Podcast: Amy Zhang, Small Cap Focus Update
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Innovation is a common theme for our companies because innovation is the best way to outgrow the economy and sustain long-term value creation.
In our latest podcast, Small Cap Focus Portfolio Manager Amy Zhang discusses her portfolio, her team process, and recent volatility.  She also takes a look at the year ahead for small cap companies.

ALEX BERNSTEIN:​ Hello, I’m Alex Bernstein and you’re listening to the Alger Podcast: Investing in Growth and Change.  Despite some exacting periods of high volatility, many small cap strategies appeared resilient in 2018.  None moreso than Alger’s Small Cap Focus Strategy managed by Portfolio Manager Amy Zhang.  In fact, earlier this year, The Wall Street Journal named Amy one of the Best Stock Fund Managers of 2018.  Since joining Alger, four years ago, her Small Cap Focus portfolio has grown from approximately $14 million in assets under management to over three billion.  

Joining me today to talk about her process in managing a small cap focused portfolio is Amy Zhang.  

So, Amy, first of all, let me congratulate you on recently becoming a full partner at Alger.  That’s an incredible milestone.

AMY ZHANG:  
Thank you, Alex.
ALEX: So, if an investor is considering a small cap portfolio what differentiates your portfolio versus another leading portfolio?

AMY: So, we are differentiated in several ways.  One, instead of filtering candidates by market cap we define smallness in terms of revenue.  At initial point of investing we look for companies with durable business models and also generally annual operating revenue of less than $500 million.  So, in many cases a lot less.  

But having said that, our weighted market cap still fits well in a small cap category.  So that’s number one.  Two is we’re benchmark-agnostic.  So, I don’t manage a portfolio by overweighting or underweighting the benchmark.  I do not sector rotate.  So, it’s all about bottom-up, fundamental stock selection.  As a result, we have high active share.  We do not own household names.  So, we believe that acts as a really good portfolio diversifier for our clients.  

And then it’s a high conviction focus strategy, but it still diversifies in terms of business risk and source of revenue.  But it is typically less than 50 holdings, so we can pay acute attention to our holdings.  

We believe we have companies that have very strong balance sheets, very strong cash flow generating capabilities, and that’s very important for the success of the portfolio.  

And then we’re long term.  So, it’s a three to five year investment horizon and beyond.  And I think to have the distinct mindset of patience is very important as small companies do not grow in straight lines.  It’s really more about step functions.  So, we do a lot of rigorous fundamental research.  We spend a lot of time differentiating bumps in the road versus permanent impairment of fundamentals.  

So, any given quarter of the year we could be outperforming or underperforming a benchmark.  But over the long term we believe that we can generate attractive risk adjusted returns.

ALEX: I’d like to talk about portfolio construction for a moment.  What do you take into consideration when you’re assembling a portfolio?  What are your criteria for a good small cap name?

AMY: 
Well, when we look at a company, first and foremost, is the “moat.”  Right?  We look for a company who has a very strong competitive advantage that really can defend its market position.  So, usually it’s a company that has something truly differentiated that can disrupt or transform a market, and usually then gain a lot of market share or create its own market.  

Innovation is a common theme for our companies because I do think that innovation is the best way to outgrow the economy and sustain long-term value creation.  That’s very important because we’re really looking for durable growth over a long period of time.  

Then also, of course, a strong balance sheet is very important for us; strong or high values or quality; the ability to generate strong cash flow that can provide a financial cushion because that’s very important for small companies; and then management quality.  Right?  A lot of our companies have sort of founder CEOs, a visionary CEO, but I always want to have a financially disciplined CFO to balance growth and profitability in addition to the vision.  So, we also want the management to not manage quarter to quarter, but really manage the company over the long term.  So, management quality is very important, especially for a small company.  

And then profitability to fuel EPS growth, that’s over the long term, and then EPS drives stock price.  So those are the things we look for.

ALEX: How long will you track a company before it makes it into the portfolio?

AMY: That’s a good question.  I mean, a lot of companies, we’ve known them for a while.  Some companies we will just have discovered, but generally in terms of idea generation, we track a lot of private companies and then we track all IPOs.  So, we generally know what’s in our universe.  Sometimes we run screens as well.  

Everybody runs screens so running the screen is not a primary source of new ideas, but we also go to conferences and we just have a big inventory list.  But sometimes we would have just discovered a name and then if I thought it’s interesting and an analyst on my team thinks it’s interesting then that could just be a relatively shorter period of time.  So, it really depends.

ALEX: What themes are you and your team currently excited about?

AMY: We invest in the technology area.  We invest in a lot of software names.  The SAAS companies.  The cloud-based because everything is moving to cloud.  The way people work, how people live, and it’s really about automation.  Right?  Automation is still a very big theme.  So, turning data into actionable information especially with the big data theme, that’s very important.  Because we overall invest in companies that save time, life, money, headaches.  And digital transformation, that’s universal, including health care.  

But of course, in health care, the aging population with medical needs is a focus.  And then also digital transformation is a big theme in health care.  And then manufacturing area and consumer.  We think there’s still a lot of tailwind, especially for lower middle-class consumers with the tax refund and also the rising wages going forward.  There should be a significant tailwind for them.

ALEX: Over your 16 years of managing small caps you’ve seen quite a few companies grow themselves right out of your portfolio.  How do you feel when one of your “babies” outgrows the portfolio?  

AMY: Well, I don’t get emotional, but yes, in the sense that I think it’s a sign of success.  Because our tagline is “exceptional small companies have the potential to become exceptional large companies.”  When they’re bigger we hold them to even higher standards in the sense that there are a lot of larger numbers. I think one third of the portfolio still have tremendous growth opportunities.  

But we really want to still look for companies where their growth is not priced in and this is the best idea portfolio.  So, we try to stay rational and we do sell companies when all good news is priced in and when the risk/reward is not that attractive.

ALEX: You mentioned volatility.  And with small caps, volatility is obviously something you really have to factor in.  How have you been managing volatility, especially over the past year?

AMY: I pay a lot of attention to risk/reward.  But when to buy is very important.  We use volatility as our friend in those times.  As Ben Graham said, “over the short term the market is a voting machine and over the long term it’s a weighing machine.” So, that’s particularly true in a small cap space.

ALEX: And how do you manage downside risk?  

AMY: Well, I think on an individual company level that our companies generally have a much lower debt to capital ratio.  So that’s very important because I think to own companies that have financial quality that helps us to weather the storm better.  

And then I also think about a portfolio holistically in the sense that even though we clearly have a lot of exposure in the health care and technology areas, but within each sector there are a lot of subsectors, and the business drivers for those companies are quite diversified.  So that’s how I think about managing downside risk.  And really for us the most important thing is to deliver attractive risk-adjusted returns for our clients.

ALEX: Do you think we’re done with volatility in 2019?  

AMY: Oh, probably not.  I feel like volatility is the way of life for a small cap space.  So, it’s going to be pretty noisy.  You know, there’s the election, the anticipation of election, the trade wars.  There’s a lot of macro noise, but we really try to look past those macro noises and use sentiment.  

A lot of times we need to be the contrarian, right?  Because we’re not momentum driven.  So, we could underperform in any given quarter or even year if there’s a big disconnect between fundamentals and stock price, but eventually for our companies the value usually gets realized.  Because stock prices still usually attract value creation.  But one just needs to look past the quarter for that or several quarters sometimes.

ALEX: Amy, let’s talk about your process for a second.  Do you have a dedicated research team at Alger or do you leverage the entire Alger research team?

AMY: I have a dedicated team with four and a half analysts.  “Half” meaning that analyst spends 50% of their time with me.  And that’s great, in the sense that a specific process, it’s more productive that I have a dedicated resource.  Because every portfolio manager’s process is different and time horizon, the strategy is different.  And small cap is also different from large cap.  But I also can leverage the Alger general research.  So, on an analyst level there’s a lot of collaboration.  So I think it’s really the best of both worlds.  It’s really a win-win situation

ALEX: How often do you review ideas with your team?

AMY: Well, my workflow and their workflow is different.  So, we have team meetings.  As a matter of fact, I just finished a team meeting.  But we met yesterday, and we met today.  We typically meet at least twice a week, but sometimes more, whether it’s new ideas, existing names, model reviews, stock reviews, company reviews.  So that’s what we usually do.  

I spend a lot of time on research.  I rank the portfolio all the time, if not daily, or at least weekly in terms of risk/reward, and in the process, I talk to my analysts a lot.  It’s a lot of back and forth and try to probe certain ideas what we call “problem children,” in the sense that whether its valuation is too full or fundamentals are challenged.   Because the key is to gain a deeper understanding of our company.  Because change is a constant for our company, for small cap, so we spend a lot of time differentiating bumps in the road versus permanent impairment of fundamentals.  

So most of the bulk of my day and my analysts’ day is spent understanding companies and we do a lot of due diligence, calls, meetings, or just reading.  Modeling.  Reading and modeling.

ALEX: Amy, you’ve been investing in small caps for a long time, well before you started at Alger.  What, if anything, has changed for you since you started being a manager here?

AMY: The process is the same, but it’s the implementation of the process that’s different.  Right?  I think as the sole manager of the fund, it does have more of a responsibility and I think it has worked out well.  

And also, at Alger we have a lot of resources, so we do have the best of both worlds in terms of having a dedicated team plus a general research pool.

Alger’s “positive dynamic change” - I fit well on the left side especially, companies coming of age under the radar.  But exceptional small companies have the potential to become exceptional large companies has always been how I manage it, with 16-plus years of managing the same sort of strategies.  

Clearly, there’s also the specific process, which is a consistent and disciplined process that I’ve implemented for over 16 years.  So, in some ways it’s a diversification from other strategies at Alger, but we still have a common core.

ALEX: And 16 years later - you’re still enjoying yourself?

AMY: I love what I do.  I love what I do for managing the market.  Small cap is a very exciting area.  It’s really very exciting, and very rewarding to watch a small company blossom into a large company.

ALEX: Amy, thanks so much for speaking with us today.

AMY: Thanks, Alex.  Great talking to you.  

ALEX: And thank you for listening.  For more information on Amy Zhang and the Alger Small Cap Focus strategy, please visit www.alger.com.


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