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Investment Advisor

OFI Global Asset Management, Inc.


Subadvisor

OppenheimerFunds Inc

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All Weather Small Cap Blend

Mar 23, 2015

Oppenheimer Main Street Small Cap Fund

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Q: What is the history of the fund?Our small cap investment strategy has been around for a long time and the mutual fund has been in place since May 2013. We are managing $2 billion of assets in the strategy, of which $258 million is in the mutual fund. 

Q: How do you apply your investment strategy?

At the time of purchase, we focus on opportunities in the market cap range between $500 million and $4 billion, and at least 80% of our holdings are in the market cap range of the Russell 2000 Index at the time of purchase. However, most of our holdings fall in the range between $1 billion and $4 billion.

When we do find a strong idea we want to invest with conviction, but it is often challenging to do that in companies with market cap below $1 billion, and even more so when we go below $500 million. The reason for this is that trading liquidity is thin, and we generally do not find the same level of quality and competitive strength as readily in smaller companies.

As part of the Main Street team at Oppenheimer Funds, we carry out extensive research in search of portfolio candidates across all market caps. Our strategy is best described as a blend strategy. Essentially, we build a core portfolio, sourcing investment ideas across the full spectrum, from growth to value. We are set up as sector managers, as well as portfolio managers, and everyone on the team has an analytic responsibility to choose stocks within their sectors regardless of market cap.

Q: Would you elaborate on your all-cap investing team function?

Whether it is a matter of large, mid, or small cap, we are agnostic in our approach because there is a portfolio strategy and a mutual fund to place every good stock idea in the most relevant way. We have our Main Street Fund (large-cap), Main Street Mid Cap Fund, and now we have the Main Street Small Cap Fund, respectively, among other retail mutual funds. 

Looking at stocks in the same way, we use the structure of our unified team as a common backbone of people, philosophy, and process. This all-cap expertise serves as a major advantage, so when we are evaluating a small-cap stock, we are able to examine the whole ecosystem of a company. We understand the company within the context of its industry, both in terms of as a competitor to larger companies, as well as in relation to customers, suppliers, and industry dynamics.

Only when you are part of an ecosystem that includes large companies do you have a full understanding of the opportunities, threats, risks and challenges of being a small company. This methodology enables us to assess effectively the fundamental risk reward, which translates into a better and more robust process for analyzing the upside and downside risks, as well as the various scenarios for individual stocks.

Portions of our long-term compensation are explicitly tied to each of our investment strategies—large, mid, and small—which is heavily weighted toward three- and five-year performance. 

Q: What are the tenets of your investment philosophy?

Our team’s investment philosophy is quite straightforward. We seek to build an all-weather portfolio with a similar risk profile as our benchmark, but with higher returns generated by stock picking success. Such a portfolio enables us to be competitive in all market environments. What we focus on is not a particular defensive or offensive stance but the ability to generate additional return through our stock picking. 

When it comes to populating the portfolio with individual stocks, we look for companies that can demonstrate superior management execution. We want to buy well-positioned companies at attractive valuations, with the strongest opportunity to create long-term value.

We look across the spectrum from growth to value stocks to find those well-managed and well-positioned companies with the potential to build shareholder value. We will look at a growth company in a similar way to how we will approach a value stock, but it comes down to figuring out the fundamental multi-year scenario of what can go right, what can go wrong, what a probable outcome would equate to for an upside or a downside in stock price, and what the alpha opportunity turns out to be. 

Our goal is to beat the Russell 2000 Index and stay ahead of our peer group over a full market cycle. 

Q: What is your investment strategy and process?

We are a stock picking team and we start out by finding good investments first before we find a place to put them, regardless of its market cap. As mentioned earlier, our strategies encompass the full cap range and the full valuation range, from growth to value. Although we can do a limited amount of investing in foreign companies, our team is predominantly focused on domestic stocks. 

In addition to fundamental research, we have other resources available, ranging from our own insights into companies to findings gathered from external sources. In our process, quantitative tools are an additional source. One of these tools is a proprietary model that scans the entire universe and rates stocks against their sector peers in the ten widely followed sectors, taking into consideration a combination of valuation and fundamentals and price and earnings momentum. That is an interesting tool to periodically scan for ideas that may be slipping off the radar in spite of their potential of becoming attractive. Still, we will not use these tools as a pre-screening mechanism and we do not constrain our universe because of them. In many cases we may buy a stock that scores poorly on the model because we see things that might not be so obvious to the model. The underlying difference here is that models typically look backward whereas we are always looking forward.

Furthermore, we have some additional quantitative screens that are tailored more toward individual industries or sectors. Analysts may say that they want to keep an eye on companies with particular trends, which will undoubtedly vary by person and sector. While it could be measures of valuation on book value or operating earnings for some, it might be measures of estimate revisions for others. We have a team that makes use of high quality tools to capture all that.

Q: Could you discuss one of these tools?

A more recent tool that I find exciting—we have generated a number of ideas recently from it—is an event screen that was created as a quantitative model a couple of years ago. After doing well in the testing, it seems to be showing promise as a fruitful idea-generating tool that looks at various corporate events, such as cluster insider buying, insider selling, or share buybacks, dividends, and so forth. 

We are cognizant that insider selling does not show any efficacy on average, but insider buying by multiple executives does. Also, while small dividend initiations do not matter, big ones certainly do. So, we generated a couple of dozen ideas for analysis from this tool, and six of them actually made it into the portfolio in 2014. Our fundamental research and event screens generated ideas that were in sync because these events were either coincident with, or possibly causing, some positive developments at these companies.

Q: Would you dwell on your research process?

While researching companies up and down the market cap spectrum, especially large companies, you often learn about a new smaller competitor or a customer supplier. Conversely, when you are looking at small companies, you find out about aspects of the business, whether it is direct or indirect, of larger companies. This is a mutually beneficial loop that we like to take advantage of.

Our principal source of ideas is the preliminary research from our sector specialists. As an analyst, I cover real estate, business services and some smaller segments such as automobile retail and rental. In addition to that, I cover a couple of other small segments that collectively add up to about 15% of the Russell 2000 Index.

We generate ideas from our daily research, which includes meetings with management teams thanks to our strong corporate access, both being in New York, and being a sizeable firm. Once we have the germ of an idea, we proceed with the next analytical step that allows us to understand the company in the context of its ecosystem, especially with a smaller company and the points of vulnerability in that particular ecosystem. Possible risks of this kind include a highly concentrated list of customers, which tends to be a big risk in the tech space, or simply being the third or fourth player in an industry displaying oligopolistic characteristics. 

In order to understand what is happening in the ecosystem, we need to analyze what could possibly go right or wrong, before we can calculate with precision the probability of success or failure. Once we come up with a multi-year view—we think in terms of two-to-five years—we can estimate what would be an appropriate upside and downside price for that optimistic or pessimistic scenario, respectively.

As a rule of thumb, although it is not a hard limit as different stocks have different volatility characteristics, we look for upside to be at least twice what the downside is. When a stock is currently at $40 and you think the upside is $60 and the downside is $35, your scenario is tilted to an upside rather than a downside price.

When we purchase a stock we look for that margin of safety from the fair value upside. Then, over time, as we own a company we keep an eye on the relative upside and downside and we revise our assumptions with each new piece of news, at least on a quarterly earnings basis. We will manage our position size—whether it is through adding, trimming, or exiting a stock—with a close eye to the upside and downside of the individual security.

Q: Would you share some examples of companies that have met your research criteria?

On Assignment, a staffing company, is one of the names that fall under my research coverage. I was familiar with this stock for a long time in the context of having owned Robert Half, a much larger company. Robert Half has also been developing technology staffing capability, which they feel has the same profit potential, and a larger addressable market than their core business of financial staffing, yet the company that has been most successful in tech staffing has been On Assignment. 

Things were going well for them in 2012 and 2013 and as I was watching the stock go up without me, I was hoping that I would be able to make a reasonable purchase at some point in time. Then, in the middle of 2014, the stock had a sharp sell-off due to a greater-than-expected slowdown in one of their divisions called Oxford, which in turn caused an overall slowdown of the company. Consequently, their high price to earnings multiple compressed quickly after the earnings slowdown. 

On Assignment came back onto my radar as possibly being attractive, but I was waiting to see how fundamentals would unfold. In September 2014, we got a flag from our event screen of a significant share buyback. That gave me the impetus to “front-burner” the idea. At that moment, I saw a pretty attractive entry point to get into a company that still had excellent long-term prospects, so I initiated a position. The stock essentially hit a speed bump, then recovered, and is now back chugging along again. This is clearly a good example of understanding the ecosystem, getting to it by understanding larger companies, and sourcing an idea from the event screen.

Q: What is your portfolio construction process?

We typically have between 90 and 100 stocks in the portfolio, with individual position sizes based on the respective upside and downside potential, and the level of our conviction. An individual position size will typically be 1% or less at purchase, and we will not buy above a 3% weight. Our top 10 positions will normally average about 20% of the portfolio.

We allocate sectors by staying fairly close to benchmark weightings and we have a five-percentage point internal limit versus the Russell 2000 Index. So, if a sector is 20%, we will always be between 15% and 25%. More often than not we are within 2% or 3% of the sector weight in the index. 

We do not approach the investable universe with the conviction that we prefer stocks in the tech sector to manufacturing, or healthcare to consumer. Instead, we are agnostic and we want to make sure that we generate alpha in as many sectors across the portfolio. We want to keep the sector weights roughly neutral in order to generate alpha through stock picking. It has been proven over time that our performance attribution in good times and bad times is usually due to stock selection, not sector weights on other macro bets. 

Our portfolio turnover is typically between 50% and 75%, and for the last two years it has been steadily in the 60% range. We do not target any specific turnover, but we do want our ideas to have some staying power. At times we will add and trim to manage risk and we may squeeze out some extra return. While this may increase the level of turnover, we believe that it is the right approach from a total return standpoint. 

Our active share is typically 93% or higher, which is above average for the small-cap category. We do believe in high conviction investing and that is a philosophy that goes across OppenheimerFunds. We pride ourselves on having a fairly high active share whilst maintaining reasonably low tracking error levels versus the benchmark. Our efforts to limit our common factor risk keep our tracking error fairly low.

Q: How do you define and manage risk?

We view risk at the security level, the strategy level, and the firm level. At the firm level, we have the independent risk management team, who monitors our compliance with risk limits at the portfolio level. We have a maximum limit for tracking error of 8% and we rarely go above 4%. 

At the strategy level, in addition to having sector limits, we also spend a lot of time with the risk models to understand other risks, such as correlations and covariance of stocks, to make sure we avoid having large factor bets that may have to do with currency, interest rates, or beta among others. We want to be certain we do not have a portfolio that is directly or indirectly overexposed to a given factor.

Our risk control process also benefits from our strong, repeatable system and the stability in our team. We see our team of people as the most important aspect of our efforts. As a seasoned and experienced group, we have a lot of continuity and an average level of experience on the team of more than 20 years.
What is more, we stick to what we know best, and that is picking stocks without resorting to anything exotic. We do not use derivatives or sector ETFs, but we pick individual stocks and assemble them intelligently to create a broadly diversified portfolio.
 

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