Q: How has the fund evolved since inception?

The strategy enjoyed success for the first decade of existence. In 2011 we added resources, upgraded talent, and refined the execution of the strategy. We believe these evolutionary changes have reignited the strategy’s successful performance over the last few years. I [Jim Golan] have been part of this fund’s management team since 2005, while David Ricci who is also co-manager of our mid cap growth fund, joined in late 2011 as co-portfolio manager. 

We have refined our investment strategy somewhat. While we continue to focus on quality growth, we have an added increased focus on the long term. We have a deep research approach, where we are intent on identifying the critical questions that David and I need to have answered in order to assure ourselves that an investment we’re considering will be successful over the long term, that is, three to five years.

Such a process drives a portfolio with fewer names, with our fund guidelines targeting 30 to 40 names in the fund at any given time. This greater concentration means lower name turnover as well as lower overall portfolio turnover. 

Q: How would you define your investment philosophy?

Quality growth is our goal. And, having adopted more of a long-term outlook these days, we look at an investment horizon of three to five years. We focus on what we call “structurally advantaged companies”—in other words, companies that we estimate will be in a better position in the future than they are today. We want to see that the industry profit pool is growing at least at market rate, preferably faster, and we target companies that are gaining their share of that profit pool at a greater rate than the typical participant in their industry.

Many managers zero in on only what is happening today, whereas we pay attention to what will happen tomorrow. The market has become short-term oriented, with decisions to buy and sell based only on the most up-to-the-minute data. In contrast, we have chosen to take a step back and concentrate on the long haul in order to get the three- to five-year timeframe correct. That puts us in an excellent position to exploit the sale of investments based on only the most recent data points, because we have done in-depth, intensive research and strive to know these companies and their sectors well.

In terms of how we define growth, we first look for companies whose earnings are likely to grow at a faster rate than the benchmark over time. We also look for companies that are above average quality—while quality can be subjective, it can also be quantified. And we look for an above-average return on capital that has staying power, a return that can be sustained over time. 

We also look for management teams who are intent on creating shareholder value long term. When we evaluate a company and its industry, we look to identify advantages that we estimate are sustainable over time; whether it be the product, the service, intellectual property to support that, leading market shares, or it’s on its way to building and growing market share over time.

Q: What is your investment strategy and process?

We start with the investable universe as largely defined by the Russell 1000 Growth Index. From this, our analysts, together with the portfolio managers, create what we call our “eligibility list.” Then we cut the list in half, keeping only those companies that exhibit above average growth rates and are above average quality.

From this, we hone further, cutting until we achieve a list of those companies we see as structurally advantaged. Again, we look at the rate of growth of the industry profit pool, and the particular company’s share of that profit pool. At this point, we have reduced the list of companies on the Russell 1000 Growth Index down to about 150 names, companies that we deem as potentially investable.

Then, we start examining trends in the industry. We look at the companies’ dynamics and where they are headed. At this stage, we layer in valuation. We are always looking for names that represent current attractive risk/reward profile. 

When a name is deemed worthy of investing, we add it to our research agenda list, which contains maybe a dozen or so names. These are the companies that our analyst team actively researches. As we stated earlier, we take a deep research approach, conducting extensive, intensive due diligence. It can take weeks or even months to complete our research process and for the analyst to decide whether a company merits a buy rating or not. 

Q: Can you give us a glimpse into your research process and how you look for opportunities?

We have six essential research verticals: technology, financial services, healthcare, industrials, consumer, and energy/resources. We have analysts in the large- and mid-cap space who work in each of those verticals. These are dedicated analysts with industry and sector expertise.

The portfolio management team works closely with the analysts to hatch ideas. Analysts put an idea on our research agenda, and, together with the idea’s portfolio manager sponsor, they vet it to see whether it makes sense for the portfolio over the long haul.

Each and every week, we hold a morning research meeting, where we review both the portfolio and the research agenda. If we identify any critical issues that need a deeper dive, we have a deep-dive session later that afternoon.

One distinct advantage that we feel we have is our perennial access to our international analysts and international portfolio managers, because we all work mostly in our Chicago office, on the same floor. This gives us the opportunity to sit down with the firm’s international analysts, who travel year round, to share their insight about what is happening in the relevant countries (e.g., supply chains and competition)—all things that affect other companies we invest in as well, so we are enriched with considerable context on any number of levels.

We spend a lot of time meeting with management—not just of the companies we’re investing in but also competitors, as well as companies in other industries, which provides us even richer context. We go out on the road, we go to conferences, and we visit headquarters. By talking to other players within the industries, it provides us with a larger, more balanced view of what is going on. It’s all part of the in-depth approach we take to research.

Q: Can you share an example? 

Starbucks Corp comes to mind as one of the companies we invest in. It caught our eye several decades ago, because the idea of offering a better cup of coffee on practically every street corner, highly convenient and accessible, struck us as a potential high-growth area. As people moved from making a less-expensive pot of coffee at home to spending considerably more for the convenience of buying a quality version at a retailer, it had the potential to expand the size of the industry and related revenue. Again, that was decades ago. Fast forward today and Starbucks still has no viable competitor to speak of, not one with a national footprint on any scale that can encroach on its market share. 

It has moved beyond the United States and is now available around the world. Emerging markets in particular offer a lot of growth opportunity for it. For example, it has been investing in China, a nation of traditional tea drinkers, for many years. Starbucks in China started out as a place where expats would visit to get a cup of coffee, one that they recognized from home. From there, it evolved to attracting tourists, and it is now, very slowly, being embraced by locals. 

Not only does that mean that Starbucks’s core product still has growth potential, but that one day it might make coffee drinking an everyday ritual with Chinese nationals, in a country that represents nearly 20% of the world’s population. There is additionally a lot of growth opportunity as it expands into other types of beverages, and into the fast-growing K-cup (Keurig single-serve coffeemaker) market to brew at home, as well as into food products.

One of the reasons we have been in and out of Starbucks is valuation—even though coffee is a staple, and, as such, the price would not ordinarily change much, the cost of coffee historically is volatile, because of the planting cycle. If there is a freeze, it shrinks the crop. New plants take three years before becoming harvestable for coffee beans. Naturally, that has an impact on earnings and share price, particularly in a market that is so geared to a moment-to-moment outlook.

For example, we began selling in late 2013 when the price of coffee beans was low, and then we got back in as soon as coffee bean prices spiked again. The price/earnings multiple had contracted, which represented a buying opportunity for us because, as long-term investors, we could look past the short-term spike in coffee knowing full well that, in three years’ time, there would be a glut of coffee beans and the price of coffee would come down—a veritable tailwind for Starbucks.

We are valuation sensitive, and that is the deciding factor as to whether a stock is in the portfolio, or the position size that it represents within the portfolio. This is another example, too, of the partnership aspect we exploit with our research analysts, in this case those working in the restaurant industry, where we benefit to get a better look at valuation.

Q: Would you give us another example, one in a different industry?

We can look at how we try to exploit market inefficiencies, one of them being what we call “a fallen quality growth.” In this circumstance, we are talking about a company that we believe is still structurally advantaged in the longer term, but there exists a short-term issue. One that immediately comes to mind for us is Apple Inc. 

Apple Inc is a great company with several great products. It has tremendous revenues and earnings, and plenty of cash. Two years ago, the market became concerned that it was all over for Apple. We didn’t agree. We hung in there instead. And while we suffered a bit in 2013, after doing serious analysis on the company and the market opportunity, and gaining confidence that the next product cycle for the iPhone 6 and 6 Plus would prove significant, we made our move when the market was selling Apple to step in and buy the stock and make it our largest position in the portfolio.

Why? What the market missed was that Apple remains an aspirational brand for a lot of people around the globe, particularly in China. It is considered a status symbol to possess an Apple product. The Apple platform is also still the best ecosystem in terms of applications and security. The market was, in our estimation, shortsighted in not taking these factors into consideration.

When the iPhone 6 came out last September, an astonishing 40% of those purchasing it were new customers that Apple only picked up over the previous six months. Apple has upgraded merely 20% of their existing customer base to the iPhone 6, which tells us there is a lot of runway for growth over the next couple of years.

Why? Because Apple has an impressive retention rate of over 90% of existing iPhone users, substantially higher than any other handset operator or manufacturer today. 

Q: How do you go about constructing your portfolio?

Our goal is to outperform the index by way of thoughtful stock picking. We are bottom-up investors, so we evaluate each stock on its own merit and try to avoid major macro risk. We have a well-diversified portfolio. For example, we would not own Home Depot Inc and Lowe’s Companies, Inc; we would pick one. We then look at market cap and sector weightings, and seek to minimize benchmark-relative exposure to foreign currency and other macro factors.

We invest in quality growth companies. Therefore, when the market swings excessively in favor of something that does not embody quality growth, it creates what we refer to as a headwind. For example, in 2011 the market was moving quite excessively to dividends as an alternative to long-term Treasuries for fixed income. Dividends are not a characteristic of growth companies, so we tend to be under-indexed on dividend yield.

In terms of the individual positions we take and how they’re weighted, an initial position size for us represents anywhere from 1% to 2.5% of the total portfolio. The position limit, our maximum, is typically 7% of the fund. The one exception to that limit is Apple, which represents 7.9% of the portfolio as of the end of April 2015. We could take a security up to one and a half times the index weight for that specific security. If Apple represented 6% of the Russell 1000 Growth Index, for example, we would consider going to 9%. 

Our core position size is 3% to 3.5% of the fund itself. Of our 35 positions, we have 30 or so core positions and maybe five or six stocks coming in or out of the portfolio at any given time. 

As far as average market cap is concerned, the fund is close to the Russell 1000 Growth Index, and our minimum, at purchase, is $5 billion. We are fairly balanced between what we call mid-cap stocks ($5 billion to $20 billion–$25 billion), and our large-cap stocks ($25 billion–$50 billion) and mega caps ($50 billion and above), compared to the index. Again, we are bottom-up investors. We construct the portfolio based on what we find in the marketplace. 

For sector allocations, we own stocks in all the major economic sectors. We might be a little overweight in one sector over another, but that is simply a function of the stock ideas we find in the market.

With regard to how and when we decide to sell a stock, there are two basic considerations that drive our selling process: valuation or a change in our long-term fundamental expectations for the company. 

When we sold Starbucks back in 2013 due to the volatility in the price of coffee beans, it was a decision driven by valuation. When the opportunity to get back into the stock later presented itself, as we anticipated it would, we did. We also might decide that a stock is a candidate for sale due to a change in the investment thesis, or how we view the structural advantage of the company longer term—if its competitive position has been weakened. 

Q: How do you define and manage risk?

We feel that the most important risk management is done at the stock level. Because of our in-depth, intensive research approach, we make sure that the companies we buy are structurally advantaged. 

We make a point to avoid unnecessary risks, beyond, of course, the natural risk of being a quality growth manager. We are generally neutral in market cap and sector weight, and we try not to take major risks when it comes to interest rates, currency, or overall valuation, so as to avoid any one extreme. We manage momentum and keep everything in check so that the true outperformance of the individual securities is what drives the performance of the fund.