Market Watch: Coming of Age
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April 24, 2018
How to find ‘coming of age’ companies whose stocks could rise 10-fold By Philip van Doorn Amy Zhang has led a big companies to double revenue within three to five years.
We are not looking for stocks to shoot up 20% to 30% in this portfolio. We are looking for a stock to grow two, three, four, five or 10-fold over a long period. We invest in long-term, value-creating engines. That’s how alpha is generated. MarketWatch: You have also said you were looking for companies to be led by managers with “long-term vision.” Can you elaborate on that? Zhang: Small companies do not grow in a straight line. Our investment horizon is three to five years and beyond. Vision is also not linear. I generally favor companies that have founders as CEOs with substantial stakes in the companies. They generally have a long-term strategic vision that goes beyond quarterly results. Small companies usually have limited resources, so how they allocate capital and resources is very important. It is also important for us to have a CFO with very strong financial discipline to balance the vision of the CEO. We don’t want a company to grow merely for the sake of growing. It is important for them to balance growth and profitability. MarketWatch: Which metrics do you look at before diving in for closer analysis? Zhang: We look for high growth, but I also spend a lot of time looking for financial quality to provide downside protection. Our companies have very strong balance sheets and high cash-flow-generating abilities. So if we look at our portfolio as of Dec. 31, the weighted median debt/total capital ratio was only 2.6% versus the Russell 2000 Growth Index, which was 28.3%.
turnaround at the Alger Small-Cap Focus Fund by finding innovative companies Amy Zhang, manager of the Alger Small- Cap Focus Fund, has greatly improved the mutual fund’s performance since she joined Fred Alger Management in February 2015. The Alger Small-Cap Focus Fund (AOFAX, US) has grown to $804 million in assets from only $14 million when Zhang took over. The fund was holding 49 stocks at the end of January, about half that of three years earlier when Zhang came aboard. In the literature it provides to financial advisers, Fred Alger Investment Management talks about “investing in dynamic change,” and buying shares of companies that are either “coming of age” or going through a “positive life cycle change.” It is the first group that Zhang focuses on, following a ”high-conviction” strategy she has used for 16 years. Zhang described her approach as “index agnostic,” while also saying it was fair to compare the fund’s performance to the Russell 2000 Growth Index (RUO, XX). “We don’t own household names. We believe this is an excellent portfolio diversifier for our clients,” she said. She also emphasized the diversification of companies owned by the fund. “They are not correlated in terms of sources of revenue,” she said, making the fund “generally less volatile than the index.” Here’s an edited version of Zhang’s
Amy Zhang, manager of the Alger Small-Cap Focus Fund
conversation with MarketWatch: MarketWatch: Can you describe the typical company that is “coming of age” that the fund invests in? Amy Zhang, portfolio manager of the Alger Small-Cap Focus Fund: We are looking for high unit volume growth. Usually there is a large, growing, fragmented market. We also look for pricing power, or at least not significant pricing pressure. That’s where innovation comes in. For us, it is really about sustainable, robust top-line growth. The key words are sustainability and durability of unit growth. This will correlate with EPS [earnings per share] growth, which ultimately drive stock prices. MarketWatch: So you do not simply hunt for bargain small-cap stocks? Zhang: At the initial point of investing, we look for companies with durable business models but operating revenue of less than $500 million. The sweet spot is probably $100 million to $200 million. We look for
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Zhang: Nobody has ever asked me this question before! It is such a critical question. A lot of it is about instant gratification. That creates anxiety. I am sure you can cite so many unhealthy behaviors, based on behavioral science. I go back to what Benjamin Graham said: Over the short-term, the market is a voting machine. But over the long term, the market is a weighing machine. Short-termism also creates opportunities for investors like me. We are investors, not traders. The power of compounding should outshine any short-term trading, in my experience. If you sell a stock with a gain of 20%-30%, then you have to find another one. We look for exceptional small companies and don’t find that many. We look for gems. That’s why I run a focused portfolio. To use a garden analogy, we are planting the seeds to see the flowers blossom in three to five years. Eventually it will be beautiful. We spend a lot of time differentiating. A lot of people react and over-manage to quarterly results. We spend a lot of time understanding the bumps in the road. It is very important to let the market serve us. I actually get excited when there is a big disconnect between the fundamentals and the stock price. Owning a relatively small number of companies enables us to become experts on those companies. That leads to high conviction, bigger position sizes and potentially more alpha generation. MarketWatch: Can you name a company held by the fund that you are particularly excited about? Zhang: Veeva Systems (VEEV, US) was the fund’s top holding as of Jan. 31. The company started in 2007 and went public in 2013. They provide cloud-based software for the pharmaceutical and life- sciences industries. They started with customer relationship management (CRM) software through a long-term partnership
We have a combination of high quality and high growth. Our estimated three- to five-year compounded annual EPS growth rate for companies in the portfolio is 19% compared to 14.3% for the Russell 2000 Growth Index. The weighted median net margin for our companies was 11.1% for 2017, compared to 5.8% for the index. Our ROIC [return on invested capital] number was 14.7% versus 11% for the index. We generally don’t invest in biotech companies, because we are trying to avoid companies that face binary outcomes. MarketWatch: Such as clinical trials for drugs? Zhang: Yes, that’s a good example. MarketWatch: Can you describe any painful lessons you have learned about selecting companies for investment? Zhang: Very early in my career, I used to think if a company had a fantastic product that anyone would be able to run it. I knew of a company that had great products but didn’t know how to sell them at a profit. This particular company just wanted to grow for the sake of growing. They basically were selling at a discount. I talked to the CEO, who was supposed to be a visionary but didn’t know how to sell. We sold the stock and later on the company was acquired at a minuscule price. It is about being differentiated — knowing how to sell and to do it profitably. I am very wary of hyper-growth companies. We have to make sure companies have sustainable growth with profitability. If they are not currently profitable, we have to see a clear path to profitability. MarketWatch: Do you believe the problem of “short-termism” among investors and the financial media has gotten worse? It seems money managers are being held to impossible standards, as long-term strategies can take years to play out.
with Salesforce.com (CRM, US) and are now the market leader for CRM in the life sciences industry. Soon after their IPO, Veeva invested in Vault, which is a content-management platform that was initially for the life- sciences industry. A lot of key people in 2015 were skeptical that Vault could be successful. But I felt it was a very critical area and that Veeva was a very innovative company. I believe in their ability to make it successful. We started to invest in 2015 because we thought they had the potential to be dominant in that life-sciences CRM space. The total potential market for Vault, just for life sciences, is over $4 billion. Now they are expanding into other regulated industries through Vault. They call it Quality One. It is for industries, such as chemicals, cosmetics and manufacturing. Another new product coming to market is called Vault Safety. So total TAM [total adjustable market, or potential market size] for the company is about $9 billion. The company’s revenue is still less than $700 million. The company has a GAAP operating margin of 23%, which is the highest in the SaaS industry [software as a service], which includes Salesforce.com. They have no debt. They have $762 million in cash. We expect the margin to continue to expand because Vault has higher margins. Vault is now providing 39% of total revenue and that has continued to grow very rapidly because the potential market for Vault and Quality One is a very fragmented, paper- based market waiting to be disrupted. This is why it is our top holding. Veeva is a cross between health care and technology. It represents our portfolio and my philosophy very well.
Here are the fund’s top 15 investments (of 49) as of Jan. 31:
Total return - 2018
Share of fund
Total return - 2017
Total return - 3 years
Total return - 5 years
through April 10
Veeva Systems Inc. Class A
3.8% Medical Specialties
3.4% Medical Specialties
3.4% Internet Software/ Services
3.3% Medical Specialties
Cantel Medical Corp.
3.3% Medical Specialties
3.0% Electronic Production Equipment
Tyler Technologies Inc.
2.9% Data Processing Services
Guidewire Software Inc.
Information Technology Services
2.6% Medical Specialties
OraSure Technologies Inc.
2.5% Medical Specialties
Canada Goose Holdings Inc.
2.4% Medical Specialties
Information Technology Services
Paycom Software Inc.
Sources: Morningstar, FactSet
This article reprint, originally published by MarketWatch on April 12, 2018, is considered sales literature for the Alger funds mentioned only and not for any other products shown. Please note that MarketWatch is an independent publica- tion and the performance and ratings cited in the article do not represent the experience of any individual investor. For the period ending March 31, 2018, the Alger Small Cap Focus Fund (the “Fund”) returned the following: Average Annual Total Returns (%) (as of 3/31/18) QTR YTD 1 Year 3 Years 5 Years 10 Years Since Inception Class A (Incepted 3/3/08) Without Sales Charge 7.40 7.40 27.56 12.37 13.81 10.13 9.92 With Sales Charge 1.77 1.77 20.84 10.36 12.58 9.54 9.34 Class C (Incepted 3/3/08) Without Sales Charge 7.11 7.11 26.51 11.53 13.01 9.33 9.13 With Sales Charge 6.11 6.11 25.51 11.53 13.01 9.33 9.13 Class I (Incepted 3/3/08) 7.34 7.34 27.50 12.41 13.97 10.33 10.11 Class Y (Incepted 2/28/17) 7.46 7.46 27.95 — — — 27.83 Class Z (Incepted 12/29/10) 7.46 7.46 27.95 12.76 14.29 — 12.59 Fred Alger Management, Inc. (“FAM”) has contractually agreed to reimburse Fund expenses (excluding interest, taxes, brokerage, and extraordinary expenses) through February 28, 2019 to the extent necessary to limit the total annual Fund operating expenses of the Class A to 1.20%, Class C to 1.95%, Class I to 1.20% and Class Y to 0.90%, of the class’aver- age daily net assets.This expense reimbursement may only be amended or terminated prior to its expiration date by agreement between FAM and the Fund’s Board of Trustees, and will terminate automatically in the event of termination of Investment Advisory Agreement. FAMmay, during the 1-year term of the expense reimbursement contract (“ERC”), recoup any expenses waived or reimbursed pursuant to the ERC to the extent that such recoupment would not cause the expense ratio to exceed the lesser of the stated limitation in effect at the time of (i) the waiver or reimbursement and (ii) the recoupment. Only periods greater than 12 months are annualized. Prior to 8/07/15, the Fund followed different investment strategies under the name“Alger Growth Opportunities Fund”and prior to 2/12/15 was managed by a different portfolio manager.Accordingly, performance prior to those dates does not reflect the Fund’s current investment strategies and investment personnel. Effective 8/07/15, the Fund’s primary benchmark is the Russell 2000 Growth Index. The performance data quoted represents past performance, which is not an indication or a guarantee of future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance quoted. Performance figures assume all distributions are reinvested. Returns with sales charges reflect a maximum front-end sales charge on Class A Shares of 5.25%. For performance current to the most recent month end, visit www.alger.com or call 800.992.3863. Risk Disclosures: Investing in the stockmarket involves gains and losses andmay not be suitable for all investors. The value of an investment maymove up or down,sometimes rapidly and unpredictably,andmay be worthmore or less than what you invested. Stocks tend to bemore volatile than other investments such as bonds. Growth stocks tend to bemore volatile than other stocks as the prices of growth stocks tend to be higher in relation to their companies’earnings andmay bemore sensitive tomarket,political,and economic develop- ments. Investing in companies of small capitalizations involve the risk that such issuers may have limited product lines or financial resources, lackmanagement depth,or havemore limited liquidity. The Fundmay have amore concentrated portfolio than other funds,so it may bemore vulnerable to changes in themarket value of a single issuer andmay bemore susceptible to risks associated with a single economic,political or regulatory occurrence than a fund that has amore diversified portfolio. Since the Fund concentrates its investments in the health sciences sector,the value of the Fund’s shares may bemore volatile than those that do not similarly concentrate their investments. Changes in applicable regulations could adversely affect companies in these industries,and the pace of product development and technological advancement in comparative companies may result in greater volatility of the price of securities of such companies. Many technology companies have limited operating histories and prices of these companies’securities have historically beenmore volatile than other securities due to increased competition,government regulation,and risk of obsolescence due to the progress of technological developments. The Fundmay have a significant portion of its assets invested in securities of healthcare companies,whichmay be significantly affected by intense competition,aggressive pricing,government regulation,technological innovations,product obsolescence,patent considerations,product compatibility and consumer preferences,andmay bemore volatile than the securities of other companies. The cost of borrowingmoney to leveragemay exceed the returns for the securities purchased or the securities purchasedmay actually go down in valuemore quickly than if the Fund had not borrowed. Foreign investing involves special risks including currency risk and risks related to political,social,or economic conditions. Morningstar calculates a Morningstar RatingTM based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a fund’s monthly performance (including the effects of sales charges, loads, and redemption fees), placing more emphasis on downward variations and rewarding consistent performance.The top 10% of the funds in each cat- egory receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars and the bottom 10% receive 1 star. (Each share class is counted as a fraction of one fund within this scale and rated separately, which may cause slight variations in the distribution percentages.) The Morningstar RatingTMmay differ among share classes of a mutual fund as a result of different sales loads and/or expense structures. It may be based, in part, on the performance of a predecessor fund.The Overall Morningstar Rating for a fund is derived from a weighted average of the performance figures associated with its three-, five-, and ten-year (if applicable) Morningstar Rating Metrics. Alger Small Cap Focus Fund Classes A, I, and Z were rated 4, 4, and 3 Star(s), and Class C was rated 4, 4, and 2 Star(s) for the 3-, 5-, and 10-year periods among 592, 531, and 402 Small Growth funds as of 3/31/18. The Morningstar ratings are displayed for informational purposes only and should not be relied upon when making investment decisions. ©2018 Morningstar, Inc.All Rights Re- served.The information contained herein: (1) is proprietary to Morningstar and its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information.When an expense waiver is in effect, it may have a material effect on the total return or yield, and therefore the ranking and/or rating for the period. Past performance is no guarantee of future results. Investors should not consider references to individual securities as an endorsement or recommendation to purchase or sell such security.Transactions in such securities may be made that seemingly contradict the references to them for a variety of reasons, including, but not limited to, liquidity to meet redemptions or overall portfolio rebalancing. Holdings are subject to change. As of March 31,2018,the securities mentioned in this reprint represented the following as a percent ofAlger’s assets under management:Veeva Systems Inc.0.30%,Salesforce.com, Inc.2.57%.Holdings are subject to change; do not constitute recommendation by Fred Alger Management, Inc. Before investing, carefully consider the Fund’s investment objective, risks, charges, and expenses. For a prospectus and summary prospectus containing this and other information, or for the Fund’s most recent month-end performance data, visit www.alger.com, call (800) 992-3863, or consult your financial advisor. Read the prospectus and summary prospectus carefully before investing. Distributor: Fred Alger & Company, Incorporated, Member NYSE Euronext, SIPC. NOT FDIC INSURED. NOT BANK GUARANTEED. MAY LOSE VALUE. Russell 2000 Growth Index 2.30 2.30 18.63 8.77 12.90 10.95 (Since 3/3/2008) 10.83 (Since 2/28/2017) 18.33 (Since 12/29/2010) 12.10 TotalAnnual Operating Expenses (Prospectus Dated 3/1/18) WithoutWaiver: WithWaiver: A: 1.22% 1.20% C: 1.97% 1.95% I: 1.21% 1.20% Y: 1.51% 0.90% Z: 0.90% —
Fred Alger & Company, Incorporated 360 Park Avenue South, New York, NY 10010 / 800.992.3863 / www.alger.com
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