Q: What is the history of the fund?
The AllianzGI Mid-Cap Fund was launched on November 6, 1979. When RCM Capital Management merged with Allianz in 2013, RCM was focused more on large-cap growth stock investing and at the time, we were looking for ways to broaden our reach.
Tim McCarthy and I took on the challenge of running this mid-cap portfolio and we have been managing the fund since 2014. The fund currently has assets of approximately $289 million.
Q: How are you different from your peers?
What differentiates us from our peers is our focus on risk. Our strategy is to build a diversified portfolio across mid-cap market sectors, but to concentrate the risk at the stock level.
A second point that differentiates us from many of our peers is that we have a dedicated team focused just on this fund. The team is plugged into the resources and leverages the information flow from the RMC research platform.
Q: What core beliefs drive your investment philosophy?
Our investment philosophy reflects the heritage of RCM, which is to focus on quality, growth and valuation. We do not just pick stocks; instead, we are focused on constructing portfolios where most of the risk is coming from our specific stock selections.
Our objective is buying high-quality names at a discount. We have 17 analysts located in San Francisco who try to identify growth companies whose value is either understated or underappreciated by the markets.
They identify the company’s key growth drivers and look for a pending catalyst. We then evaluate the drivers and catalyst to determine if they are embedded in the market’s consensus view. Finally, we look at the company’s valuation to determine the degree to which the current discounted value is reflected in forward estimates, multiples and expectations.
For us, company quality is a basic requirement because it provides an additional margin of safety. We look for companies with strong management teams and a clean balance sheet.
High-growth companies often have high operating leverage. We tend to shy away from companies with high financial leverage. A company with double leverage has a much higher risk profile than we are comfortable with, so we focus on high-growth companies with strong balance sheets. In addition to providing a margin of safety, companies with strong balance sheets can take advantage of strategic opportunities or acquisitions to enhanced performance.
For example, we own Newell Brands, Inc. which recently bought Jarden Corp. For Newell, this was a unique opportunity to bring together two businesses and take advantage of a tremendous amount of cost synergies, as well as opportunity to accelerate top-line growth.
Because of their balance sheet, Newell was able to leverage strength and take advantage of the acquisition. Following the acquisition, they have been aggressively deleveraging by utilizing the free cash flow generated from that deal.
Typically, when we look at growth companies we avoid non-earning companies or companies that are far away from generating free cash flow. We usually avoid companies with negative free cash profiles, but we favor companies with good cash flow conversion rates, as well as improving free cash flow outlooks.
Q: What is your investment process?
The process starts with the identification of interesting mid-cap names from the Russell Midcap Growth Index list. With over 800 names in the benchmark, there is no shortage of potential ideas or opportunities available.
The ideas may come from a variety of sources like our 17 analysts in San Francisco. Those analysts are all experts in their field and have a tremendous access to company management teams, sell-side resource, and many other resources.
They are our primary source of new positions, and when they make a recommendation, we work very closely with them in evaluating their ideas.
A second source of ideas is from our analysts that manage money. For example, Sebastian Thomas is the head of our technology sector and, with three other analysts, is responsible for $2.5 billion of technology dedicated money.
We look at the names that Sebastian is buying in areas like artificial intelligence. If a company falls within the mid-cap universe, we will give it a look. We use these sector fund analyst, who have expertise in technology, healthcare, energy, and other sectors, as a source of ideas.
Finally, we talk to companies, meet with analysts, and look for broader thematics. We also incorporate some quantitative analysis; but for the most part, the quantitative work is less about sourcing new ideas than identifying broader themes.
Q: How do you evaluate individual opportunities? Can you describe some examples?
One recent example is our decision to buy Coach, Inc. Retail is a very challenging area especially with big box retailers continuing to struggle and mall traffic declining.
We viewed Coach as a differentiated name within the broader retailer space. They had been going through a very painful restructuring process for about three years due to their mall exposure. However, we believed that they had a number of exciting growth opportunities.
Coach continued to grow in Asia; and, while they had pretty much avoided Europe due to competitors like Michael Kors, we viewed Europe as a major growth opportunity. Then they had recently acquired Kate Spade New York, the fashion designer, which we thought was a smart acquisition. Kate was very strong in Japan, but had zero business in China. Coach, on the other hand, had built a strong China franchise.
Another thing about the acquisition we liked was based on our evaluation criteria. They paid only 8 times EBITDA on forward earnings, which we viewed as a bargain, without even including the potential top line growth. Coach had cost synergies with Kate that were very visible, especially after considering Kate’s entire supply chain.
After the acquisition, we estimated that Coach was able to achieve a $50 million of cost synergy, which was offset by a $50 million revenue synergy. So, when we looked at the forward numbers and the growth profile, we felt comfortable that Coach would be able to profitably integrate Kate into their business.
We have owned Coach over the years and know the management team well. They just hired a Chief Financial Officer who has been tasked with identifying strong brands to bring into Coach.
By using their leverage and brand strength, their attractive valuation suggests that the stock has room to move higher. And if they can rebuild their top line momentum, which we think they are actually close to doing, the Coach brand can do well again.
Q: What is your portfolio construction process?
Portfolio construction is a key part of our investment strategy. It is all about understanding risk and making decisions to mitigate those risks.
The fund is not diversified across sectors; but, while we don’t have a hard limit on sector exposure, we typically stay within plus-or-minus 500 basis points relative to our benchmark’s sectors. It is easy to fall in love with a certain area, so it is important to have limits on sector concentration.
For example, in 2017 the financial sector was viewed as the sector most likely to outperform. We bought into that view and added names in that sector. Today it is clear that financials are underperforming; and, it’s good that we didn’t go overboard. I think our guiding principle of plus-or-minus 500 basis points relative to sector overweights has helped our performance.
Initially, we owned well over 100 names; but over the last few years, we have aggressively worked to reduce that number and the count now stands at 60. The characteristic of the portfolio didn’t change all that much and it remains a mid-cap growth portfolio.
We characterize the nature of our portfolio construction process as growth at a reasonable price that is based on a fundamentally driven, bottoms-up, stock picking process. Our portfolio typically has a higher, earnings growth profile than the benchmark; yet we construct portfolio in such a way that the price-to-earnings is at or below the overall benchmark.
The portfolio is not diversified. Many of our largest overweights are roughly 2.6% of the portfolio; and we are comfortable letting our overweights increase to 3%. Rarely do we allow individual names to exceed 5%, because we don’t want one or two names driving our entire performance.
We use the Northfield Fundamental Risk Model to evaluate our portfolio daily and review an APT model every month. Both models essentially tell us the same thing: that most of our risk comes from stock selection. At least 75% of our risk is coming from stock selection and very little is coming from factor exposure or beta.
We like to maintain a little bit of price momentum in the portfolio to offset the small amount of beta skew from the stocks. We also try to minimize our factor exposures. Typically, we strive to have more exposure to price momentum and earnings growth, but less exposure to leverage.
Q: How do you define and manage risk?
Understanding the exposures we have and bets we are taking is one of the most important aspects of our portfolio management process. We make sure that what we are doing is purposefully and that there is nothing unintended emerging from the process. We sit down with our risk assessment team monthly to go through risk and attribution to understand what is working out in the market and where our risk is coming from.
Ultimately, our job is to differentiate ourselves from our benchmark by taking positions, but to make sure that those positions and the associated risks are justified. The positions that we take are typically justified in terms of a higher earnings yield, earnings growth profile, a lower debt-to-equity, or leverage profile.
As a result, our portfolio typically has a higher price momentum and a lower dividend yield profile than the benchmark. We also look for free cash flow and the growth of free cash flow, where the free cash flow is used to buy back stock instead of paying out dividends.
Q: What lessons did you learn from the financial crisis?
We learned two lessons. By focusing on companies with lower leverage and better free cash flow profile, we were able to outperform the benchmark when the markets were coming out of the downturn. We also learned that some of the fundamental risk models were very slow in providing signals during the downturn because they did not capture risk at a fast-enough rate.
However, the APT model that we use does provide interesting results. It often picks up sensitivity in our portfolio for which we were unaware. Just recently, it signaled that we had some exposure to the Japanese yen. We don’t own Japanese securities, but owned companies that had exposure to Japan.
That forced us to think that maybe we had some risk that we weren’t considering; and that we should start thinking about how to manage it.
