Q: What are the benefits of investing in small- and mid-cap stocks?
When we approach small and mid-cap investing, we seek to invest in smaller cap companies that offer faster growth potential, and mid-cap companies that offer a good balance of growth and stability in a well-diversified fund. Defining the universe in this way, allows us to own companies longer and benefit from market cap appreciation, potentially generating greater wealth for clients over time. Moreover, small/mid-cap portfolios tend to generate lower turnover as opposed to investing in separate small and mid-cap funds where market cap constraints can lead to increased trading.
Q: Historically how the fund has evolved?
The Goldman Sachs Small/Mid Cap Growth Fund was launched in June 2005. Our investment team at Goldman Sachs Asset Management has a track record that goes back to 1981, when we began managing a large cap growth strategy. Our return attribution analysis showed the team had a propensity not only to identify large cap winners, but to also identify winners in the mid-cap segment. In May 1999, we launched the Goldman Sachs Growth Opportunities Fund, where we have a successful track record investing in purely mid-cap growth stocks. This success, combined with the depth and structure of our team, enabled us to develop our small cap investing capability, and eventually leverage this expertise through the launch of our Small/Mid Cap Growth Fund in June 2005. The mutual fund alone has approximately $2 billion of assets under management and the overall strategy has $2.2 billion of assets under management (as of December 31, 2013).
Q: What principles drive your investment philosophy?
Our investment philosophy starts with a core belief that wealth is created through the long- term ownership of a growing business. What we mean by that is we act as if we are buying the whole business as opposed to trading in and out of stocks like pieces of paper. Secondly, I referred to investing in growing businesses, and as growth managers we seek to identify companies whose stocks we believe will appreciate substantially as a result of above-average sustained growth of the underlying business. In terms of the types of companies we find attractive, we look to buy companies that have strong business franchises, favorable long-term prospects, and excellent management teams and we do all this while seeking to invest in businesses that have attractive valuations. We believe that wealth is created through the long-term ownership of a growing business and seek to maintain a long-term perspective and take advantage of short-term disconnects in the market when our long-term thesis remains intact.
Q: How is your investment team organized?
From an investment team perspective, we have a deep team of 15 investment professionals that is organized by industry expertise rather than by arbitrary market cap ranges. For example, we have four analysts that cover the technology sector, and two that cover healthcare; we don't have a small cap healthcare analyst or a small cap tech analyst. We have industry experts and task each investment professional with immersing himself or herself in their respective industry. These individuals are often attending industry conferences and tradeshows, conducting on-site visits with companies and management teams, and from this research we then seek to identify the best positioned companies independent of market cap. It’s those small and mid-sized companies that meet our investment criteria that we could potentially own in our small/mid cap fund. One of the reasons we organize our team in this way is that we find if you're looking at a whole industry you may identify a large cap company that has for example, scale benefits, and this may make it difficult for a smaller company to become as successful in that opportunity set. In other cases we may identify a smaller company that has ample room to grow and can identify that soft underbelly of the larger competitor. Our analysts cover small caps all the way up to large cap companies within their industry coverage, meaning they can really become experts and identify the best positioned companies and put the whole competitive landscape in perspective. At the end of the day the small and mid-sized companies aren’t competing in a vacuum. They are competing against the larger competitors as well, and we want to make sure that we understand all of the competitive dynamics.
Q: What is your investment process?
We have a five-step investment process that encompasses how we approach investing from a research perspective. I’d say the beginning part of that process starts with the entire Russell 3000 Index universe, although we’ll also look at some select American Depository Receipts of foreign companies and private companies because we want to be apprised of emerging threats to existing public companies. We’ll then begin to narrow down this universe to what we believe is our investable universe. In step one we look to narrow the universe to high quality growth companies. High quality is defined as businesses that have strong franchises, excellent management teams and favorable long-term prospects. The second step for each investment analyst is to conduct thorough fundamental analysis to really determine the sustainability and strength of the franchise. That analysis and process is going to involve meeting with management teams, building financial models, assessing competitors, suppliers, and customers. We then perform rigorous valuation analysis. In the third step, the analyst will present the idea to the entire investment team, and it’s then discussed and debated by all 15 of us. Once a week we have a two-hour research meeting to facilitate more in-depth discussions. Topics range from work an analyst has been doing on a new idea to changes in industry views or controversial topics. In addition to this, we meet before market open the other four days, and these meetings are intended to be 15-minute team catch ups where important news events and any incremental takeaways from meetings, which may warrant portfolio action ahead of market open, are discussed. I think that’s important especially in the small and mid-cap segment where liquidity does matter. So by meeting daily and meeting before market open we’re going to be ready from a transaction standpoint because liquidity can be more difficult in this part of the market cap spectrum. In the fourth step, our co-lead portfolio managers, which consist of me, one other lead portfolio manager and the CIO of the team, implement the teams overall views, determine suitability and position sizing when constructing the portfolio. The fifth and final step is to continue to monitor and evaluate positioning on a daily basis.
Q: In your experience, what characteristics of factors are critical for long term investing in small and mid-cap companies?
We strongly believe in investing in strong franchises. By this I mean businesses that have a wide moat, either through the franchise’s brand, patent protection, or scale that may give a cost advantage. These are all elements that define the sustainability of the franchise. That favorable long-term driven growth could be underpinned by demographic trends or long-term penetration opportunities of a technology as opposed to pure cyclical growth. We would be aware of the cyclical dynamics, but what is most important to us is what is really underlying long-term sustainable growth. This type of company would be attractive to us if we couple both the franchise, that wide moat if you will; with a management team we believe has shareholder interests aligned with management goals. To assess the quality of management, we look at its capital allocation track record. When you tie together an excellent management team, favorable long-term prospects and a strong business franchise with a business that is trading at a reasonable valuation, we think you have a recipe for sustainable long-term growth. We’ve employed this same philosophy, which I mentioned has been in place for the past 33 years, in large cap, in mid cap, and in small/mid cap, where we have a nine year track record. It has been a consistent philosophy and as a result, has been successful for us across the market cap spectrum over the course of three decades.
Q: Can you discuss two examples of companies that met your investment criteria?
The portfolio since inception has held SBA Communications, a provider of tower infrastructure to the cellphone industry (as of December 31, 2013). The tower industry is very much a real estate location business; the mobile operators seek quality coverage for their user base, and there’s a “not in my back yard” dynamic of the tower industry, (what’s referred to in the industry as NIMBY), where it is difficult to build more towers. SBA Communications builds towers in attractive locations, providing the company with a compelling business model and it has been able to experience significant pricing power. Additionally SBAC signs long-term contracts with the cellphone operators that have built-in price escalators. SBA Communications has benefitted from the secular growth experienced by the mobile phone industry over the past decade. The emergence of wireless data in the smart phone industry has only served to increase the company’s growth potential. We believe that the demand for towers in attractive locations will continue to grow as wireless carriers build out their networks. From a management team perspective the company has continued to involve itself in accretive M&A and on top of that is pursuing conversion to a REIT, which will provide tax benefits to shareholders.
Q: Can we discuss one more example in a different industry?
Healthcare Services Group has been in the portfolio for a number of years (as of December 31, 2013). Health Care Services Group is a leading provider of outsourced janitorial and food services to the nursing home industry. While this may seem like a mundane industry, it is not a focus for the nursing homes themselves as it is not their core competence, meaning there is a demand for companies such as Health Care Services Group. Health Care Services Group executes with a lot of scale and quality performance and they can do it more efficiently than the nursing homes themselves. From an outsourcing perspective, they offer a value proposition to their customer base. Additionally I’d say it’s a very fragmented industry; there aren’t that many other big players and their biggest competitors are often the nursing homes themselves doing it in-house. So when we think of a franchise, they really are the best alternative in this industry for what they do. From a favorable long-term growth prospects perspective, we continue to see further outsourcing of such services taking hold, as companies such as Health Care Services Group are more efficient and cost-effective for the nursing homes, which are typically not that profitable entities. On top of that, Health Care Services Group has sought to expand into areas including food services, which has twice the revenue opportunity per nursing home than some of the janitorial services they provide. From a management team perspective, it is family run; there are a number of members of the family within the senior management, but they act as owners and they pay a healthy dividend and have steadily grown that dividend. The company has been very effective in growing both organically and through niche acquisitions to expand into certain new geographies. The company is seeing a lot of success in selling to either new customers or more capabilities to existing customers.
Q: What is your portfolio construction strategy?
We seek diversification both in the number of holdings as well as bringing broad industry and sector exposure to the portfolio. We invest based on research conviction rather than benchmark orientation. We target 90 to 125 holdings in this portfolio, which is more diversified than our Mid Cap Growth Strategy as well as our larger cap portfolios. The main reason we target a greater degree of diversification is that the small and mid-size companies we find are often naturally higher risk, so we look for a higher degree of diversification. If you think about 90 to 125 holdings, average weights of holdings are approximately one percent in the portfolio. Our largest holdings, where our greatest conviction lies, are typically around 2%. I’ll maybe use one example here, biotech, which we believe is an important part of the small-mid cap growth universe. It’s a bit over 6% of the benchmark in fact and we think that’s an area we've navigated well over time but it’s a sector that we typically hold smaller weightings. We do that because each biotech company is subject to a greater degree of risk from FDA approval so we do think it’s prudent to have an even greater degree of diversification within this industry. It wouldn’t be unusual to see 30 to 60 basis points or an allocation between 0.3% and 0.6% in the portfolio.
Q: What is your benchmark and what are limits at the sector and stock level in the portfolio?
We use the Russell 2500 Growth Index as our benchmark and I talked about seeking a diversified portfolio that has a broad exposure. We do have limits on sectors and industry groups. If you look at the portfolio, the target range has typically been within 3% to 7% of each of the industry groups. The guideline for the maximum limit of a single stock is the greater of 5% or 300 basis points active, and from a sector perspective I referenced the 700 basis point active, or no more than 7% active in a given sector.
Q: Companies with successful franchise have expensive stock and how price sensitive you are when you buy stocks?
We believe we have a good history of navigating companies that have what the market may be perceiving as a long runway of growth but are richly valued on more near term and traditional valuation metrics. We find a lot of these types of companies within the small and mid-cap universe. The rigor with which we analyze such companies and value them is actually no different, and the qualitative dynamics that we require of those companies is no different than any other business. As always, we believe it is important to maintain a long-term perspective. So when I talked about franchise, growth prospects, management team, all that will apply to a business that is maybe earlier in its life and richly valued. We’re still going to hold companies to those same criteria. Now the one nuance around valuation analysis is that we’re typically going to look further out so it wouldn't be unusual for one of our analysts to look out three-to-five years to a point in time when the business may still be seeing relatively high rates of growth but maybe not quite as astronomical rates of growth as today. We will put a lot of effort into what its margin structure can be when it’s more mature and we will place a value what we think that business could be worth from there. So we will look five years from now and assess how that business is positioned for growth, what may its margin profile look like then and how may it look beyond that. We then try to find a disconnect between how the market is valuing the business and what our intrinsic value is. So we will think five years out and then discount that back to a fair value today and if that value is at enough of a discount to where it is currently being valued that may be interesting to us, even if that business is making no money or losing money on a forward one or two year basis, making it difficult to use more traditional valuation metrics.
Q: Generally most investors are very forgiving as long as it is volatility that is trending upwards but of course at the wrong point if you pull the trigger it could be pretty expensive. In this business it is relatively easy to understand where the growth is going to come from; what is not easy to understand is how investors will value the future slowdown in the growth. How do you deal with that?
That’s very much aligned with what I was saying. We have a view of the opportunity set for this given company, a perspective on what its margin structure will look like at that point time. We also have to be able to say at what rate the company can still grow thereafter. To envision how the market will value that business at that point in time is the other key dynamic that fits with what you're talking about because, if its growth has meaningfully slowed or will slow from there, the value the market then places on that business will be very different than if it still had ample room for growth. So it is critical to be thoughtful about where the company currently is in its life-cycle and put yourself in the seat of what the market will be thinking at that point five years from now and then discounting it back to today. Assessing whether or not we can earn an attractive return over that window of time given the risks we’re taking is very much how we think about investing in those types of businesses.
Q: Risk has a negative connotation but risk is also something that we cannot always quantify; some risks we don’t even know until they manifest themselves. How do you view risk and how do you measure or manage it?
We have an in-depth risk management process. We believe it is important to anticipate risk by looking forward, not backward. We seek to manage risk by maintaining a thorough knowledge of portfolio companies, employing a team-driven investment approach, and adhering to a disciplined portfolio construction process. We receive daily reports outlining the portfolios’ various risk exposures and we also meet weekly with our chief risk officer. We feel that how we approach risk and the depth at which we look at risk management is a differentiator in the industry so we feel good about the work that we've done from that perspective. What we seek to do is avoid unintended sector or factor bets and ultimately achieve our goal of generating excess returns through stock selection. This is complemented with what I’d consider the more traditional risk analysis at sector, industry or stock level. We use the overlay of portfolio level risk management to help us navigate different market environments. This risk analysis that I’m talking about really comes to light and helps in environments when correlations are at extreme levels. When I talk about non-specific risk, we break the portfolio into 10+ different non-stock-specific-factors, which include volatility, market sensitivity, growth factors, balance sheet leverage factors, exchange-rate sensitivity, and a number of other risk factors. We analyze our portfolio across each of those different non-specific factors with a goal of ensuring that they are as muted as we can. When any of these factors are at an elevated level we seek to drill down and understand which holdings are causing such deviations. If they are a part of our highest research conviction ideas, that’s actually okay, and if it’s coming from ideas that we still like but have lesser conviction, those might be names that we choose to trim to bring these non-specific risk elements in the portfolio closer to balance.
Q: Who decides what stocks become part of your portfolio?
We have a team-oriented investment process, where each member of the Growth Team contributes investment ideas and discusses and debates the full portfolios’ holdings. However, from a portfolio construction decision-making perspective of what names we decide to own and the weightings that they end up in the portfolio, they are decided by three of us, myself and my two other colleagues Steven Barry, the CIO of the Growth Team and Craig Glassner, co-lead portfolio manager on our mid and small/mid cap growth strategies. I wouldn’t call it a committee decision, but the three of us have ultimate accountability for implementing the team’s research views, and hence determining portfolio weights. Nothing would be owned in the portfolio without a significant debate and unless we have research conviction.
Q: How do you incorporate learning at the organizational level in the last ten years?
I referred earlier to our approach to investing in the biotech industry. We do feel that this is an important area of the market, but realize that each individual name has binary risk in what is often a single product company and if they don’t get the FDA regulatory approval you lose almost all your money. I think the approach that we take of being more diversified within biotech is something we refined five to seven years ago so it was a few years into the strategy. I think the work we've been doing on the private company analysis is more of a recent development from a process standpoint, to identify younger companies that either could be a threat to existing companies or ultimately come public so that we can be ready to identify them early on in their life not after they've been well discovered. Those are a couple of elements that have been improved upon over time. One last thing from a process standpoint; in the 2008-2009 downturn we instituted robust scenario analysis work, where we build into our projection a range of various scenarios that may deviate from our base case. I think this helped us in the early part of the recovery coming out of the 08/09 recession. We had a number of our business that were trading at below what we thought was a bear case analysis and that led us to perform quite well in 2009 relative to the benchmarks. This rigorous scenario building was not done in the past.
