Q: What is the history of the company and the fund?
Pioneer was founded in 1928 and has its roots in value investing. Our concentrated growth strategy has been in place since 1994. There was a period of time when it was an institutional only strategy. Then, in 2007, we adopted it in a mutual fund, known as the Pioneer Fundamental Growth Fund.
The fund is a concentrated portfolio of high quality companies, and we believe that what differentiates from others is our definition of quality.
Q: How do you define your investment philosophy?
We believe that a concentrated portfolio of companies, with businesses that generate high returns on incremental invested capital, that possess a sustainable competitive advantage and also capitalize on secular trends, can provide superior performance over time.
We seek companies that grow intrinsic value and efficiently allocate their capital to generate high returns above the cost of capital.
Since we are long-term investors, we value the compounding of the returns above their cost to capital over time, as this generates growth of intrinsic value and creates shareholder wealth. We prioritize companies that have a moat to defend their businesses from competitive threats, as they are better equipped to sustain their returns over the long term.
Q: Would you describe your investment strategy and process?
As part of our investment strategy, we may consider things that are not normally part of the capital base. In order to have a more comprehensive view of the incremental cash flow these companies generate over long periods, we observe their investments in research and development expenditures, in product development, and in their brand or distribution.
We look at both the history going back seven or eight years, and forward-looking, forecasting out four to five years. Once we find companies that have both high incremental returns and sustainable returns, based on our qualitative assessment, we then look at the secular growth opportunities in which these companies can invest to generate capital for growth.
We differ from our peers in that it is not the absolute level of growth that attracts us to a business, but rather the stability and predictability of growth. The sweet spot for us is high single digit growth to low double digit growth.
Pioneer has a very long history with a valuation discipline in place. Compared to other growth managers, we have a heavy valuation focus and are very sensitive to valuation in terms of security selection.
Q: What is your research process and how do you look for opportunities?
To do our research, we rely heavily on our research team, which is made up of fourteen analysts in Boston; 12 fundamental analysts plus two quantitative analysts who help us with idea generation. They are all career analysts, committed to research, with an average of 20 years of experience.
We have defined the strategy and philosophy of what we are looking for, and these analysts target their ideas specifically to meet those criteria. They help us identify the companies with high incremental returns by conducting a custom analysis for each company. There is not a simple screen we can run, so each analyst meets with us to decide which assumptions and adjustments we have to make to determine the incremental returns of that company.
Next, we get into the qualitative part and debate the secret to the business sustaining its returns. During this process, we identify specific strengths the company has and some of the elements within the industry structure that will allow them to sustain these good returns.
In the case of a technology company, their patents could pose a high barrier to entry. Other examples of positive elements are Google’s search algorithms or Microsoft’s entrenchment within the enterprise software space. A company’s scale advantages or brand name are other factors that allow them to sustain their positioning.
Q: What type of growth opportunities do you look at?
We look at secular growth opportunities. We are less focused on the cyclical growth, focusing instead on the overall market opportunity and the level of stability in those earnings and growth rates going forward.
In the tech area, although the market has attributed that there is less sustainability to revenue and earnings going forward for some of our companies, we have observed that these companies have a much higher sustainability in revenue and earnings going forward than the market has anticipated. That is why we believe the valuations are very attractive on some of those companies as the market has underestimated their earnings power.
With the help of our analyst team, we focus on the intrinsic value analysis, with discounted cash flow being an important part.
The quantitative analysts can run strategy specific screens for us. We can do some proxies for return on incremental investment capital. It is not a simple screen, but there are some calculations we can do to get to an approximation of that before we do the custom analysis.
Furthermore, we look at high free cash flow generation. In addition to having good balance sheets, our high quality companies generally do not need to access the capital markets for debt and equity in order to grow their business. On valuation we are looking at free cash flow measures.
Q: Do you have examples of companies that have high intrinsic value?
One of our top ten holdings that we looked at a little differently is The Walt Disney Company. We started a position in the stock in 2011. At that time, Disney and media companies in general were a bit out of favor. The market was looking at those companies as poor allocators of capital over time. They had done some poor acquisitions and overpaid for content.
In general, returns were somewhat depressed, even for Disney, which was one of the better quality companies. If you just looked at the stated returns on capital as traditionally defined, it was not that impressive. At the time it was about 10%, but when we looked at the incremental returns and how they were investing their capital going forward, as well as the discipline they had applied to their capital allocation, we were getting much higher returns than that, north of 20%.
Disney had set up a structure that gave them an advantage in how they could leverage content across multiple platforms. They were investing in content and in some cases buying companies. They bought Pixar, Marvel Studios, and Lucas Films. They had their own film studio and global distribution on film, but they were also leveraging across their cable TV networks, running animated series related to those franchises, and they also have a very large consumer product franchise and global distribution of consumer products.
Then there are the Disney theme parks, which had new rides and attractions related to those Pixar and Marvel characters to pull in visitors.
Disney had set up a way to structurally get better returns on those content investments than other media franchises. When making an investment in content, they consistently seek to leverage their investments across the relevant platforms, rather than have a one-off content investment that may not have value in the long term across all of the different business lines.
The other key asset within Disney is their ESPN cable network, the most valuable cable network out there that also dominates sports broadcasting. Here is a business that has both a brand and scale advantage, when compared to other competitors.
They have a dual revenue model where they are getting not only the advertising revenues but also the revenues from their distributors, known as affiliate fees, which are getting paid by the Comcast, DirecTV and others. This has given them the strength to be able to go out and further increase their purchasing of sports rights and getting an even larger scale advantage.
In this media environment, there are a lot of viewers that are watching online or watching later, viewing DVR and skipping commercials. Because of this, a lot of sports content is getting a higher and higher premium from advertisers. We are seeing that the pricing power they have both with advertisers and distributors is increasing the value of ESPN. This gives them a lot of visibility on earnings and revenues.
Q: Would you share another example?
Another one of our holdings is MasterCard Inc. They are one of the few very large global payment networks with very high barriers to entry in that industry. After the financial crisis, they have been through a period of testing the model; the position not only survived the period where there were some challenges to the existing payment networks, but they are further entrenched and they will continue to have secular growth opportunities and pricing power going forward.
MasterCard’s key to generating high returns has been their scale. They have made a massive investment in the global payments network. To grow it further, for incremental revenue opportunities, there is not a lot of additional investment they need to make to grow revenues. They have been growing revenues at over 10% without a lot of incremental capital investment.
Despite concerns in the market at times when the stock has declined a bit, MasterCard has proved resilient. There is a new wave of innovation when it comes to payments, such as Apple Pay and PayPal. However, we are finding that Apple Pay, which is very successful and doing very well, is only reinforcing the existing position of the major networks, such as Visa and MasterCard, so it does not pose a significant threat.
There is some competitive dynamic, but there is also a partnership dynamic there, which will allow both sides to benefit going forward.
Q: What is your portfolio construction process?
A new position usually comes into the portfolio at around 1%. We will build it up over time so that we are targeting a portfolio of roughly 35 to 40 stocks. On average, position sizes are a bit more than 2% over the benchmark weight. Our larger positions would be in the range of 300 to 400 basis points overweight relative to our benchmark, the Russell 1000 Growth Index.
From an absolute basis, at the time of purchase we are no more than 5% in any single stock. If it appreciates and gets up to 6%, we will reduce the position.
We do have sector overweights and underweights, but this is mostly a byproduct of our security selection. Where we find a lot of companies that meet the criteria for the strategy, traditionally in areas such as consumer staples and healthcare, we tend to be overweight.
We are underweight in the telecom and utilities sectors. We only have one financial stock, but we generally do not find many companies in financials that meet the criteria that drive sector allocation.
If you look at risk by tracking error and relative to benchmark, the majority of it comes from stock selection risk. We have a clear style bias in the portfolio, which is consistent over time. With a focus on high quality, we tend to have companies that have better balance sheets, lower debt levels, higher stability of earnings, and lower volatility overall. At the moment our beta is 0.92.
We are large cap focused, with over 95% of the portfolio made up of large caps.
Q: What is your sell discipline?
Our sell discipline is determined by whether we see deterioration in returns on incremental capital invested. We either start to see that deterioration or we expect to see that deterioration. Oftentimes this is driven by a change in the competitive dynamic or by a lowering of their barriers to entry with new competitors coming in.
Valuation is another factor that drives our sell discipline. If a company is significantly beyond our estimation of fair value, that could trigger an exit from the portfolio.
If a stock has done well and has hit our fair value target, but all the other elements of the investment case are intact, we are more likely to reduce the position rather than completely exit. We will then look for an opportunity later to build it back up.
Q: How do you define and manage risk?
Even though we run a concentrated portfolio with 35 or 40 names, we have lower volatility and we have been able to diversify the security risk quite a bit, given our constraints. We also look at how any individual security contributes to the overall portfolio risk.
We define risk as both the absolute level of risk, given what is the prospect for permanent impairment of capital, but also the relative risk versus the benchmark.
We manage risk at the security level by owning companies that earn high returns, have a stronger balance sheet and more stability of earnings, as well as high quality companies tending to have less volatility and less risk.
At the portfolio level, we manage risk by making sure we have adequate diversification of the security specific risk.
At the sector level, there is some allocation to the risk profile, but it tends to be far less significant. We do not want to have any real macro overlay to the strategy that would drive it. Whenever you have a large sector bet, there is an implied macro call within that. We try to avoid that and build more from the stock level risk rather than a macro risk.
At the moment, our tracking error is at the low end of the range at 3% as we have had higher correlations in the market and lower volatility. Over time we typically see 3% to 8% versus the benchmark. When the markets are more volatile, the strategy tends to do best on a relative basis, which leads to strong performance against our benchmark.
