you go about constructing the portfolio?
The portfolio typically consists of 50 to 70 names diversified across market cap, sectors and growth life cycle stages. The goal is to build a risk-balanced and bias-controlled portfolio, where no single bet on a stock, sector or secular growth trend would dominate the positioning and the performance outcome. That’s why we employ a few risk parameters around the position sizing.
The maximum weight for individual stocks is limited to 10%, but the target weight is typically less than 5%. The initial size usually starts at 30 basis points and the top ten holdings currently represent 40% of the portfolio. The larger positions tend to have lower business volatility as reflected in future growth rate expectations and smaller shifts in earnings estimates.
Relative to the benchmark, which is the Russell 1000 Growth Index, we allow maximum overweight of 5% and maximum underweight of 2% to a stock. In terms of relative sector weights, we limit the overweight to 10% and the underweight to 5%. The turnover is usually less than 50%, which underlines our ambition to be diligent stock selectors with a long-term view. Cash is usually less than 2% of the portfolio.
Q: What is the rationale behind holding cash in the portfolio?
A key lesson from the financial crisis was that cash can at times be your only friend during a strong market correction. At such instances, the individual stock and the underlying fundamentals are not as important as keeping some powder dry and maintaining a list of attractive buy candidates. That approach can lead to outsized gains when the markets stabilize, but it requires a flexible mindset, which allows you to realize the opportunity.
Recently, the market volatility was at all-time low and there were early indications that things may deteriorate. If we have strong reasons to believe that it makes sense to raise cash, then we will do it for the purpose of cushioning a volatile period and being able to take advantage of dislocations.
Q: What are the main risks that you identify and how do you manage them?
From an absolute standpoint, the biggest risk is permanent loss in a single position, which we aim to mitigate by diligence and discipline in stock selection. Our process ensures that we invest into sound businesses with the ability to weather temporary storms. Their underlying growth component should be strong enough to enable them to do well across the market cycle and under varying economic conditions.
In addition to the fundamental business risks, there are stock-level risks like insider transactions, rising levels of short interest, crowding, ETF ownership and extended valuation relative to the market or the history. These factors can result in drastic perception changes for the stock and in significant multiple contraction, even without fundamental change.
We constantly monitor these aspects and ask ourselves three key questions on a per position basis. The first one is what the next thing that significantly matters is. The second question is what would provoke a movement of 20% in the stock, either up or down. The third one is about the factors supporting the valuation multiple and if they can weaken. The answers to these questions, combined with the four Cs, usually give us a very clear idea whether we need to make adjustments.
From a portfolio standpoint, we set ourselves risk parameters around our benchmark and aim for a tracking error that is driven mainly by stock selection. We remain cognizant of the fact that no one can foresee all of the potential risks. Therefore, the key is to make sure that we learn from past events and apply the insights in a continuous loop of improvement.
Q: Is attribution analysis part of your process?
Yes, because attribution analysis gives awareness of the positioning, what’s going on today and what happened in the past. It makes sure that we understand where our exposures are and whether we are consistent with our goal. This is especially true in terms of whether performance and tracking error are driven by stock selection or another type of underlying exposure. We have monthly assessments and checks on all the metrics; it is part of a more general setup at our firm.
For me, the key to a balanced-risk portfolio is the diversification across several aspects, including market cap, sector exposure and growth life cycle stages. An important aspect is that most of the portfolio is invested in more long-term, stable growth companies versus the more unproven, vulnerable and disruptive growth companies. We can tweak the portfolio incrementally in any direction depending on the market environment, but the basis is always the core growth segment, which represents 60% to 70% of the portfolio.
While most people associate risk with something negative, volatility can actually be positive. It provides opportunities during a phase of market dislocation or during the early stages of an innovative company, which is potentially disrupting the competitive landscape for some of the incumbent players. So we consider these factors when deciding on the portfolio holdings.
