Finding Quality Growth

Could you illustrate your research process with some examples? A great example would be FirstService, a residential real estate services company, which has grown at about a 20% compounded annual growth rate over 20 years. The industry is growing at single-digit rates, but FirstService has dominated the competition. It provides all types of real estate services that the owners don’t want to do themselves, such as mowing the lawn, dealing with the insurance contracts and the homeowners association, managing the pool, the clubhouse or the golf course and hiring the concierge. These are simple services, which are difficult to do at scale, so FirstService beats the competition in terms of its service level. The company has many of the characteristics that we look for. It has a high-quality management, long-time experience, a known and understood competitive set and the potential to reach our desired growth. Its return on invested capital is improving over time; it has a strong balance sheet and free cash flow to support growth. It meets our criteria, especially in terms of the quality of management and its sustainable competitive advantage. We spend a lot of time on competitive analysis, understanding the size and the growth of the market, the players and the advantage of the companies. FirstService illustrates the type of Weatherbie growth stocks that we look for, which is a company that works predominantly in the U.S., trades on U.S. exchanges and has a dominant position. The company grows with the market and benefits from the new communities built as its reputation spreads across the industry. FirstService often competes against regional players, who don’t have the same scale and can’t offer such utility contracts and 24/7 service. Its scale allows FirstService to dominate the local mom and pop competition. It is consolidating a highly fragmented market, while generating significant Once the approved list of Weatherbie 50 is established, each portfolio manager creates his own high-conviction, diversified portfolios from these 50 stocks. We act independently of each other, because each of us has different experience and conviction level for each stock, which is reflected in the weightings. For example, FirstService is the top position in the overall portfolio because it is a high-conviction name in each of our sleeves. The weightings are not equal; the stock may represent 5% of George’s sleeve, 6% of Matt’s sleeve and 5.2% of Josh’s sleeve, but it’s a high-conviction name for all of us. Of course, we have certain risk parameters at the fund level. Generally, the largest position has to be 6% or lower, while the largest dynamic growth area exposure has to be 35% or lower. As long as we are within the risk parameters, each portfolio manager acts independently and with accountability. How do you combine diversification with concentration? The portfolio generally consists of 50 names and we believe that’s the right point to provide enough diversification without diluting returns. We achieve diversification through investing in various sectors of the economy, where we find growth and quality. The second layer of diversification is the analyst coverage of different areas. The third layer is at the portfolio manager level, where the fund is managed by three people. Our analysis concluded that our top high-conviction names actually outperform the rest of the portfolio by a significant margin. Therefore, we invest about 45% free cash for acquiring selected regional players. What is your portfolio construction process?

of our capital in the top 10 names and about 58% of our capital in the top 15 names. As a result, the portfolio has benefited from the outperformance of its best companies. Those are the dynamics between diversification and concentration and we believe that we have found the sweet range to be in. We are extremely picky

stock pickers in a huge investment universe. How has the fund evolved over the years?

Our investment process really hasn’t changed in 22 years, but there have been tweaks and enhancements. At the end of 2014, we undertook a detailed analysis of our past performance, which determined that cumulatively, as well as in three out of four years, we would have added alpha by investing more capital in the biggest names. We decided that we should deliberately and gradually invest morein the top names. The result was a higher conviction, better performing portfolio. The multi-dimensional diversification was another enhancement. We understand that we work in a competitive business and we have to get better over time; we can’t just rest on our laurels. Since 2015, we generally invest only in 50 names (versus 50 – 60 names previously) and further concentrate the capital in the top names. We also have backup analysts to support the primary analyst or to sponsor new ideas. The backup analyst acts as a second pair of eyes to independently evaluate the prospects of the top holdings and to make sure that we haven’t developed an institutional blindness and we are not missing a significant change What are the benchmark and the turnover of the fund? We are most often compared to the Russell 2500 Growth Index, because of the investment universe, but as active managers, we go very narrow as we concentrate only on the 50 best smaller cap growth companies in America. In the current environment, which is dominated by algorithmic trading platforms, there is a lot of short-term volatility. Our portfolio turnover is much lower than the turnover of the funds in our space, so we can take advantage of market volatility. Because we know our companies well, we have the conviction to invest for the longer term. What factors drive your buy and sell discipline? We have a valuation discipline, but it is no more than 20% of the total equation. About 80% of our process is focused on getting the company and its earnings growth right, because the earnings growth will deliver the stock price growth, if we pay a reasonable price. We are not GARP investors, but we are also not momentum investors, who would pay any price for high growth. We have a disciplined approach to valuation that results in an attractive PEG ratio. In terms of sell discipline, we will sell a stock if we acknowledge that the company doesn’t deliver the earnings growth that we expected. If we have made a mistake, we have to sell the stock and move on. The second reason to sell is valuation. Actually, current interest rates and inflation levels have produced an environment of expanding P/E ratios, which is a wonderful environment for growth stocks. We resisted the temptation to be overly precise in identifying target prices, because growth companies are dynamic,

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