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

A: Principal Global Investors has managed U.S. small-cap equities for retirement plans since 1990. I came on board as an analyst in 2000 and this fund was launched in the following year. In 2006, I became the portfolio manager. Since then, our investment philosophy hasn’t changed much, although we have introduced proprietary tools to help us better execute it. Currently, assets under management are approximately $1.8 billion in the overall strategy and $700 million in the mutual fund.

The fund’s mission is to identify companies that are undergoing positive and sustainable change, and to do so early on. We believe that the market persistently underappreciates the potential value that this brings companies, which leads to stock mispricings and gives us the opportunity for active management.

Q: What are the core beliefs that guide your investment philosophy?

A: Our philosophy starts with this basic precept: a company’s value is determined by the amount, timing and certainty of its future cash flows. So, we look specifically for positive fundamental change that affects one of these three things. When the market finally understands the change, the stock will be re-priced in line with its value.

To us, investment management is very much a human business. Our clients have worked hard to save for retirement, and the firm has advisors who help them throughout the process. In turn, we assist advisors by offering a product that can deliver consistent long-term alpha without unpleasant surprises. It’s important for the fund to invest in companies that not only make decisions in the best interests of their shareholders, but also take care of their employees and customers, and that don’t exploit their supply chain. As the world changes, this will put them in a good position not only from a profitability perspective but perhaps from a moral one as well.

Q: How would you characterize your approach to investing?

A: The fund invests in small-cap equities with market capitalizations ranging from approximately $300 million to no more than $5 billion. Equities below the bottom end of that range aren’t suitable for institutional investors because liquidity starts getting too thin. The top end of the Russell 2000 Index, which is our benchmark, has also been $5 billion for the past two years.

The key to our investment approach is to be early identifiers of companies undergoing positive and sustainable change. Change is a broad concept, but we find it most frequently in three specific types of companies: Innovators, Renovators and Pacesetters. Innovators are companies with new products and services that are disrupting their industry or creating entirely new markets. Renovators are established companies where positive change is helping them to realize their full potential. Pacesetters are also established companies, but what sets them apart is a competitive or managerial advantage that creates higher and more enduring growth rates and profitability than their competitors.

We are true bottom-up investors and seek to isolate positive change on a company-by-company basis. Although tools help us to identify potential opportunities, our fundamental research drives the process. During portfolio construction, we minimize top-down or systemic macro risks that could undermine stock selection, but don’t make calls on where the overall market is going or sector performance. Markets go up and down, crises come and go, but companies that consistently deliver positive change will win in the long run.

Q: What is your investment process?

A: The fund’s investable universe is approximately 2,000 companies, which we narrow down with a proprietary quantitative ranking tool designed specifically to identify characteristics of positive fundamental change. It helps to prevent us from falling victim to the very behavioral biases we are trying to exploit.

Investment ideas come from the top 20% of this list. Our analysis of them begins by identifying the source of change, and more importantly, understanding how that change affects a company and whether it is sustainable. Taking a longer-term perspective, then we measure things like the expectations gap, the potential for future positive earnings surprise or the re-rating of the company’s valuation multiple. These are explicitly part of our research process for any candidates for the portfolio.

Q: Can you cite an example of the type of change you look for?

A: We look for different types of change depending on whether we consider a company an Innovator, a Renovator, or a Pacesetter. Innovators are companies like Carvana, a leading e-commerce platform for buying and selling used cars. The company has created the type of expectations gap we look for by transforming the used-car buying experience into one that’s surprisingly pleasant and offers customers value, convenience, transparency, free delivery and seven-day returns. Yet investors largely continue to underappreciate the size of Carvana’s market, the rate at which it is gaining market share and the scalability of its business.

Carvana has had an impressive ramp-up. Its automated car vending machines allow people to purchase vehicles from home or a mobile device, bringing the company a lot of recognition and enabling it to establish a physical presence. On the purchasing side, Carvana has proven to be a better choice for consumers than traditional trade-ins. The cars are prepared for resale at regional reconditioning centers across the country, which essentially act as hubs to the surrounding markets and strengthen Carvana’s local presence.

Early-stage sales growth has been high, at about 100% a year, though the company isn’t yet profitable. Carvana needed to become nationwide quickly to take advantage of the scalability offered by its e-commerce platform. At some point, growth will slow as will its growth spend. What we find especially encouraging is that Carvana’s per-vehicle profit margins are the highest in the industry, making its path toward profitability look quite favorable.

Q: What steps do you carry out when analyzing other categories of companies?

A: Lindblad Expeditions is an example of a Renovator—a company making changes to get back on track or take business to a new level. Lindblad operates expedition-style cruises and in 2004, began a co-branded relationship with National Geographic. The positive change we identified arose from the confluence of Lindblad’s strong reputation in ecotourism with current demographic trends and consumer preferences.

To appeal to the growing numbers of people who are aging, active and affluent, the company is increasing its fleet, adding smaller ships with more intimate environments, and going to more unique destinations. We see a lot of upside potential here. Lindblad has the cash flow to fund expansions in the coming years and its bookings are strong, ensuring that it will continue generating industry-leading profitability. Once a sleepy company, it perfected its product offerings and is now switching to a growth strategy.

An example of change from within our Pacesetter category is Manhattan Associates, which provides supply-chain management software that enables retailers to move to e-commerce. A few years ago, the stock paused a bit while retailers faced competition from Amazon and declining mall traffic. Manhattan’s existing customers were trying to figure whether to go online or not, and the industry as a whole struggled with store closures and rightsizing brick-and-mortar operations.

All the while, Manhattan Associates continued improving and expanding its products. Now that retailers have strategies in place for this new environment, about 75% of the time, they choose a solution from Manhattan Associates. I think retailers realize that transitioning to e-commerce is a cost of doing business today and it’s critical to do it right—that’s why Manhattan gets the higher win rate.

Q: How is your team organized? And how does the decision-making process happen?

A: Five analysts support me, with their coverage divided by the sectors and industries they are experts in—everyone in the group has multiple decades of experience, and four of the five have been with us for over 10 years. They gain an in-depth understanding of a company’s operations, the expectations gap, and which levers must be pulled to take advantage of the positive change they’ve identified. All this is spelled out in a written investment thesis they provide me.

Although I am the final decision-maker, our environment is fairly collaborative. We meet as a team daily, and I hold weekly one-on-ones with each analyst to discuss research in progress. Feedback is critical to improvement, so we look at the historical record with the analysts so they’re aware of our successes and failures. Also, we collaborate with our large-cap and emerging markets teams to share ideas and learn from each other.

By the time an investment thesis reaches me, it would be rare for an issue to come up; if one does, we wait until it’s resolved. Otherwise, the idea is added to the portfolio. As the fund’s manager, I monitor the portfolio to make sure we don’t have unintentional top-down systematic macro exposures sneaking in, and make any changes needed to accommodate a new holding.

Q: Do you establish price targets?

A: Once a change is identified, the expectations gap is crucial in determining a price target. For a typical company, we look two years out to see where consensus estimates are, then forecast how much upside there is. Likewise, when considering valuation, we may determine that a company is trading at a discount to its peers. Combining a company’s estimate upside and its valuation-multiple upside gives us the target price.

If we see a 10% upside to both an estimate and to a company’s valuation multiple, these compound to give us a 21% upside for the price target. This also acts as a monitor: when a stock we are forecasting to go up 21% reaches that mark, we evaluate whether the investment thesis has played out, whether we have greater comfort that the change will endure, or whether it’s time to move on.

Q: What is your portfolio construction process? Are there any maximum position sizes at the sector or individual security level?

A: Historically, the fund has had a large number of holdings—at one point they numbered over 300—but we’ve brought them down to about 135 today using a multi-faceted approach to control risk. Our aim is to isolate stock selection as the primary driver of alpha while minimizing macro biases and exposures. Sector weightings tend to stay closely aligned to the benchmark, the Russell 2000. We avoid trying to make a call on where sectors are going, because getting that wrong for one sector can undermine all the effort that goes into identifying change at the company level.

Liquidity risk is managed through position sizing. Our aim is to hold positions that are no more than three days of trading volume. As a result, we may not have as big a position in one of the smaller, low-liquidity companies as we would in a larger small-cap company.

At the company level, we typically take scaled-down positions in companies with historical above-average volatility and in those where we see fundamental risk. The fund’s smallest holdings tend to be biotechnology names, companies that by their nature face binary outcomes like the success or failure of a clinical trial.

On average, Pacesetters have larger position sizes. Because companies that are Innovators and Renovators can be associated with higher risk factors, average position sizes tend to be smaller. Some companies start off as Renovators or Innovators but ultimately graduate to become Pacesetters, so that is where you’ll find some of the fund’s longest-term holdings.

Another reason we might make changes to the portfolio is if, over time, we see one of its characteristics becoming unusually expensive in the marketplace. For example, in August 2019, we noticed that momentum had gotten fairly expensive in the portfolio. In response, we sized back the fund’s positions in high-momentum stocks and in some cases exited them altogether. When there was a sell-off of high-momentum in September, we didn’t disproportionately suffer.

Q: What drives your sell discipline?

A: First, we use our proprietary ranking tool to monitor existing holdings. It can alert us to instances when it may be time to move on from a company that we’ve fallen in love with. The price targets we derive also facilitate our sell discipline.

One way to get stocks out of the portfolio is to find better ones to come in. Our analysts are always looking at opportunities, and when they bring a new idea it’s typically because they think it’s better than a current holding. So, we may choose to exit a stock even through a positive change is playing out when we think there is greater upside elsewhere.

Finally, I require every investment thesis to be extremely specific and to articulate a strategy in writing. As the quarters go by, I can then refer back to see whether a thesis is playing out or whether we’ve drifted from it.

Q: How do you define and manage risk?

A: I split risk into two categories: unrewarded risk and rewarded risk. Unrewarded risk, which can be intentional or unintentional, comes from making binary calls like whether interest rates are going up or down, or oil prices will rise or fall. We monitor and neutralize this in the portfolio.

Rewarded risk is found at the company level and is something we can diversify out of the portfolio. When I speak with the analysts, my interest is always piqued when they express concern or uncertainty about a company during their research. Often, it’s related to an issue disputing the positive change. We see that with Carvana, for instance, when people wonder whether the company will be able to maintain growth. While that is a bit of a concern, it’s the kind of risk we want to bring into the portfolio because it essentially translates into return. If there is no risk in a stock, then everything is probably already priced in.