Ticker Symbols

DFCIX (Class A) DEEVX (Class C) DFRIX (Class R) DFZRX (Class R6) DFDIX (Inst Class)

Investment Advisor

Delaware Management Company

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Riding Leading Disruptors

Jan 17, 2020

Delaware Smid Cap Growth Fund

  • AUM

    $1.8 billion

  • Inception Date

    Mar 27, 1986

  • Portfolio Holdings


  • Portfolio Turnover


Q: How has the fund evolved and how does it differ from its peers?

A: The Delaware Smid Cap Growth Fund is a growth-oriented, small/mid-cap (SMID) strategy. Our investment team has used the same philosophy and process since 1987, but it’s the portfolio’s concentration—about 40 positions at any particular time—that makes it unique.

To make such a concentrated portfolio, we insist that a company demonstrate not only a significant level of growth, but also be a leader within an industry undergoing some form of disruption. Typically, these names have found better, cheaper, or faster ways of doing things that change how business is done over time. Our goal is to identify these long-term economic trends and the companies that are leading them, then take and hold positions for enough time to allow the fundamentals to play out.

Q: What is the range of investable market cap for your SMID-cap strategy?

A: A typical entry position for us is between $1 billion and $10 billion, with occasional dips lower or higher. Currently, positions range from between approximately $600 million and $25 billion. Because this is a SMID-cap fund, if a name does well and continues to grow, we don’t have to cut it should it become a mid-cap stock.

As of Sept. 30, 2019, the average market cap in the portfolio was about $7.2 billion. In comparison, the Russell Small/Mid-Cap Index is $5.3 billion. We tend to ride a bit higher than the index for two reasons: we invest in companies with leadership positions and sometimes let our winners run.

Q: What core beliefs drive your investment philosophy?

A: There are always industries undergoing disruption. Someone has found a better way, which creates economic trends. Identifying these trends is at the core of our investment philosophy, as is buying the companies leading the trends because they will benefit for years.

Specifically, we look for disruption that will undergo secular expansion—the kind of change that will take place regardless of what happens with oil prices, an election, or the trade deal with China. An example of this is happening right now in the banking industry, where significant changes are taking place as currency goes digital and banking becomes more mobile. We see a huge industry being abandoned and as investors can find advantage in this foundational change. Our investment philosophy keeps us focused on the greater longer-term opportunities and sees us through the inevitable headwinds and issues in the markets.

Q: How does your investment process help you generate and distill ideas?

A: We generate ideas in-house. We have individual analysts focused on the sectors we believe offer the most opportunity for growth: consumer, healthcare, and technology sectors. However, we still pay attention to companies that aren’t growing as quickly and to larger ones in these spaces.

Our SMID-cap growth universe is small, with a total of just 1,500 distinct stocks. We look solely at companies in the U.S. because we see the pace of innovation here as faster than anywhere else. Also, because of strong regulations and standards, innovators in the U.S. are rewarded for doing well to a different degree than they are in other parts of the world.

Of these 1,500 names, we look for companies exhibiting significant growth—for instance, 10% revenue growth or 20% earnings growth—year after year. That’s a high bar that only about 200 companies can meet. From there we insist on leadership, with our definition of leaders being the companies with the largest market share, the best product, or the best service.

Isolating our universe to leaders leaves about 120 candidates for the portfolio. Our research is a team effort that relies on old-school fundamental methods to understand whether a company shares our vision regarding the industry disruption and longer-term economic trends. Each year, our group meets with every company on the list and we visit most on a quarterly basis. We talk not only with management, but also with their clients, partners, and competitors to get a complete understanding of the positives and negatives.

Ultimately, selection decisions are driven by two tenets: first, the size of the disruption—we want industries that are undergoing large, long-lasting change; and second, whether a company has a clear leadership position.

Q: Can you give several examples of your research process?

A: In the 1990s, we began investing in high-quality foods in the consumer staples sector. After identifying a strong trend toward people buying organic foods and taking a greater interest in healthier cuisine, we started purchasing Whole Foods. Over time, as we talked to competitors like Kroger and Albertsons, we learned that they were also increasing the availability of all-natural foods in their stores. They weren’t doing this simply to meet demand, but because they made more money selling higher-margin foods.

As this trend began spreading to restaurants about 10 years ago, we added companies like Panera Bread and Chipotle Mexican Grill. Today we see this disruption continuing in different ways. Our insistence on growth and our understanding of the trend led us to Shake Shack, which sells a higher-quality burger-and-fry experience than McDonald’s. It’s the fastest-growing restaurant in the country and is increasing units by over 30% a year. Since there are 37,890 McDonald’s stores in the country and just 240 Shake Shacks, there is plenty of room to run.

A second area we like is Software-as-a-Service (SaaS). SaaS offers significantly better and cheaper ways to adjust software if viruses or other problems occur. The key for SaaS companies is to create a network effect—once a company becomes the largest in its area, it gets more and more customers. More customers lead to more and better functionality, and at this point, companies can clearly differentiate their service offerings and grow in a secular fashion.

We began investing in SaaS over 20 years ago when we purchased Salesforce.com. It was the first large public company to actually provide SaaS solutions. Another name we own in this area is The Trade Desk, which was the first to offer a media-buying platform powered by SaaS software. The company has seen exponential growth and we believe it will continue.

Q: How is your team organized and how does the decision-making process happen?

A: On average, our team has over 20 years of industry experience. We’ve also been working together for a very long time; more than 16 years on average. As CIO, I’m supported by three analysts who each cover a specific sector and take the lead on company information, filings, earnings calls, and meeting with companies. I am in charge of the macro and market outlooks. While we work in concert to understand the disruption, trend, and leaders to make selections, I have final responsibility for what goes in or out of the portfolio.

Q: What is your portfolio construction process?

A: We try to allocate to the largest trends and the clearest leaders, and diversify the portfolio by owning 2% to 4% on average in these names.

Though our active share is about 95%, we consider ourselves index-aware and don’t want to differ dramatically from the sector and industry exposures of our benchmark, the Russell 2500 Growth Index. At the moment, our largest overweight is tech at about 7% and our largest underweight is industrials by about 7%. There are also areas where we won’t own anything, such as materials or energy companies.

Position sizing is crucial. We want positions to be large enough to make a difference if companies do well, but not large enough to hurt us if a problem arises. Typically, we’ll start a position at 1.5% to 2%, then as it moves up to 3% we will hold it to let the fundamentals play out. If a position goes over 5%, we trim it to prevent overexposure.

Once we create what we think is a best-in-class growth portfolio, we manage risk. We look at a variety of factor risks and are constantly reducing names due to high valuation, high market cap, and high levels of volatility or momentum. The only factor that isn’t curbed is growth—we want to have that in this portfolio.

Q: What is your sell discipline? How do you avoid being a momentum investor?

A: Two things can lead to turnover in the fund. The first is capital preservation. If a name falls by more than 20% relative to its portion of the index, we will sell a third of that position; were it to fall by 30% or more, we exit the position. We don’t want any one name to hurt us and will never have a position that goes from $30.00 down to $3.00.

Performance preservation is the other reason we will sell. Often, names in the fund make dramatic moves. I mentioned Trade Desk earlier. In the last 18 months, its stock has risen more than 400%. Because we don’t want it to become a huge portion of the portfolio, we’ve actively reduced the position—at this point, we’ve probably sold 70% of it.

When we regularly review factor risks, we pay particular attention to momentum to see if we can trim high-momentum ideas while buying low-momentum ones. It is key to keep these risks balanced because if there were a macro market shift at a time that we are holding too much momentum, we would expose the portfolio to too much volatility.

For instance, earlier this year many strategists on the Street were insistent that a recession was coming. The problem was that they were focusing on the wrong things: they were looking at the wrong industries, at auto sales or plane sales, or at how agricultural equipment stocks were doing. But none of those things matter to us. They aren’t the new economy ideas where we find secular growth, like consumer staples where terrific innovation is taking place.

As the Street stared at those old industries and saw a slowdown, they predicted a recession.

These predictions of a recession kept coming until signs of optimism finally started taking hold – like a trade deal, for one, but more importantly, the Fed started cutting rates to provide liquidity and allow more growth. We also continued to receive good news about unemployment and job creation. All at once, everyone who had been calling for a recession changed their minds. Growth stocks fared poorly in general, especially momentum names. Investors who had been hiding in the few names that were growing well suddenly wanted out of those and into areas of the economy that had been compressed like semi-conductors, equipment, and regional banks.

Because momentum wasn’t extended within the portfolio, our clients didn’t experience too much of this volatility. It’s for this precise reason that we actively reduce momentum.

Q: How do you define and manage risk?

A: Being aware of our industry exposure, sector exposure, factor exposures, and trimming larger positions are some of the ways we manage risk. They help ensure there isn’t too much commonality in the portfolio, and we drive diversification to keep exposures from becoming out of whack in any one area. We constantly compare how the fund is doing relative to the index. If it were to fall by 20% and we were down just 10%, we would know that we’re doing well to control risk within the portfolio.

Clients who give us money to invest in SMID-cap growth names are already taking risk. We want to take that risk for them in the most diligent, controlled, and contained way that we possibly can.

Q: Did you learn any lessons from the financial crisis of 2008-2009?

A: I learned a great deal from managing money then. First, I became far more diligent about factor management, particularly regarding momentum and volatility. Though this was always important, it is now more of a focus and we’ve enhanced the ways in which we control it.

Second, based on our experience managing through previous recessions, we’ve improved our understanding of whether and when we might enter one and how severe it might be. For instance, Microsoft was a clear leader riding a long-term trend through the 1987 crash and the 1990-91 recession. It remained okay to own Microsoft; although the stock went down a lot at times, nothing upended the company’s secular expansion via PC penetration.

The recession of 2008 was different—it was a severe recession, perhaps our generation’s depression. Because of it, we no longer look at companies primarily from a fundamental basis, but rather in respect to systematic risk; we ask what would happen to a company if a banking system were to be nationalized or if the euro breaks up.

When might the next 2008 happen? I am not too worried at the moment. Recessions of its severity happen when the economy is really extended, and right now consumer credit scores are at all-time highs, unemployment is at multi-decade lows, and wage growth has been accelerating. So, we think we’re in a good position.

I don’t believe the next severe recession will come until the early 2030s, and that’s what makes us feel bullish and constructive on the markets.

Annual Return 2019 2018 2017 2016 2015 2014 2013 2012 2011
DFCIX 35.33 0.13 35.13 -4.33 7.05 2.81 40.84 10.38 7.96