Q: How has the fund evolved since inception?

A: The fund was established in the late 1990s as a large-cap growth fund. I have been with the strategy since 2005. I started at William Blair as an investment analyst covering technology, energy, materials and industrials. David Ricci, who is the co-manager, joined in late 2011. With David’s arrival, we refined our investment strategy and enhanced the investment process.

We are quality growth investors. We look for high-quality companies with a durable growth profile. Over time we have become more granular in terms of the desired characteristics in a quality growth company. Simply said, we look for companies which will be in a better position in three to five years than they are today. To achieve this goal, we need deep and intensive research effort both on companies and industries.

Q: What differentiates you from your peers?

A: We believe a key differentiator is the emphasis on industry knowledge. We forecast the industry developments over a multi-year period and we try to pick the winners within that industry, or the companies that will gain share of the industry profit pool. Getting the industry analysis and the stock selection right has been key for our performance over the past eight years.

Another differentiator is our team approach as opposed to a “star manager” approach. Our analysts spend a lot of time accumulating knowledge. When we are successful, we give credit to the people who made a great call. We chuck our egos at the door, because the team dynamic is really important for our culture and for a winning atmosphere. We are all in this together. David and I lead the team, but the analysts are really important for our success.

Q: What core beliefs drive your investment philosophy?

A: We emphasize quality growth, industry knowledge and a deep analytical mindset. We search for structurally advantaged companies, which will be in a better position in the future than today. That means that we are highly selective and we aim to invest in industries with secular growth and in companies that will lead these industries by capturing significant profit share.

We focus on figuring out the next five years in terms of the direction of the economy and the effect on the industries. For example, we invest in the digital transformation trend, because we see more advertising dollars going to digital and away from traditional media. We view the traditional media as structurally disadvantaged, while holding a positive view on digital media, because that’s where the profits are going over the next five years.

The core principle is building a structurally advantaged framework or identifying the right industries and the right companies through deep intensive research. We spend weeks and months researching to build confidence in the investments. We run a concentrated portfolio of 30 to 40 holdings, but typically less than 35 holdings. We make active bets relative to the benchmark weight in the companies since we want to get paid for our unique insights.

Q: Why do you believe in concentrated as opposed to diversified portfolios?

A: We manage a diversified, sector and market-cap neutral portfolio. We believe this approach provides a smoother ride for our shareholders.

We generally have less volatility in the portfolio, which was notable in 2018, when the market grew for the first nine months and sold off in the fourth quarter. We were down in the fourth quarter, but by less than the Russell 1000 Growth Index and we ended the year with positive gains while the market was down. The reason for the performance was stock selection within a diversified, sector and market neutral portfolio.

Q: What are the critical steps of your investment process?

A: Our investable universe consists of more than 800 companies with market cap of above $5 billion. We break our research across six different research verticals - consumer, financials, healthcare, industrials, technology and resources. We focus on getting the right industries within that sector and the right companies within those industries.

We narrow the universe down to our eligibility list, which represents our views and consists of 150 to 200 potential investments. The main consideration in preparing the list is whether the industry is potentially structurally advantaged and what secular drivers will help the industry grow faster than the overall economy. If the industry is structurally advantaged, then we identify its leaders.

Twice a year we review this list with the responsible analyst. We discuss the direction of the industry over the next three to five years and we look at the future industry profits, margins, and growth. Then the analysts identify the companies that they view as structurally advantaged. Going over the eligibility list is critical, because those are the names for our next steps, which include the research agenda, buy list, and portfolio construction. Ultimately, the analysts make the call on what goes on their eligibility list and the type of companies they will work on over the coming months. Our process requires a lot of trust between PMs and the analysts.

The research process itself could take weeks or months. Working closely with the analyst, we try to identify three or four critical drivers or issues to help us gain confidence that this will be a successful investment. We meet the companies, attend industry conferences and do third-party research to understand the industry dynamics and how the company competes within its industry.

Over the course of a year, each analyst might look at a dozen companies that might go through our research process, but given our high standards, a lot of them just drop off.  If an idea is not as good as the current holdings, it is dropped and the analyst will begin work on a new idea.

We end up with about 50 to 75 fully vetted buy ideas. David and I use those ideas to construct a portfolio of 30 to 40 high-quality holdings. We evaluate the sector and market-cap neutrality and how the stock fits within the portfolio in terms of risk parameters and upside potential.  

The key aspects are the eligibility list, the structurally advantaged companies that flow from the eligibility list and the highly selective process. It is a repeatable process because of the discipline we have in terms of the eligibility list and the high bar we have for new investments. All the team members, PMs and analysts, understand this.

Q: How is your team structured in terms of responsibilities and decision making?

A: We have a flat organizational structure, where everyone has responsibilities. We believe that’s an important differentiator, which is tied to our success. It is a two-way street, where there is constant feedback and dialog between the analysts and the PMs.

We have five large-cap analysts, who can do both company and industry analysis. They are self-starters, who are comfortable running their own business model. The analysts have a lot of autonomy in finding the companies that David and I consider for the portfolio. They are out there trying to find great ideas and add value to the portfolio. The analysts have been key contributors to building the track record and growing the shareholders’ assets.

David and I are very involved in the overall research process. Every Monday we go over our research agenda and the existing holdings with the analysts. The analysts and the PMs are in each other’s office every day, talking about stocks and ideas, the issues that we have identified, and the stock drivers. We invest a lot of time in understanding the companies we invest in.

Ultimately, David and I make the decisions for the portfolio holdings and weights. The decision has to be unanimous between us. We think alike, so we typically reach an agreement. Part of this is due to the fact that by the time a new stock idea is presented to us, a lot of work has been done, and it is obvious the new idea belongs in the portfolio. The biggest debate is the position size. Since we run a fully invested portfolio, to buy a new company, we either have to sell or trim an existing holding.  

Q: Could you illustrate your research process with some examples?

A: I am actually the analyst on Microsoft, so I can highlight the overall process from the standpoint of both analyst and manager. The fund had owned the stock in the 1990s and sold it in the early 2000s. I took a fresh look at it in 2014, when Microsoft was trying to find new growth avenues and had a management change. Prior to that, Microsoft was a stagnant stock. It had all the pieces in place and it was just a matter of execution.

The critical element was the digital transformation of corporate America and the growth of the public cloud, which was still in its infancy. Amazon was ahead of this trend, but Microsoft was catching up. I did a lot of third-party work to confirm the developments. Microsoft’s relationship with its key enterprise customers was solid and the company was able to execute better with the right investments. On a secular basis, it had the right elements for driving the digital transformation and the shift to the cloud. The management change in 2014 was a key catalyst.

After researching the industry, I was confident that it was structurally advantaged and the outlook for Microsoft was positive. The company had the opportunity to take share of the profit pool at a greater rate than its competitors. It took six to eight months to confirm the thesis, which involved meeting with the company, attending conferences, and talking to third-parties. Then I built the models and wrote the report.  We started a position in late 2014. That position grew over time as our confidence in the transition of Microsoft came to fruition.

Since then it’s been a great investment. Today it is our largest holding and we are confident in the positive outlook for the next three to five years. The public cloud is still early in the process because corporations have just started the acceleration of moving their workloads to the cloud. Given its strength in the enterprise market, Microsoft’s Azure is well positioned to take advantage of the shift to the cloud by corporate America. We feel good about where Microsoft stands today and about the stock’s ability to generate alpha over time.

Q: Do you set price targets for the holdings? At what point does price become an issue?

A: When we buy a new stock, we use a multitude of valuation techniques, including P/E analysis, discounted cash flows, and EVA analysis. We come up with an approximate target; we can’t be too precise on the company’s worth, because there are many moving parts.

Typically, when we buy a stock, we need to be reasonably confident that the stock can double over the next five years. When we bought Microsoft in 2014, the stock was around $50 per share and I thought there was potential for the price to double over a five-year timeframe. Today, the company still has a significant operating margin opportunity and I believe it can grow its revenues faster than the market expects, so the stock still has upside opportunity. 

Valuation does play a role and is incorporated in our fundamental analysis of understanding the industry drivers and the share of the company in the profit pool of that industry. We invest only in what we believe are quality growth and structurally advantaged companies. We analyze whether the market underestimates the long-term earning power and its durability. If the valuation doesn’t make sense to us, then we pass on the opportunity.

With a concentrated portfolio, we have the luxury of adhering to high standards. Our selection is a function of the right companies and the right valuation.

Q: How did you decide whether to buy Microsoft or Apple in the portfolio?

A: Both of them are great companies. When we made the decision to make Microsoft our largest position, Apple had to eventually exit the portfolio in order to fund our Microsoft position. In the case of Apple, we were concerned with the maturity of the smartphone market. The operating profit growth of Apple over the past three years has been in the 2% range. Overall, we had to make a choice for the next five years, because we manage a concentrated portfolio. We thought that Microsoft had better secular drivers in terms of top-line and profit growth.

Q: What are the key elements of your portfolio construction process?

A: First, the portfolio has to be sector and market-cap neutral over time. We believe this approach decreases the volatility and provides a smoother ride for our shareholders. Second, it has to be concentrated. It’s a conviction-based portfolio, so the analysts, David and I need to have conviction in the success of the investment over a three to five-year period.

Our index is Russell 1000 Growth Index, which is a high-quality index itself, but we aim to run a portfolio that is of higher quality than the index. That means that we prefer companies with low debt relative to overall capital, companies that can fund their growth organically, without relying on the capital markets, and companies with high and improving ROE or ROIC over time.

Since the portfolio is diversified across all sectors, we may invest in companies that are more defensive. For example, most of our competitors probably don’t own a consumer staple company, while we do. We believe that the companies we own provide a good balance, which again provides a smoother ride.

The turnover of the fund has ranged from 25% to about 40% annually. We add seven to eight new companies per year, but the number can vary due to acquisitions. For example, Red Hat was acquired by IBM in 2018 and we had to sell our position. That obviously creates some turnover.

Q: What are your limits in terms of position and sector sizes?

A: The position limit at market price is 7% or we can go to 150% the weight in the index if the stock is a significant part of the Russell 1000 Growth Index. Typically, our positions are about 3% of the portfolio. Our initial position can be anywhere from 1% to 2.5% of the portfolio. We start with small positions and build them over time.  The market cap of our holdings is above $5 billion at time of purchase.

Q: What is your sell discipline? Why would you consider selling a stock?

A: The first reason to sell a stock would be valuation. When the stock is fully valued in terms of P/E, EVA or discounted cash flow, we would start a conversation with the analyst to see if we are missing anything and, potentially, we would sell the stock.  Also, when we find an interesting new opportunity, we have to make space for it by selling or trimming less attractive holdings.

Another reason to sell would be a change in the investment thesis. It might be provoked by a management change, a change in the company’s strategy, or a change in the competitive dynamics. We evaluate, discuss, and we may downgrade or exit the position. As long as our central thesis remains solid, the stock remains in the portfolio.

Q: How do you define and manage risk?

A: The important aspect is running a diversified, sector and market-cap neutral portfolio of higher quality stocks than the index. Typically, our portfolio beta and the standard deviation are lower than those of the overall market. This is a function of the companies we invest in – structurally advantaged.

We have quantitative tools to better understand some of the unintended bets that we make. We have a review with our risk committee every quarter to see if anything is out of line. Being outside of our various risk pockets or risk controls hasn’t been an issue, because of the rigorous process we have in finding high quality companies for the portfolio.

I also believe that the biggest risk control is having the best possible understanding of the company and the industry. It is a bottom-up, fundamentally built portfolio, so we spend weeks and months on analyzing the companies and the drivers behind their financials. Avoiding industries and companies with melting profit pools is critical for any managers’ success.