Q: What is your investment philosophy?

The Schwab Small Cap Equity Fund was established in 2003 and has nearly a 12-year track record with a proven process. We run an integrated approach that follows a disciplined model with an overlay of qualitative analysis. Our goal is to provide high quality exposure within an exciting asset class while generating returns that exceed the fund’s benchmark. 

Our investment approach seeks value, and we are a firm believer of that approach because, in the long run, it is the price you pay that matters. We do look at the growth attributes of a company and we certainly look at the quality of the business model, but, over time, it is the value, meaning the price you pay for growth, that separates profit from loss. Buying equities at the right price is fundamental, while growth is a story about what will happen in the future. We are sympathetic to the growth story, but we do believe it comes back to value.

Our investment process is focused on stock selection, so we carefully manage our market, industry, and style exposures. Although our performance in part comes from factors such as value, size, growth, and return-on-equity, it is a measured, well-controlled exposure achieved mainly through stock selection.

The strong initial quantitative selection process is important because it simplifies our work on a day-to-day basis. Instead of spending our time trying to find everything that is right, we spend most of our time trying to find what is wrong. It is all about falsifying the model and finding gaps in our thesis. 

It is our core belief that models have inflection points and blind spots, so we overlay the model with macroeconomic data and qualitative insights to make sure that we aren’t missing anything. We have to be able to respond to obvious changes in the marketplace that our quantitative process has yet to pick up.

Q: How would you describe your investment strategy?

The portfolio management and research team manages nine mutual funds and two separately managed accounts. The team is made up of six people who are fully dedicated to this process: two full-time researchers and four portfolio managers. We have an average of 14 years of industry experience, with a total of two PhD, eight Master’s and six Bachelor’s degrees as well as 5 CFA charters.

There are about 2,200 names in our investment universe, as defined by our coverage universe and benchmark, the Russell 2000 Index, with no individual name dominating the benchmark. We run the quantitative process on all 2,200 names on a daily basis to examine each stock’s relative attractiveness.

We don’t believe in making dramatic changes, but incremental change is very important to what we do. In addition, we are always mindful of the period over which the research was conducted and how that compares to the current market environment. We dedicate a lot of time to looking at the risk-adjusted opportunity of a specific concept. We also make sure that the concept has enough potential to justify being included in our quantitative process. It really needs to add value to justify the known turnover cost.

We make sure that we do not have a lot of exposure to major risk factors such as beta. We do not place market bets, since it is all about stock selection. When we make changes to the process or, ultimately, the portfolio, we always consider and manage the turnover in the portfolio.

Q: What is your research process?

We have a three-pronged research approach. We focus on strong fundamentals (also known as quality-of-earnings), attractive valuations, and recognized momentum. The latter is important, as it allows us to calibrate the optimal entry and exit points for any one investment.

In terms of strong fundamentals, we do an in-depth analysis of a company’s financial statements. For example, we make sure that the cash flow from operations is stronger than the net income because we want to be certain that the company doesn’t borrow from its future. It is also important that the company generates higher return on investment than its peers. As far as valuation is concerned, we use many different, well-known metrics, such as price-to-sales and price-to-book ratios, to make sure that we are paying the right price for the company. 

In terms of recognized momentum, we break it into two categories. On one hand, there is fundamental momentum, which is mostly about finding companies with improving long-term trends in their earnings. On the other hand, there is price momentum and what the rest of the market participants think about the company. We want to make sure that other people become excited about our idea over time. We call that sentiment.

We have a big matrix to help us understand how much fundamentals we should use in cyclical companies versus non-cyclical companies. Tailoring that information is paramount, as it allows the investment team to make changes when opportunities emerge or when we see that something is not working well.

We continuously monitor these aspects to make sure that a company with good performance is doing well from both a fundamental perspective and a valuation perspective. Even if it has all the right sentiment attributes, it may be in an industry where those concepts are simply not holding up. We re-examine the inputs if they have a tendency not to work in a specific area. In short, we are continuously engaged with how we evaluate these companies. 

At the industry level, we build specific clusters of companies that belong together as we are conscious to not bet on a specific industry; instead we focus on finding the best companies within an industry or group. 

In terms of management meetings, we believe that it is much more useful to spend our time reading regulatory filings, listening to earnings calls, and reading research reports rather than meeting with managers. They most likely will only tell you what they want you to hear. 

Q: How do you generate ideas? Could you give us some examples of specific investments?

Most investment ideas come from a combination of in-house research, academic research, and sell side research. Using an integrated process is not very different from what a good fundamental analyst would do. However, it allows us to process 2,200 companies overnight in a very systematic fashion without any biases.

A good example is Molina Healthcare, Inc. The company focuses on Medicaid health care plans and software that helps states manage their Medicaid program. It appeared on our radar mainly due the cash flow they were generating and improving. The company exhibited substantial quarter-over-quarter growth in cash flow from operations.

As they were growing the business, they were not taking on more assets than they were selling; they were managing their assets-to-sales ratio very well. However, the strong cash flow yield was not reflected in the stock price.

We took a substantial position in the company with a significant risk contribution. As the portfolio manager, I need to be keenly aware of why we are holding a stock. In this case, the business model was giving good indications. During the research process, we came to believe that the company could be one of the greatest beneficiaries of the Affordable Care Act and the consolidation that is going on within the healthcare industry.

We selected Molina based on the data we saw in our model, which was tailored to the managed healthcare industry and was overlaid with our team viewpoint. In addition, we compared Molina to other names in that industry, evaluating the state of the managed healthcare industry and what was going on at a macroeconomic level.

Another example is JetBlue Airways Corporation. We started underweighting oil back in August/September, well before the big decrease in oil prices. Looking at the names we wanted to stay away from, we realized that the airline industry would be a big beneficiary of the trend. We believed the industry learned its lesson from the financial crisis, had cut capacity massively, and was very constrained in terms of capital expenditure.

JetBlue is a well-managed company with conservative accounting and cash flow that is stronger than its net income. Moreover, as a portfolio manager using an integrated approach, it is important that other people see the potential of the company as well. Our high-level macro viewpoint, their business model, and the price sentiment, were key considerations in choosing the stock. 

Since we do not expect oil prices to quickly bounce back, we expect positive momentum for the airline industry. I am not saying that airlines necessarily will do better as a whole, but that there are names that will benefit from the trend. 

Our average holding period is about one year. Since we rely heavily on fundamental data, the ideas often play out within three to four reporting cycles. There are only few names that we hold for two, three, or four years. 

One such example is Emergent BioSolutions Inc, a company specializing in anthrax vaccines. In comparison with its peers, the company offers tremendous value. They generate strong net income, which is not reflected in the price yet, and they have very strong fundamentals.

Q: What is your portfolio construction process?

Portfolio construction is the most important steps in our investment process. We are portfolio managers, not individual stock managers. Everything we do, including company research, is focused on risk-adjusted returns. 

In the small-cap universe, there is so much noise in individual names that the portfolio has to be diversified. The benchmark holds 2,000 securities and our portfolio holds approximately 300 securities. The reason for diversification within the portfolio is that individual names can be very volatile. Therefore, we invest in 40 industries to avoid being over-/under- exposed to any one industry.

In addition, our position sizes are well-measured. About 80% of the risk allocation is dedicated to stock selection. Our goal is for the fund to be rewarded for taking intentional bets and to avoid unintentional ones. We make sure that we avoid being significantly overweight or underweight in any industry and sector. We keep in mind that if the portfolio is slightly overweight in four industries within a specific sector, that would lead to a substantial sector overweight.

Before we decide to sell a position, the company has to exhibit material negative change since we look for improvements to the overall portfolio after trading cost. Trading cost is important because it is a known cost to the portfolio, while our expectation of future returns is, with good fortune, a value-enhancing proposition. 

Our market cap range is between approximately $100 million and $3 billion at the time of purchase. We allow the largest securities to appreciate an additional 50% before we harvest gains. Some of our top names have been big success stories, so we are continuously monetizing those gains. When a company becomes too big to be called a small-cap name, we slowly sell out of it even if we still favor it. 

Liquidity is a huge part of being successful in the small-cap space, but it is often misunderstood. We are cognizant of the fact that we are not going to put too much of our overall portfolio’s liquidity in one name or even in a group of names. 

Q: How do you define and manage risk?

We define risk as a failure in delivering on the expectations of our investors. Our assumption is that they are focused on asset allocation and that they should get a premium to the return on the Russell 2000 Index. 

But, we are mindful of the risk and we manage it at every step of the investment process. It starts with performing company and stock research on a risk-adjusted basis. We then build risk-adjusted portfolios where we care immensely about individual positions, industry and sector exposures. We also consider style exposures, such as beta and volatility. 

However, risk is not only about risk minimization or mitigation. It is also about carefully and intentionally letting it increase because it can create opportunities. So, for us, it is not only about keeping risk low, but also about understanding why it may be high and when it is too high. At that point, we adjust it—not by blindly selling positions, but by managing the portfolio.