Q: Would you give an overview of the fund?

I was involved in the formulation and the original investment policy for the fund, which was launched in mid-1993, and I have managed the fund ever since.

The fund was designed to be a quality growth strategy. We had different growth products, some of which had substantial international exposure. However, this fund is designed primarily to be a domestic U.S. growth stock focused product. 

We considered calling it ‘quality growth’ fund with the goal to own companies with leading market positions and seasoned management teams that know how to allocate capital and manage expenses, as well as with strong financial fundamentals.

The fund has grown steadily over time, although it has had periods when the assets grew more rapidly, either due to market appreciation or due to inflows. The product has several long-term holdings, some of which have been held for over 10 years, while others have been held for over 20 years.

The methodology used for managing the fund has been fairly consistent over time. As a result, the number of holdings, which is also a distinguishing characteristic, has been relatively constant. 

We run a portfolio with typically 100 to 140 names, but the top 20 holdings often make up between 40 to 50% or more of the assets. While we value the benefits of diversification, we are also willing to make meaningful bets where we believe the risk reward is most attractive.

Q: What is your investment philosophy?

Stock prices, essentially, follow earnings and free cash flow growth over time. A big part of our methodology is to find companies that we feel will have durable, sustainable earnings and free cash flow growth.

Looking at free cash flow growth has gained much more credence and is much more broadly used, but we have employed this approach consistently since inception. We have empirical data going back to 1954 that substantiates that free cash flow growth is a good predictor of investment results.

Sometimes free cash flow’s value is more striking in unexpected areas, such as technology, where you would not necessarily think that it would be a good predictor of investment results. But if we are looking for durable and sustainable earnings and free cash flow growth, a lot of qualitative work is required to discern which companies that will deliver consistent results over time.

For example, in the drug distribution and retailing business we own CVS Health Corporation and Walgreens Boots Alliance, Inc. The sector is not particularly cyclical, and both companies have a number of characteristics that allow them to generate substantial recurring revenue and durable earnings and free cash flow.

Q: How do you implement your investment strategy and process?

We look for companies that are operating in fertile growth fields. For instance, we have important investments in biotechs, and have owned Google Inc. since its IPO. We are not afraid of more rapidly growing companies, but we seek out companies that have sustainable growth. Additionally, we like management teams that know how to skillfully reinvest cash flow.

When we start assembling the portfolio, we carefully study whether each company is a franchise company or has a sustainable competitive advantage. We value an industry structure where the margin structure is stable or improving, where there are high barriers to entry, low threat of substitute products, and where companies have power relative to their customer and suppliers. 

For example, Biogen Inc., which is among our holdings, has a dominant share in multiple sclerosis, while The Sherwin-Williams Company has 36 consecutive years of dividend increases in addition to well-managed paint stores. In our view, both are franchise companies with a sustainable competitive advantage.

Q: What kind of management quality do you look for in companies?

We typically want to meet with several layers of management to assess the depth and quality of management. We seek to determine if they are thoughtful about how they allocate capital because we are very aware that high quality companies can “deworsify” if acquisitions are flawed. 

Everyone wants companies with innovative products, but they are not willing to pay for companies who invest in R&D. On the contrary, we like companies that thoughtfully invest in R&D, companies with brands and a high significant degree of intellectual property.

We look for management that has strong internal control systems, because we are investing in complex multinationals that are often operating in 50 or more countries. We also want management that shares the incentives, and it is always a red flag if the senior management is hogging all the stock options or any other incentives.

When we see an industry structure that is conducive to profitable growth, and a high quality company that is managed by honest, conservative management with a strong set of internal controls, that is a strong starting point for us.

Our valuation work is similar to that performed by many investors, the most difficult part of the process, and what differentiates us the most is making a qualitative assessment of the business model. 

If we are doing our job well we should be like a good carpenter who measures twice and saws once, without an inordinate amount of turnover. In the past, we have had below average turnover, typically one third of the growth group average.

Q: What are the quantitative and qualitative steps that form your research process?

Analytical work must be done on the front end, and more substantive work must be done after investment candidates have been identified. One of our main types of analytical work to identify candidates is the quantitative screen.

We have a model that has 15 ratios, all of them looking at a number of measures that connote quality to us—revenue growth, earnings growth, free cash flow, return on invested capital, and a number of balance sheet measures. We do not want companies that are typically heavily leveraged.

Not only do we want companies with a strong balance sheet but we also look for the ability to replenish the balance sheet through free cash flow. Quantitative screening to source candidates is important, but that is not the only source of candidates. Here, our research group is also unearthing and bringing ideas to us.

Both of those methods are just a starting point for us. We would never buy a company just based on the fact that it passed some quantitative screening that we did without our research group or me meeting with the management in order to make a careful assessment of the industry and the company’s position within that industry.

Preferably we not only meet with management but we also visit headquarters and even a couple of their manufacturing plants. With retailers, such as Starbucks Corp, we would meet with management, visit headquarters, and then do a good bit of field research; looking at their actual stores, the products in the stores and quality of service. 

We seek to corroborate what management tells us with customers, suppliers, and competitors. If management is honest and conservative, they will always strive to tell you the truth and they are unlikely to hide problems or overpromise. A good management will always try to underpromise and overdeliver, which in turn makes our job a lot easier. However, it is important to maintain a posture of professional skepticism, and to try to assess the reasonableness and veracity of assertions made by management.

Q: How is your research team organized and how does the decision-making process work?

We have a large, robust research group with over 200 analysts working globally so there is some global delineation. For the most part, those 200 analysts are also organized on an industry concentration basis. As we have grown in size there has been some specialization on a capitalization basis so that we do have some small- and mid-cap specialists in certain industry areas.

However, we believe that it is best to have analysts organized in industry silos and, if possible, to have them follow companies across the market-cap spectrum. If an analyst is following small- or mid-cap biotech companies, those grow up into larger-cap companies, so there is some benefit to having that continuity.

As we have grown, there is even more geographic specialization, and we have added a European industrial analyst to our team. With 200 analysts, more specialization or bifurcation is inevitable, but in general it has served us well to have the pool of analysts work with all the portfolio managers. 

To put a finer point on this, it is rare for a portfolio manager to command resources exclusively. The analyst pool essentially works with all the portfolio managers. For example, if I am interested in Chinese Internet companies, then I am going to work with an analyst who also works with all of our other portfolio managers showing interest in that particular area.

Q: What is your organizational structure?

We believe in a flat, decentralized organization that is nimble and where information can flow up through the organization quickly. So, if the Chinese Internet analyst wants me to buy a name, he can call me on the phone, but there are also a lot of broadly available databases. 

There is a blue sheet daily research summary that is disseminated electronically but if an analyst finds something of importance, he or she can inform everyone in the organization instantaneously using a related intranet product or e-mail. 

Typically, when an analyst initiates coverage, he or she might write a 10- to 15-page research report. But if our analyst has been recommending a name and finds a problem, or finds something that he or she is more enthusiastic about, he or she can send a one- or two-page summary and we will have that instantaneously.

There is no governor, committee, vote, restriction, or approval process whereby that analyst’s recommendation is filtered before it gets to me. Neither is there any committee that I have to have approval from before I buy a name. It is designed for both the research analysts and the portfolio managers to be proactive and nimble.

We often travel with the analysts and work with them side-by-side. When they are writing something, it should not come as a surprise to us. 

Q: What is your screen-based selection process?

We are sticklers for looking at per-share amounts. What we have learned is that some companies are serial dilutors. They are always issuing shares. They may make smart acquisitions or they may buy things that fit strategically, but they are issuing so many shares that it is not a wise acquisition in the end. It is very difficult for them to overcome the dilution. For example, they may have incentive plans to issue so many shares that they are diluting the success of the company.

We also look at time series analysis, even for information fields, outside the 15 ratios that I mentioned. We look at 5-year, 3-year, 1-year, and sometimes even quarterly data, to try to discern acceleration or deceleration in key metrics.

We have changed things in the proprietary model, but we have found that free cash flow is more important than we initially thought. The free cash flow has assumed more importance in that model.

Aside from the quantitative screening, we have learned to focus on incentives. We take a lot of time looking at pay structures, stock option plans, and so forth, which has gradually improved our process.

Q: How do you go about portfolio construction?

We are benchmark aware. We compete against the Russell 1000 Growth Index on the institutional side and the Lipper Large Cap Growth Index on the retail side. There are a lot of clients, particularly European clients, who eventually want us to be competitive versus the S&P 500 Index.

Since we are running a large-cap quality growth product, we are cautiously optimistic that if we construct the portfolio prudently, paying attention to risk/reward and trying not to overpay, we can be competitive with large growth benchmarks and the S&P 500 over time.

We analyze the quality of the company, the durability of the earnings, how fast the earnings are growing, but also the valuation of the company and where it stands in terms of a risk/reward assessment. We have downside risk and upside reward for every company in our portfolio. If a company is up at the top of the valuation range, then we will have less appetite for it. If it is cheap and we think it is misunderstood or out of favor, but a high quality company that we think is poised to accelerate and durably grow for a period of time, we are much more willing to build a meaningful position.

Our portfolio construction is not formulaic; it is art. In cases when we buy a lot of something and it performs well, we may be willing to maintain a large position if we are confident that the company is executing well and the valuation is still reasonable. If we feel confident that our price target is conservative and it will have to be moved up over time, we also might err on the side of keeping a bigger position longer.

Q: How do you diversify? Why do you have so many holdings in the fund?

In terms of diversification, we have done back testing to see whether the bottom half of the portfolio is adding value, and it varies. Sometimes it adds a significant amount of value. What we have noted over time is that names where we might only own 10 or 15 basis points often grow into larger positions where we own a significant amount.

When you look at the S&P 500, or any growth benchmark, once you get past the top 15 or 20 names, you are quickly dealing with 15 basis point or 10 basis point positions. We would argue that if you own over 100 basis points in a name, you are making a very significant bet. 

We think you can produce differentiated results with over 100 names, with the added benefit of diversification. Although we agree that you can over diversify, we have not done that. We certainly look at tracking error, active share, standard deviation, information ratio, and a number of other measures to determine that we are not taking unintended risk. 

Our view is that we are taking enough risk to differentiate our results from the benchmarks over time, and that has been borne out by the performance.

Q: How concentrated should your portfolio be?

To begin with, the S&P 500 Index has 500 positions, but it manages to outperform 80% or 85% of the managers over time. I do not think that having a few more positions than a concentrated portfolio is necessarily harmful. Quite the opposite, it can be helpful as long as we are proactive in terms of selling or adding to positions.

Concentration works very well until it does not work, and then it can create significant problems. We have been running the portfolio in this style for roughly 22 years and the mix of being fairly broadly diversified, but still willing to make significant bets, is a nice mix.

Q: What drives your sell discipline?

Regarding our sell discipline, 75% of our sells are driven by a flawed investment thesis or something that has violated our original investment thesis, such as incompetent management or management that is dishonest. 

There can also be dramatic changes in the competitive environment. I recall selling Safeway Inc. aggressively when we caught wind of the fact that Wal-Mart Stores, Inc. was going to be aggressively building out their grocery business. We had no idea that Wal-Mart Stores, Inc. would get to be the size where it sold 35% of all the groceries in the U.S., but we were concerned about it enough that we were willing to sell the entire Safeway Inc. position.

Companies that hit our price targets drive just over 25% of the sales. If they are valued too richly, we do not think the risk/reward is attractive anymore. 

Q: Do you have personal investment in your fund?

I assure clients that we will try to be disciplined about maintaining exposure to the portfolio we are managing on their behalf. I have most of my own retirement money in the product and I have never sold any of that investment. Not only do we eat our own cooking but we do not ask others to be long-term investors unless we are willing to do the same thing.

Q: How do you define and manage risk?

The entire portfolio is built bottom up with an additional risk management overlay. That means we may find 10 ideas in the financial area that we really like with attractive risk rewards, so we will be buying the financial industry aggressively. However, before we finalize industry exposure we employ a risk overlay. This involves not only a top-down assessment of industry concentration but it also employs several other risk models as well.

We have a Wilshire risk model where I can look at the risk exposure of the portfolio to changing interest rates, oil prices, momentum factors, or size factors. I want to make sure I am not taking unintended risk. If I have more risk to one of those particular factors than I am comfortable with, then I am going to be peeling back the onion and looking at the individual companies that are contributing to that risk.

Q: What does risk mean to you at the fund level?

We look at several classical measures of risk, such as volatility measures and standard deviation. We look at tracking error and then we also look at diversification and valuation.

Warren Buffet defines risk not as volatility. What he says is he does not care if the value of his investments fluctuates over time, and he defines risk as the chance of suffering permanent catastrophic harm. 

Apple Inc. has been quite a volatile stock, but it has little debt, has very strong free cash flow, and has tremendous financial strength. What is more, they have the strength of the franchise too. As a result, we were willing to have Apple represent a significant part of our portfolio.

The most important thing in analyzing risk is to look at the underlying business models and to make sure that we understand, as best we can, how the companies make money. Sometimes the earnings process and revenue recognition process are convoluted and we do not really understand how the company makes money. There also may not be a stream of free cash flow to corroborate the quality of the business model. In these cases we are fond of saying that they do not give points for degree of difficulty. We do not need to own that investment: we can rather own a company that is easier to understand.

In that regard, we like companies like Starbucks, which are cash-and-carry business models. They know what they earn at the end of every day, and there is a low threat of product obsolescence. There is not a lot in the way of receivables, and the revenue and earnings recognition process is straightforward and the company generates healthy cash flows.