Q: What is the history and the objective of the fund?

We have been managing the fund for Wells Fargo since 2000, the peak of a cycle in technology stocks. In this environment, the manager had to understand the companies well and to build a portfolio that would capture the long-term potential of the sector without having to worry about timing the exact entry and exit points.

Our goal is to generate capital appreciation. Although we measure ourselves against different tech benchmarks, we don’t have portfolio constraints relative to the benchmark. We aim to build a fund that captures the leading companies in technology by buying them at reasonable valuation and enjoying the appreciation as they grow.

Q: Is your approach global or do you focus on the U.S. market?

We have a global approach, but a large percentage of our assets are currently in the U.S. Over 70% of the global indices are concentrated in U.S. stocks. One of our advantages is that we are based in San Francisco, not in Japan, Hong Kong or London. We are a little less inclined to invest in foreign companies, unless they are the leaders in their technology subsector. We have been investing in China, Europe and Japan. However, we currently find higher growth and reasonable value in U.S. companies.

Q: What is your definition of technology?

Our broad definition classifies a company as technology if it is driven by or associated with technology. That broad definition has served us well, because technology is broadening its reach and is redefining industries. When we see that an industry becomes driven by technology, we are happy to buy the stocks. Amazon and Tesla are examples of technology-driven companies that fit into our portfolio.

Q: What are the core beliefs that guide your investment approach?

The portfolio consists of three parts – growth, value, and GARP. Growth represents the largest part of the portfolio, more than half of it. Within growth, we look for segments of technology that have a new or a lower-cost approach. We thoroughly research the companies in that subsector and we gravitate toward the leader. Basically, we aim to capture the growth of the segment through the leader, because the leader tends to gain share over time both in consumer and enterprise technology. Even if the leader is priced with a premium to the second or the third company, we would pay more to capture that subsector growth.

As stock pickers, it is important for us to understand the drivers behind the industry and the companies. We meet with managements to discuss their strategy and we benchmark them against their targets to see if they execute. That’s how we find companies that make or will make money. We want the managements to understand that earnings and cash flow drive the valuation of their company. We make sure that the companies target free cash flow growth.

Fundamentally, we look for attractive subsectors that can generate good cash flow and, therefore, good returns to investors in the fund. Then we look for the companies that lead these subsectors. We aim to understand how the financial model evolves and why growth and revenue would translate into growth and free cash flow over time.

Q: Would you describe your idea generation process?

We are located in an area that is focused on new technology; San Francisco has many venture capitalists, public investors and tech companies. There is a flow of information that we constantly tap into. One source of ideas is the community, the informal meetings of team members, the understanding of where the focus of the sales community is, and who has the new product that resonates with customers.

Another source of ideas and information is conferences. There are many tech conferences in San Francisco, probably one each month, which include both public and private companies. We go to the conferences, listen to the management presentations, visit their companies and decide if an idea is worth pursuing. We also go to industry events like the Robotics Conference in Munich or the Amazon Conference associated with cloud computing.

Q: What is the process of turning these ideas into investment opportunities?

The key factor is understanding what’s driving the market. By examining long cycles of subsector growth, we try to understand if a trend is going to last for six months or if it represents a longer-term opportunity. We use long waves of appreciation and invest in growth that is driven by new and lower-cost approach.

Once we find such growth, we visit most of the companies in the subsector to understand their position and to identify the leader. We dig into the companies and meet with the management to understand the products. Typically, we have 60 to 70 companies in the portfolio, but we visit at least twice as many companies to develop that portfolio.

We run this portfolio as a team. Usually, two or three team members are involved in the research and build an opinion on the specific subsector. Then we discuss the company and how it fits the portfolio on a relative valuation basis. If there is a disagreement about the potential of the company, then it most probably wouldn’t go into the portfolio.

It we still decide to invest, we would start with a small position until we resolve the issues that worry part of the team. Then we may increase our position or sell the stock. If two or three team members agree that it represents a great opportunity, then we would make it a large position. We also look at risk. The construction of the portfolio is a function not just of the ideas, but also of risk profile and the benchmarks that we try to beat over time.

Q: When you find an opportunity, would you invest in the entire theme?

It depends on the theme, its maturity and its impact. It is essential to establish if the theme could change the profile and the growth rate of the company, if it can change the perception and valuation.

For example, cloud computing represents more than 40% of our portfolio for two reasons. First, we had a large position in consumer Internet. Our belief was that these stocks were getting close to being fully valued relative to their potential. So, we decreased our exposure last year. We also had a large position in semi-conductors, but because we believed that we were entering a cycle in semi-conductors, we took that position down. Meanwhile, the adoption of cloud computing was accelerating and more companies were becoming public, so we increased our exposure to that sector. That’s part of the portfolio construction process.

The other reason is related to the cycles of enterprise technology adoption. Our view is that enterprise technology changes every 20 or 30 years and there must be a compelling rationale behind the change. We believe that cloud computing is a major enterprise change and we are early in that transition. Therefore, we don’t know yet who will be the eventual leader, or whether the market will be bifurcated, so we have a broad collection of companies in that area.

Cloud computing will probably continue to be a large part of the portfolio because of our view that enterprises are changing their entire infrastructure. We believe that the next trillion dollars that investors are going to realize in technology will come from the cloud computing sector. The companies that provide that infrastructure are going to be much more valuable in the future than the companies in the past were. That was the bet we made in 2017; it has worked out well this year and we think it’s going to develop next year as well.

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

I would use the example of Okta, a San Francisco-based company, which makes sign-on systems for computers and user identification systems.

I was not convinced initially, because Microsoft Active Directory had 90% of the sign-on business and was moving it to the cloud. Okta clearly saw opportunities in coordinating the identity and the security associated with moving to the SaaS world. There are SaaS companies, which are not comfortable sharing their Internet sign-on details and software with the competitor Microsoft, so there was a need for a neutral party.

Okta had relationships with hundreds of SaaS companies. When adopting the Okta system, a company can use it with any SaaS vendor, so it made life simpler in terms of IT. We started monitoring the company and then the story grew more interesting because of the change in the security world, which played well with the single sign-on concept. Companies need to understand the security and to know exactly whom they are giving access to their data. So Okta evolved into a security company, while still being a single sign-on company.

Q: What other factors influenced the decision to invest in Okta?

The competitive landscape is another important factor.

Understanding how the company competes and fits in the landscape is an important part of our process. We dig deeply; we don’t just visit the company, but we also talk to customers and competitors. We have a grassroots organization that does parallel customer research. These are some of the elements of our fundamental research work.

Q: How do you justify owning the stocks of companies that are not profitable?

We have to understand the longer-term potential, model and valuation. The key aspect is to understand the path to profitability and the size of the potential profitability, so we develop different scenarios. However, that issue is less relevant today because these companies are starting to make money and their business models are becoming clearer.

Overall, we try to find the stocks that we believe in and we trade them depending on the circumstances, their profitability, and the supply/demand aspects of the stock price. When evaluating the stock price, we develop our own earnings forecast and examine it relative to other people’s forecast. The stock position is based on psychology and fundamentals, but the fundamentals are the main driver of our long-term core positions.

We build our own revenue model and then we examine how profitable that revenue will be, what free cash flow the company will be generating, what multiple can we expect and what the target price is. If there is a big gap between the target price and the current price, we consider if we are too optimistic or if there is a lot of appreciation potential.

Q: What is your portfolio construction process?

We manage a focused portfolio of 50 to 100 stocks. We aim to own the best company in an industry or a theme, but we may have several companies in the same theme if they are differentiated enough. We aim to beat the tech benchmarks over time through buying higher-growth companies at reasonable valuations. At this point, only 20% of the tech companies are growing over 15% a year, so our investable universe is a small percentage of the tech universe.

Once we decide that we like a company, we overweight the stock compared to the benchmark. Amazon and Microsoft represent large portions of our portfolio, because they are large portions of the benchmark and because we like them more than we like the index or other companies. Overall, we aim to overweight the companies, if the portfolio constraints allow it, because we are aware that we need larger positions in the favored companies to beat the benchmark.

The idea is to build a portfolio of great companies, so our research and portfolio construction processes are about positioning us in areas with significant potential appreciation over the next few years, not just over the next six months. My partner Huachen Chen, who is an expert at evaluating near-term supply/demand, forecast and recent stock performance, makes tactical adjustments to the positions to further enhance the returns.

Q: When would you decide to sell a stock?

A key reason for selling a stock would be the sector dynamics. For example, the semi-conductor industry is 6% of our portfolio, while a year ago it was 30% and two years ago it was 11% of the portfolio. There are cyclical supply and demand trends that cause semiconductor stocks to be volatile and to be in and out of favor.

Fundamentally, we like the sector, but we understand the cyclical influences. If we believe that the sector is going to underperform, then we will take it out or take it down relative to the benchmarks.

Another reason to revisit some of the higher-growth companies is valuation. Overall, we consider the limits, the valuation, the price targets and where the stock is compared to the intermediate-term price targets. Then we consider the cycles and the relatively advantaged and disadvantaged companies.

Q: How do you define and manage risk?

The factor risk of mid-cap growth plays a role in our relative performance in a particular year. The biggest issue is that we are focused on higher-growth companies, which are predominantly mid caps, because that’s where the growth is. When there is a period of underperformance, as in 2016, it is usually because mid-cap stocks are not performing as well as large-cap or value stocks.

We manage that risk by cutting back the stocks when they have done really well, but we are always going to have that factor risk. Also, we have increased our percentage in value stocks from 10% to 20% to 30% of the portfolio, because most of the universe now consists of value or GARP stocks. Philosophically, we can invest in value, when there is a company development that allows the multiple to expand or the earnings to accelerate. In these lower-multiple stocks, we look for a potential acquisition, a management change or a product change.

The GARP exposure represents a way to stabilize the portfolio. The category varies based on our view of the opportunity and the valuation of growth companies. We tend to increase the GARP category when growth companies get more expensive or when we are concerned about interest rates and valuation. These stocks become relatively more attractive in periods when growth is decelerating in many companies.

Initially, when we started the fund, we were holding 40% to 50% in cash as one of the ways to manage risk. That approach worked for a while but I think it stopped working after 2003 and we decided to decrease our cash position to 5% to 10% of the portfolio.