Portfolio Insights: Small Cap Focus & Mid Cap Focus
Amy Zhang, CFA Executive Vice President Portfolio Manager
Amy Zhang recently provided a portfolio update for clients in the Alger Small Cap Focus Fund and Mid Cap Focus Fund. To kick off the call, Alger’s Market Strategist Brad Neuman, CFA, shared his insights on the markets and economy.
Now some reasons for hope. There's a template that we're seeing around the world for the virus easing and a return to growth. We've seen new infections and deaths peak and then decline in Asian countries such as China and Korea. In China, GDP was down about 7% year over year in the first quarter, which translates to down 35% quarter over quarter the way the US would report it, but now it's growing sequentially. China phone shipments are up three times from February to March and auto production is up over two times from February to March and they're nearly back to year over year growth in some categories. If you listen to some of the U.S. companies doing business in China, in fact, high tech manufacturing is now reported to be up year over year in China so there's been quite a bounce back there. Europe is lagging Asia, but ahead of the U.S. It's reopening after seeing its new cases peak and then decline with Spain lifting lockdowns on construction and factories, Italy and Austria are opening stores. Germany has opened some auto manufacturing and small stores and has a plan to open in schools by early next month and Denmark has even already opened at schools. Italy, we believe it's very important because the United States has been following Italy very closely with a two-week lag based on confirmed cases per one million people, and their trend indicates that the U.S. cases may fall by about a quarter over the next two weeks. Indeed, they're currently already about eight states that have discussed reopening plants here in the U.S. and they represent more than 20% of GDP.
Please note, this transcript is from a call on April 22, 2020 and it has been edited for clarity and brevity.
Brad Neuman : Thank you for joining us today. We hope you're safe and healthy and managing through this crisis as well as possible. I'd like to start with some points about where we are in the macro picture and then where we're going and finally end on a brighter note as we transition to our discussion with Amy. Some of the bad data points that you may be aware of. There are 2.6 million cases of this awful disease globally and over 125,000 deaths, 22 million people in the United States have filed for unemployment in the past four weeks, pushing the unemployment rate up to about 17% likely on its way to over 20%. The shelter in place orders have been driving down spending with Bank of America credit card data showing spending is down 28% year over year in the week ending April 16. Global GDP is likely to be down 3% to 4% this year or twice as bad as it was in the Global Financial Crisis with the U.S. likely down in the mid to high single digits for the year and possibly 40% for the second quarter. This earning season is predictably turning out to be abysmal. Earnings are missing by about 10% when they normally beat and so far, reported earnings growth for those that have reported is down about 25% in the first quarter.
In fact, the credit card data that I mentioned a moment ago, there was some silver lining there. First off, the decline of 28% was much better than the 43% or so that we saw at the end of March. Also, the CARES Act checks started arriving at the end of the period that was measured, which indicated that those who received their checks increased spending by 26% that day. As the stimulus is flowing into consumers’ hands, we're seeing better trends in spending. And you'll hear more about this from Amy, but there are indeed pockets of growth during this awful crisis. E-commerce spending within that data is up some 85%, which is broad based among electronics, home improvement, food and apparel. Even in the terrible earnings picture that I mentioned a moment ago, we see some pockets of growth. Sectors like health care are seeing growth so far this earning season despite the pandemic, so we can see some reason for optimism going forward on the macro front. I'd like to begin our discussion with Amy. Amy is the manager of the Alger Small Cap Focus Fund. Over the past three years ending March 31, 2020, the fund has mitigated risk well with its downside capture being only 63%. That, together with its upside capture of 115%, has helped propel it into a very strong showing in the Morningstar U.S. Small Growth Category. Amy, I'd like to ask you a series of questions, get your thoughts on the strategies that you manage and your view on the world. The last time we had a call with you was on March 18 and during that call you gave us several reasons about being optimistic about small cap investing. Can you talk about how you've been spending your time over the past month? Amy Zhang : Thank you, Brad, and thank you all for being on the call. We have been working harder than ever over the last 30 days since our last call. We've had a surge in manager meetings and because now management are also working from home they actually have a lot more free time, which is a positive for us. And we've been doing a lot of channel checks, a lot of them recurring channel checks of our companies. I think that it is very important for us to understand our holdings, thinking about managing through this pandemic and
overall for the long term. It's about navigating well through the short term but also positioning even better for the long term.
Change is a constant for all companies and I think we're doing well. We are maximizing our effort to manage that change. We’re also working very hard on valuation work. I feel valuation is extremely important. We always have bear/base/bull cases and we stress test a lot of different scenarios. But this year we have established uber bear cases for existing companies and prospects with assumptions that are much lower than before, of course. But those are not “the world is coming to an end” kind of assumptions, but a recession and the worst case scenario for all companies. So we have taken advantage of that to add to our existing positions and also watch lists in which to add a new names and we are using this opportunity to upgrade the portfolio. Brad Newman : Okay. And you mentioned that you're talking to company management a lot and doing a lot of these channel checks. What kind of questions are you asking and what have you learned from all that research? Amy Zhang : It's about understanding the current thinking, to adapt to the new environment. I think it's the most important for any company. We don't want them to overreact to over manage. It's manage through this downturn, but also position for the future growth because we're looking for compounders can still go on to be two, three, four, five, 10 times over the long term. First and foremost, how do they sell is the most important, right? Because most companies are going to have softness in revenue. How are they adjusting their sales force? We have a pretty good understanding of their sales model, right? They can use digital engagement, not face to face, less of face to face. How are they adjusting that high ticket item or low ticket items? Is it more about interfacing with the clients in this time, how they’re maximizing customer service effort and what are they seeing here from their customers? How are they adjusting accordingly? What are they doing with pricing? And to what extent are they going to shorten the contract?
What's their worst case scenario? Most management teams are very candid because they know this is important to the company and a lot of times they do brainstorm with us as well. For example, for Q1 a lot of companies are going to be okay. A lot of them don't have insight into Q2. But for us, we look at what companies report later. Some of the off-cycle companies actually are better because when they reported last time, they were already in the midst of this. But it's our job to now to analyze the potential sort of scenarios for Q2 and more important to me the rest of the year. And we see the weaker companies are cutting back. But why? Well most of our companies are making investments for the long term and taking more market share because I firmly believe this is the environment that the stronger will get stronger and that's part of reason our portfolio has done very well. But of course the key is to continue to do well. Brad Newman : Right. With all of that information that you've gathered, what's your thinking behind how you're positioning the portfolio? How would you describe how it's positioned right now? Amy Zhang : This portfolio has the potential to do well both in an up market and down market. And I'm glad that with this terrible pandemic there's a silver lining that shows that the portfolio has been crash tested. The high-quality and growth companies were continuing to do what companies with very strong moats and very strong balance sheets, do and do it well. And again, high growth and high quality, which is a hallmark of our strategy, I think is very important. This is a time for them to gain more market share and then they will come out of this with more prominent position and high margins because this is time that other companies may be cutting back. They can still selectively hire and that's very important. But there are always a few losers, so some of the companies are weaker, their weakness is more exposed, right? But that's a very small portion of the portfolio, but we have a big watch list. I'm very excited to
use this opportunity to upgrade our portfolio so we will come out even better after this rebound. Again, it's really about mission critical. I have used the analogy before, motorboats versus sailboats. The way I think about motorboats, our companies are not really dependent on the overall economy. They are part of the solution. So those companies are really about their own idiosyncratic drivers, less of the macro. And our secular weighting, it’s still health care. But the key is to be proactive because I know now health care all of a sudden is in favor, which is apparent why it should be. Even after this pandemic made people realize how important it is. It's both health care. It's both from an investment point of view. One, it's defensive, but it's also high growth in the companies that we invest in. And also, it's largest dispersion between winners and losers. We're still very well positioned in my opinion. But we're also very selective with tech and consumer. Our largest positions are the ones that will not have earnings risk, they will have scarcity value. We'll also look at companies that are going to be oversold in tech and consumer that long-term trajectory is still in tech. And so we're very excited about that as well. Brad Newman : So, that thinking about positioning the portfolio for the crisis has obviously served you well during the pandemic, but can you talk about how your position for the future as maybe the crisis fades away a bit and as we look longer term so maybe just talk about that long-term view? Amy Zhang : We’re always long term, right? We have a three to five-year investment horizon and I'm positioning the portfolio so it will have the potential to do well, both in upside and downside. It means the key for me is to really optimize the right offense and defense. And that's what I do day in, day out with my team. So it's really about stock selection and that's a lot of our forte. Because I don't think even coming out of this, it's not going to be the rising tide lifts all boats. So we still think about a long term and the way I think those compounders that will help build wealth for clients over the long term.
But we're very thematic. I think about the portfolio and digital transformation is in the forefront of what we do. And that's almost regardless of any industry, even a consumer company we invest in. We want to have benefit in digital transformation. For example, Wingstop. They are really focused on digital and delivery. That's why they've been doing so well. It's one of the very few companies that does well in the consumer space. And I’ve been invested since 2016. So clearly, it's long-term thinking and of course cloud computing, we have a lot of exposure out. And e-commerce, very important. Industrial automation, which we believe will come back because automation is a very important being turning data into actionable information. And the most important is health care. Whether it's in diagnostics, advanced health care testing or medical devices. It's a very important area, but I think of our portfolio one is in seeing we want to be in those, we are the key themes that cutting edge of the innovation and also how business going to trend it into that theme. Right? Because our portfolio is very levered into the digital economy, which I think going forward after we come out of this, everything will be more digitized. So, whether it's going to be from working more from home or getting food more through like digital and the delivery in health care. Even for Veeva, now they're doing a huge initiative digital engagement with the salespeople who the CRM is used by--pharmaceutical sales people. They can actually give their sell extremely efficiently and effectively online, which is very important. So, those are the important things that we are focusing on that seem to our position as well. Not just for the crisis but importantly for the future. Brad Newman : Got it. Those are definitely exciting themes. You also manage the Alger Mid Cap Focus Fund, which was launched about a year ago and has had some very strong performance. The fund was recently recognized by Morningstar on its Prospects List, which highlights up and coming investment strategies that may be worth an investor's consideration. Can you briefly discuss your management of the fund?
Amy Zhang : I'm glad that we are doing well. From the launch of the product it's always been my belief that this will be an actual extension of what I've done for over 17 years as small cap manager. A lot of companies that I've known through the years have grown to be mid cap. And a lot of small companies are graduating through mid cap. I think it will be a very fertile ground for active management because it's very synergistic and it's been mutually beneficial for our small cap strategy as well. Because we are in a particular space there are different companies that some could be mid cap and some could be small cap that either compete with each other or they complement each other. I've also made a concerted effort to reduce overlap. When I first launched the SMA, before the fund was launched last year, we had 60% overlap, which is sort of understandable since most of the names I know that I believe could do well, but one can always do better, as I believe. Now we have 26% overlap. So it's much more diversified in the sense that, because I want to position the mid cap to be complementary to small focus, that they are two different strategies. They behave differently. Also, if you look at its holdings, it's very diversified. I always believe in diversification in terms of markets served, sources of revenue, business models and a lot of companies, again, on natural hedges. And that's very important to deliver strong performance for both. Again, it's stock selection and we're looking for the same type of high-quality high growth companies. I use an analogy of knowing someone as a baby and watching it to grow into a teenager. I think having that experience and knowledge when a company was small has given me and my team more of an insight into how they would do going forward becoming larger companies. Brad Newman : Great. Well, that seems very synergistic. So that's nice to hear. We can open it up to the audience for some Q&A.
Speaker Que stion: I wanted to know if you would care to comment about oil and also the slowdown of the U.S. consumer and how that might position your stock selection and your sector selection? Amy Zhang : Well, I don't invest in energy. As you know, oil is really very macro. And in terms of demand, the geopolitical situation plays an extremely important role as well. But consumers are important, on the other hand especially because the U.S. consumer is two thirds of the economy. I think we are well positioned because we have very low leverage in this portfolio. For consumers you want to have lower gas prices. So in a way, it is positive, but again, everything is about magnitude and extreme. We wouldn't want it if the economy is in a deep recession, that everything clearly will affect consumers. We position our consumer portfolio extremely selectively. For example, a long term holding is Wingstop. Their franchisees have done very well, we’ve done a lot of channel checks because we initially were nervous. But then after we talked to their franchisees, we felt much better about it. They're doing positive and they pre-announced very strong results, which is very exceptional. And they also do digital and delivery and which will be the new trends I believe, so I think they will be well positioned for the future. Also personally, I always believe my guiding principle and invest in consumer is that you want it to give consumers good bang for the buck. Lower cost items are better for the masses and offer a strong value proposition. Brad Newman : Obviously, we saw the oil price on the near-term contract go negative. And that was because investors and companies who were long that contract didn't have anywhere to store the oil so they would actually pay to sell it, which was a very unusual occurrence, but it was because the storage tanks around in the US and even mostly around the world are generally full. Obviously demand is down significantly. Somewhere from maybe 100 million barrels per day to something like 70 or 75 million per day. And so there's just not enough demand to sop up the supply and won't be until there's either much more major supply
constraints or we start getting back to work in terms of production around the world. And 40% of oil demand is car and truck related so we need to get back on the roads as well. And until that time, oil will probably be in an oversupply situation.
Speaker Question : Quick question for you, across all your styles, about how much in the assets are you managing right now?
Amy Zhang : Yes. So currently we are managing about $4 billion in Alger Small Cap Focus strategy. And, as you may recall, we selectively soft closed, some channels are open while existing clients and certain selected channels. And the Alger Mid Cap Focus strategy is approximately $46 million, which is up from several million last June. Speaker Question : Can you speak at all on the valuation of the current portfolio today relative to historic levels and where you see it going? Amy Zhang : We do look at historical levels of our valuation metrics because in our view valuation is a range, especially for a small company. We use a lot of different methodologies, and we run a lot of different valuation metrics and some back of envelope calculations too. We should get a reasonable range because if there's discrepancies we must question our assumptions. A lot of companies, especially for small growth companies, have changed a lot. For example, we look at how they did in 2008. Some companies you can go back to 2002 because we do have companies that have more than 10 or even 20 years’ operating history. Speaker Question : From a historic standpoint you've seen a lot of money go into technology in the healthcare areas. How do you see valuation today?
Amy Zhang : I feel that tech is not cheap. That's why I trimmed our tech portfolio last year. I thought health care last year was much cheaper. You look at healthcare and technology versus the cyclical companies and they are much, much better positioned. I'm confident coming out the rebound that high quality, high growth companies have the potential to do much better because the recovery for those companies are more likely to be V-shape whereas for some, for the cyclical companies will have to be the U-shape because they just cannot recover that quickly. Plus, they’re also going to have more of a pricing power, pricing pressure. And some medical devices’ companies are clearly having a pause. But those elective surgeries, especially the kind of companies we invest in, are really mission critical and lifesaving. Someone cannot put off a heart surgery for that long. That is why we continue to invest in companies that are specialized in those areas that are extremely essential. We are buying those companies on weakness because when we open economy, which is soon but gradually, doctors plan to schedule weekends, surgeries. There is going to be pent up demand. I continue to believe growth will continue to outperform value coming out of this just because the business model exposed how cyclical they are. In terms of some of the other guy cyclical company. Speaker Question : It seems like it's been a one-way trade here where anything growth has been bid up and anything remotely value's been trashed. And I know you said you think growth will continue to do well, but you can kind of see what's happened on some of the days when the markets have had some strong rallies. I wanted to see why you feel growth is going to outperform. Amy Zhang : Yes, you can have those irrational days, right? Everything is like up a lot just because sentiment, like last Friday for example, Gilead. Its drug is not really a silver bullet in my humble opinion. Value could have some temporary snapback but the fundamental drivers are not there for those value companies. Meaning first
of all interest rates. Value would do well in high interest rates and high inflation periods. When economic growth is that robust, that will be more than 3% GDP growth. We are extremely far away from that. And I'm not being a Debbie downer. I'm cautiously optimistic. It's going just to take time. I feel it's going to be long way until we get to three and half percent plus GDP growth. The U.S. is actually not in the worst position, even though now we're not in a great shape, but the virus started here late, I think we will bounce back probably stronger than most of, even arguably Europe. I mean, that's just my personal view. So, again, interest rates exceedingly low. And look at QE. QE is happening and in QE growth would do better. I think if we take a six months to a year view, I'm confident that growth will continue to outperform value. I always want to use volatility as my friend, and that's been my sort of playbook. So I actually don't mind if something goes up, but that's for whatever sentiment reason now for fundamental reason, plus people are going to pay attention to the earning season. Earning season for that stuff is going to be a lot worse than people envision, I believe. Brad Newman : I think it's really just a, a question of whether talking about a trade or investment. As Amy mentioned, value stocks are much more cyclical, they're more loaded with financials, energy, materials. Industrials, those kinds of companies. They're more levered to the economy as she mentioned. And so when economic growth comes back, they may tend to outperform during that time, but that's really not a longer term structural type of investment. That's more of just a trade or a bounce back. We’ve written a lot about this from a macro standpoint about these structural forces that are in place that are driving growth relative to value. And we think that the classification system is structurally impaired and that a price to book value, which drives how companies are divided up between growth and value, is structurally flawed because it doesn't capture intangible investments.
The types of companies that Amy invests in, and frankly that are proliferating more and more in the economy, are investing much more in intangible assets like research and development into software, algorithms, and drugs; and advertising into branding and investing in human resources. Those kinds of spending and assets aren't reflected in book value. And so because price book value is not a good measure anymore, value stocks tend to be the stocks that are just less innovative rather than out of favor. Growth stocks are companies that are more innovative and over the past decade those companies that are more innovative with higher R&D as a percent of sales have dramatically outperformed that those companies that are less innovative and we believe that trend will continue over the next several years. Speaker Question : Is there anything in the last week or two or even today that is just so head scratching, jaw- dropping cheap that just did not make any sense to you? As specific a name as you can get to, but is there anything that even today is disassociated from reality? Amy Zhang : Oil being negative, that's very jaw- dropping. I think that will be a temporary scenario. I think I will consider that one of the black swans, although we have had several black swan events this year. From a portfolio perspective, we have companies that we believe will continue to do well, weather the storm, and are doing relatively better than their peers or competitors. But also, we are looking at companies that are at “stupid prices.” I talk to my team, we stress test all of the portfolio, and rank it in terms of risk and reward. I'm actually very excited in terms of stock selection, in terms of potentially upgrading the portfolio both in weighting and also names. I think this is a great opportunity because you’re going to have those extreme scenarios so we take advantage of the volatility. Speaker Question : Are there any names that have graduated? Are there any names that you wish you could still own but have grown to be too big? Either from
small to mid or mid to outside of mid that you just were forced to get out of because they grew to be too big and you wish you could still own?
Amy Zhang : I don't have any of that, but because I'm not forced to. This is still a small cap strategy, but it's I could have one exception, sometimes one or two. For example, we own Shopify, which is large cap. It’s my exposure for e-commerce. Do I wish I could own it as a huge position? No. It’s a smaller position. But it was a top 10 holding for a long time, until last year. Eventually, it will probably not be in the fund anymore, but I’m glad that it is for now because we do like to let our winners run. I think that's a key advantage in terms of what we do. But we also have very emerging sort of growth companies that we own like Everbridge or Avalara. So, it's really barbell. The companies that you see in our portfolio that are not small cap: there are only a few of them and they really serve a purpose. It's all about long- term for me. Brad Newman : I want to thank everybody on the phone for a fantastic turnout and spending your time with us today. I want you to know that we really value our relationship with you and we're here for you during these extraordinary times.
Amy Zhang : Thank you. I really appreciate all your support. Have a great day.
Before investing, carefully consider the Fund’s investment objectives, risks, charges, and expenses. For a prospectus or summary prospectus containing this and other information about the Fund, call (800) 992-3863, visit www.alger.com, or consult your financial advisor. Read it carefully before investing.
Distributor: Fred Alger & Company, LLC. Member NYSE Euronext, SIPC.
NOT FDIC INSURED. NOT BANK GUARANTEED MAY LOSE VALUE.
Fred Alger & Company, LLC 360 Park Avenue South, New York, NY 10010 / www.alger.com