Q: What is the history of the fund?

Sean Gallagher: The Goldman Sachs Small/Mid Cap Value Fund was launched on January 31, 2014, although the team has been running the strategy in separately managed accounts since the beginning of 2013. The fund is run by the same team of eight portfolio managers, including Co-Lead portfolio managers Sally Pope Davis and Rob Crystal, who manage our Small Cap Value Fund, which has been around for well over a decade and has over $5 billion in assets as of the end of 2013. Our broader team of over 20 investment professionals manages value-oriented portfolios across the large, mid and small cap spectrum. The team collectively manages nearly $40 billion in assets across various investment vehicles, including our Mid Cap Value Fund with over $10 billion in assets as of the end of 2013.

Sally Pope Davis: We decided to launch a small/mid cap value fund because Rob and I saw a unique opportunity to invest in stocks within the $2 billion to $6 billion market cap range. We feel this is an area of the market that is often underexploited and fertile for stock-picking, given some of the inefficiencies that exist in the space. Whereas with any large cap stock, you’re going to have 20 sell-side analysts and hundreds of buy-side analysts covering the stock, with small caps, you might only have a few. On our team, we have deeply experienced portfolio managers who are able to take advantage of those inefficiencies, and particularly because as more seasoned portfolio managers, we tend to have a longer term view. Sean Gallagher: We are excited about the recent launch of the fund as it’s largely an extension of our small cap value business which has been able to generate excellent alpha over its long term history. While the fund is currently small in terms of assets, we’re excited about growing this business over the next three to five years. Why does fund have both small and mid cap stocks? Sally Pope Davis: One aspect that we really like in the small-to-mid area of the market is that as investors, we can really capture those companies that are emerging from the small cap arena, but before they graduate to mid-or-large cap and become well-known among larger cap managers. The small cap space is somewhat Darwinian in the sense that a company either makes it to the top, or falls to the bottom. As managers who have been investing in the small cap space for a long time, we’ve already become familiar with many of these names as they’ve grown over time. If a company has a good strategy and is led by a management team making smart decisions and investing in high return projects, it will eventually graduate into mid cap. We take advantage of our in-house knowledge of small caps into this small/mid cap space. What is also really exciting about small/mid cap stocks is that historically, they share a similarly strong amount of upside capture as small caps, yet they have better downside protection, less volatility and more liquidity.

Q: What core beliefs guide your investment thinking?

Sally Pope Davis: The principles that we follow in this strategy are the same principles that we apply across the entire GSAM Value complex, and we like to call it “Price and Prospects.” While we are focused on purchasing stocks at attractive valuations, we scrutinize what the underlying business is. In other words, what are the future prospects of the business? Is it a good business in the first place? We’re conscious about staying out of value traps or getting in the wrong stock just because it’s inexpensive. We are very focused on quality, which is particularly important in both the small and small/mid cap spaces. When we talk about quality, there are a couple of different characteristics that we look for. As a team, we spend a tremendous amount of time with company management (3,000 visits a year) in order to try and understand whether they are good stewards of shareholders’ capital. That is going to be evident in metrics such as return on invested capital and cash flow. We are not necessarily looking to buy the stocks with the highest ROIC today, but rather we are looking for stocks in which we see an improving ROIC. These types of stocks can be some of the best investment opportunities. We love uncovering a company in transition, and capturing the stock at the right moment. Ultimately, we are looking for businesses with good fundamentals and margin expansion opportunities, led by management teams that are aligned with shareholders and doing the right things with their capital.

Q: What kind of metrics are important to you when you search for a value?

Sean Gallagher: Our team takes a flexible approach to valuation that varies by sector, beyond price-to-earnings and discounted cash flow. There are nuances within each sector that can be exploited by a flexible approach, and the relevant metrics are determined by our sector experts who are very experienced, many of whom have been covering their designated sectors for decades. For example, for Sally, who covers financials, her biggest focus is on ROE and price-to-book. For our media portfolio manager, there is a focus on enterprise value-to-free cash flow while our energy portfolio manager has a heavy focus on enterprise value-to-reserves. Through our differentiated valuation analysis, we might uncover a stock that initially appears unattractive, but which we determine through our research has much better prospects than initially appears.

Q: Do you have any other concepts of values other than quality companies that are cheaper than intrinsic value and have a catalyst?

Sally Pope Davis: We often like to take a view that is different from the Street to uncover an opportunity we feel the consensus is missing. Sometimes that could be because we take a longer term approach, whereas the street’s view is too short-term focused. We’re willing to look ahead two years because we may see a free cash flow inflection point as capital expenditure declines the next year, or we might see some competitive displacement issue. Our ideal situation is to find those quality value stocks that will compound their growth over time, and to catch them early. On the valuation side, we always look at the valuation history of a stock and the valuation relative to peers, and we ask ourselves whether it makes sense. We look at the returns of the business, the returns on capital, and the returns on equity. Is the valuation commensurate with what we think the return profile should be? A stock might look expensive on a P/E basis, for example, but if you take a long-term view and look out and see where it’s really going, you can discover that it’s actually quite a good value. That’s why it’s critical to dig deeper, talk directly to management teams and understand where they’re going with their businesses.

Q: How is your team organized and what is the focus of each member?

Sally Pope Davis: Our small and small/mid cap value funds are run by eight senior portfolio managers with an average of twenty years of experience. Our funds are managed on a sector portfolio manager basis, which means each portfolio manager has the ability to manage his/her sector with a very wide degree of discretion. Each sector portfolio manager is responsible for determining what reflects an attractive value and what the right entry point is. Given the size of our investable universe, it is not feasible or desirable to have a system where each sector Portfolio Manager has to clear that name with a lead PM. The broader Value Equity team of 20+ investors covering the full market cap spectrum participates in a daily research meeting. Additionally, our small and small/mid cap value team conducts standalone meetings in which we review the various sectors in greater depth. At the top of the house, my colleague, Rob Crystal and I, as Co-Lead Portfolio Managers, will take a holistic view of the portfolio to ensure that it exhibits the right characteristics and style, and is making the statement that we intend. We try to stay relatively sector neutral in this fund in order to achieve our alpha from stock selection. Over time we’ve been able to do that successfully in our small cap value fund, and we’re taking the same approach in this fund as well.

Sean Gallagher: I think what’s different about our approach is that, even though I’m the Chief Investment Officer, and Sally and Rob are the Co-Leads on this fund, we’re not telling anyone what to buy or sell. Given that we hired experienced investors on this team, they own their sector, and so there is a lot of accountability and empowerment. We don’t have a lot of voluntary personnel turnover because people buy into this system. It’s very team oriented, but at the end of the day everyone has their own book of profit and loss. We give our PMs a lot of latitude, versus other teams out there with more of a star manager structure, where a sole portfolio manager dictates and an army of generalists pitch ideas up. Each portfolio manager has the ability to do the research, visit the company, start a position and decide what the position size is going to be—whether it’s a 30 basis point, a 50 basis point or eventually a 1% position. That being said, no one is operating in isolation and there’s a tremendous amount of dialogue among the portfolio managers across the broader team, including those who cover mid cap and large cap. We’re a flat organization.

Q: How many names do you hold in your investment strategy?

Sally Pope Davis: We aim to own between 125 and 200 names in the GS Small/Mid Cap Value Fund. We take a diversified approach and have a larger range of holdings in the fund because there is a tremendous amount of stock-specific risk in small-to-mid cap investing. For example, a company might be a leader in its niche, but it could be put out of business easily if another big competitor changes pricing or the nature of the competition. We seek to distribute risk across a large number of names, and then take more concentrated positions in our highest conviction names. The top ten names, for example, will comprise about 11% or 12% of the portfolio.

Q: How important is quality of management in small and mid cap companies?

Sally Pope Davis: Quality of management is extremely important in small and mid cap investing. Often times in small-to-mid cap stocks, management teams are comprised of one or two individuals who have much more influence over their companies than is the case with their larger cap counterparts. Because of this reason, it is extremely important, in our view, to be comfortable with the management team and really know that they are managing their companies for shareholders. What you will often find in smaller cap companies is that management teams are not as experienced in shareholder management or governance, and are still learning things that we take for granted at the larger cap companies. Really understanding management is probably the most important part in analyzing a stock because it can make or break a company. Management sets the strategy. In the last couple of years we’ve done over 3,000 meetings across a variety of management teams, and we typically meet with the Chief Executive Officer or Chief Financial Officer. You’ve got to stay close to management to see the opportunities that are unfolding. We place a big premium on getting out and kicking the tires with the management teams and hearing it straight from them. Good management teams tend to keep making sound decisions, whereas bad management teams often can’t get out of their own way. If a company is not well managed, it can often compound the other way down, just as a good management can compound the way up. The business still has to be a good business and that goes back to those fundamentals; you don’t want to be the best house in a bad neighborhood.

Q: Can you discuss one example of how you found a specific stock and what attracted you?

Sally Pope Davis: I have an example of a banking company that we used to own in our GS Small Cap Value Fund, and which eventually graduated into our GS Small/Mid Cap Value Fund. We can call it our “West Coast Bank.” We liked its defensible niche, which is serving Asian Americans on the West Coast. During the financial crisis, this particular bank had its share of issues, as did many smaller banks that did real estate lending, but this bank fared better than a lot of its competitors. We really liked the management team, whom we thought were smart and good acquirers. When one of our “West Coast Bank’s” arch competitors failed, our “West Coast Bank” was able to buy its competitor with the help of the FDIC and basically doubled its size. As the company recovered and then appreciated, it became too big for our small cap portfolio, and we reluctantly sold it. When we started our GS Small/Mid Cap Value Fund, we were excited that we had a home for this stock. The company has grown and expanded right along with the economy. California, which had trouble during the recession with real estate, had a great rebound. This company, having taken out its primary competitor, now had an even better moat around its business and has been able to make additional acquisitions. The bank bought another company in the Pacific Northwest, and recently bought a company in Texas. The stock has been a great example of capitalizing on our knowledge from small cap for a company that graduated into small/mid cap. I have a number of similar companies in small cap that have made acquisitions this year, and that are going to become too big for our small cap fund. I know that most mid cap portfolio managers don’t know the stories, and the stocks are just perfect for our GS Small/Mid Cap Value Fund. That is the exact reason we started this fund.

Q: What role does diversification play in your portfolio construction?

Sean Gallagher: Diversification is key across the portfolio. If we express a strong view within a sector, for example if we own two refiners or two mattress companies, we want to make sure that that’s a statement we intend to make. Sally and Rob, as Co-Lead Portfolio Managers, monitor the portfolio holistically to ensure that. We also think that diversification in the small and mid cap arena just makes a lot of sense. One aspect that is very important in small cap investing is not only understanding the industry but understanding the risks. We will only take larger positions in companies in which we feel we understand the downside risk and have high conviction. By having a more diversified portfolio of 125-200 holdings in this fund, this by no means diminishes our ability to generate strong alpha versus the benchmark. We are still taking a differentiated view from the benchmark. For example, the active share in our representative account (in a separate account vehicle) is north of 80%, which is very healthy. In 2013, our representative account generated over 600 basis points of outperformance.

Q: What’s the maximum position you would have per holding?

Sally Pope Davis: We adhere to the general portfolio targets of being within a 4% deviation in sector weight relative to the Russell 2500 Value benchmark, but in practice, our sector weights tend to be even closer to the benchmark, due to our focus on generating alpha through bottom-up stock selection rather than other means such as sector rotation. At the individual position level, we generally target no more than 4% in absolute weight, but most large positions are less than 2%.

Q: What is your intended holding period and do you set target price?

Sally Pope Davis: We are long-term focused investors, and our ideal holding period for the vast majority of our companies is three-to-five years, or longer. In practice, as the world changes, companies change, and our holding periods usually end up being less than that. Typically, we have an eighteen to twenty four month horizon for a lot of our stocks.

Sean Gallagher: In a market that has been up tremendously over the past four years, there are a lot of stocks in sectors that are at the peak valuation levels. I give a lot of credit to our team for having a strong sell discipline. Everybody is focused on price targets and making sure that we don’t overstay our welcome in stocks that have been success stories.

Sally Pope Davis: The small-to-mid cap space is an area where we can own the stocks longer because they may be at a different part of their growth trajectory than larger companies. One of the stocks that we own in the GS Small/Mid Cap Value Fund is a name that we bought during its IPO in our GS Small Cap Value Fund. We knew this stock well, and we owned it as it appreciated and grew over time. Now the stock is ready to graduate into more of a mid cap. We still like the long-term story, and these are the types of stocks we love to own in this fund.

Q: What are your key reasons to sell a stock?

Sean Gallagher: As active managers, we believe it is critical to have a clearly defined sell discipline in order to avoid becoming too attached to any single investment. Our sell discipline requires continuous portfolio review, and could be driven by any one of a few reasons. The first reason is if our price target is achieved. We have a price target for every stock that we own. As the stock approaches our price target, we will reevaluate and determine whether it still makes sense to own it. Another reason for selling out of a stock could be if our thesis is invalidated, or if we lose confidence in the management team. We typically have three or four key reasons why we’re excited about a stock. If we feel that any of those key reasons changes, whether it’s poor management execution, increasing competitive intensity, or any other kind of setback, this would force us to rethink the investment. For example, when a company management team does something that is not something that we thought they were going to do, this changes our view. I think that our team is good about not defending a management team that takes action we’re not happy with. We have a culture in which we have open and honest debates. Rather than spinning excuses, our team tends to just acknowledge mistakes and have a forward-looking view. We take a zero-based review on every stock every day, and I think it’s a healthy attitude to have. Also, sometimes outside forces intervene, which make the risk/reward become less attractive. For example, if all of a sudden there is a tremendous amount of regulatory intervention in the industry that wasn’t there before, you have to step away. Another reason we may sell out of a stock is if better investment alternatives exist elsewhere, or new ideas offer better risk/reward profiles than existing holdings.

Q: What is your view on risk? How do you define risk and how do you manage it and contain it?

Sean Gallagher: Risk management is a huge focus on our team, and there are many metrics that we monitor through our daily risk reports. While risk management ultimately starts at the PM level, there are several layers of risk management beyond that. We monitor our active share and ensure that we have a truly active portfolio. Our team frequently meets with our risk committee to discuss (and sometimes defend) any outliers. We really try to drill down and make sure that the fund is truly driven by the bottom-up, rather than by unintended macro or sector bets. We also look at how the portfolio moves relative to the market. We analyze large sector, industry, and stock contributions to the portfolio. For example, a 1.5% weight position in the Fund that acts like a 7% position will be scrutinized. We will ask ourselves if we are comfortable with that, and if it is intentional. We are continually monitoring each stock’s contribution to total risk of the Fund. We’re looking at multiple metrics, including beta, active share, stock specific risk, and volatility contribution. A benefit of being part of Goldman Sachs is that we have access to some really great analytics and we have multiple layers of risk management. Rob and Sally, as Co-Leads, and I, as CIO, monitor the fund holistically every day from the top down to ensure that we’re staying within the boundaries that we set for the fund. We will also hold cross sector reviews on a regular basis in which the entire team will sit down and talk about their industries, sectors and why they are positioned the way that they are.

Sally Pope Davis: As mentioned earlier, the key principle in this fund is ensuring that we protect in down markets, while also providing good upside capture. We are focused on generating great risk-adjusted returns. We believe that our fund benefits from having a quality focus, and that’s where our potential for downside protection comes from. Ultimately, we are looking for companies with strong or improving balance sheets, good returns on invested capital and cash flow metrics, led by management teams that are true stewards of capital. Each portfolio manager is responsible for monitoring his/her area of coverage on an individual stock basis. Having sector portfolio managers who understand the industry, know their companies cold and have a thoughtful view of the specific risks in a particular company is key, because at the end of the day, the risk starts from the bottom-up. You have to take both a bottom-up as well as a top-down view of risk, which I think we do exceptionally well in GSAM as an organization.