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On the Right Side of Change

Aug 26, 2019

Wells Fargo Enterprise Fund

  • AUM

    766 M

  • Inception Date

    Sep 30, 1998

  • Portfolio Holdings

    70

  • Portfolio Turnover

    55

Q: What is the history and evolution of the fund?

A: Our team has been working together for 25 years. We started in a different firm and in October 2000 we joined Strong Capital Management, where we took over the management of several funds, including the Enterprise Fund. 

Regarding the evolution of the fund, we stayed the course. When we took over the fund almost 20 years ago, it had a slightly more momentum-oriented strategy. Now the strategy is more balanced and focuses on both secular growth and idiosyncratic growth opportunities.

Our team manages about $9 billion across six different strategies, which are distinguished by the market cap. However, we function as one team and we execute the same process across the market cap spectrum. Within the mid-cap strategy, where the Enterprise Fund is located, the total assets are about $1 billion, and the fund represents the majority of these assets.

Q: How does the fund differ from its peers? What makes it unique?

A: In general, capital allocators seek to increase their assets, to preserve their assets or to generate income. The fund represents a good building block for increasing assets. We provide clients with the power of compounding through investing in businesses that we believe are on the right side of change. 

We identify our investment targets using a non-formulaic approach that leads to non-consensus ideas. Our insights are developed through an intensive research process, where we select the companies that we focus on through deep fundamental analysis. As we do that research, we look for opportunities to exploit the market’s mispricing of future growth. That process drives our investment decisions.

Another unique feature is that our team is more sensitive to risk than other growth investors. For every holding, we assess the risk versus the return potential and we construct our portfolios to balance the risk among secular and idiosyncratic growth opportunities. That approach differentiates us from the strategies that are more momentum oriented and from the strategies that are more valuation sensitive.

Q: What core beliefs drive your investment philosophy?

A: In a nutshell, we are stock pickers. We focus on making great investment decisions one stock at a time. We are not top-down investors and we are not index huggers. We are not quant or systematic investors. Instead, we believe that the stock selection determines alpha. 

One of the keys to success is defining your circle of competence and competitive advantages and being laser focused on exploiting these strengths. The strength of our team is stock selection and it has been the driver of our returns.

We aim to invest in companies that are on the right side of change. Typically, these are businesses with the ability to grow their list of customers or to extract more revenue from existing customers. They can extract more revenue by selling additional services and products or by increasing the prices. We focus our attention on these companies and avoid the ones that don’t fit those criteria. 

Q: How do you translate that philosophy into the investment process?

A: Although we are a fundamentally-focused team with a bottom-up approach, we are aware of the macro environment through the lens of each business that we focus on. We do a lot of scenario analysis and stress testing to identify how the different macro environments would affect the fundamentals of the individual businesses that we own or would potentially own.

The process is divided into different steps. It resembles a funnel, where at the top we focus our attention on identifying attractive targets that are on the right side of change. Once we’ve identified them, our research process begins. In that step, we seek to understand if the company worth our time or if we should allocate that time elsewhere. It involves fundamental analysis and assessment of the management team and its capabilities, the strategy, the industry structure, etc. 

One of our differentiators is that our team has roots in high-yield investing, so our training involves focusing on all the financial statements, not just on the income statement. We research the quality of the business, the opportunity, and the returns above and beyond its cost of capital. We also look at the balance sheet and the cash flow statement for leading indicators of growth.

In the next step, we move from research to analysis. I believe that it is important to differentiate between the two. While research is the process of gathering information, analysis is taking that information and generating insight. That third step is the most critical part in our process,  because there we can gain an advantage over other investors by determining what’s not priced into a stock, who is on the other side of a trade, what do they know that we don’t, etc. We try to identify what’s not priced in both qualitatively and quantitatively by analyzing the earnings growth trajectory and how that’s different from the consensus.

Then we move to the decision-making stage of our process, which is step four. Here we rank the opportunities that we are interested in based on risk versus return and the catalyst that can unlock the upside. We rank our ideas on a scale from one to four, and we concentrate our capital into the best ideas using that proprietary ranking system. 

In the fifth step of the process, we focus on portfolio construction and risk management with the purpose to add consistency to our return stream over time. We balance the risk among secular and idiosyncratic growth holdings. Actually, we diversify across three different types of growth stocks – core holdings, developing situations and valuation opportunities. 

Our clients hire us with a set of expectations and views on how the portfolio should perform over time. Nothing is more important than delivering great long-term performance and not surprising the clients in a negative way. Of course, the strategy doesn’t work perfectly in every scenario or market condition, but we can influence how it behaves relative to the expectations and we aim to be consistent in doing well.

Q: How do you estimate value? Do you set price targets or other benchmarks to define it?

A: We aim to estimate two things when defining value. First, we try to estimate how much money we can make if we are right. That’s the upside price target that we set for every stock that we are involved in. Our analyst team is responsible for maintaining and updating those views. The second estimate is how much money we would lose if we are wrong. So, we have not only an upside price target, but we also have a downside case, where we estimate the potential loss if our thesis proves to be inaccurate. 

We use this set of inputs on each of our strategies to make informed investment decisions. Overall, the single greatest input into the investment decision is the risk/reward ratio and measuring the upside if we are right, divided by the downside potential if we are wrong. When we enter a new investment, we like to see a minimum of 2:1 ratio of upside to downside. For large positions and for the top 20 holdings of the portfolio, that ratio needs to be 3:1.

Q: How is your team organized? What’s the decision-making process?

A: Chris Warner is the co-manager on each of our six strategies, including the Enterprise Fund. We have 10 analysts, who are organized by sector, but we have a different idea for sector coverage than the typical the Wall Street research. Our analysts focus on the areas where we see a concentration of companies on the right side of change. Their job is not to evaluate and rank every stock within their sector. Instead, they collaborate with our team to find the best opportunities within their sector and to focus on the companies that meet our criteria. We are both former analysts and we believe in collaboration, because it leads to the most effective decision making.

Q: Would you give some stock-specific examples that would illustrate your research and analysis process?

A: I can point to a couple of examples that highlight the balance between secular growth and idiosyncratic opportunities. Among our top 10 holdings are companies which are now popular holdings among other growth and high-growth strategies. We had some insights and became involved in these opportunities early in the investment lifecycle.

On the flip side, for more idiosyncratic opportunities where there are more questions why we own these opportunities. The reason is related to the significant pricing power, the unique set of assets, and the management culture regarding operational excellence, safety and capital allocation. 

The key point is highlighting the balance between secular and idiosyncratic growth. A substantial part of our process is analyzing what the market is missing, if there is something we see that other people don’t, who is on the other side of the trade and what they might be thinking that we don’t. 

Over the last several years, our most successful investments have been in companies, which added a second or a third product that became successful or in companies that managed to expand their initial addressable market opportunity several times by broadening the customer base effectively. When we do our early analysis of opportunities, investors can easily ask how we can justify the valuation, but those are the signs or symptoms that help us determine if the market is actually paying enough for this opportunity. Through our analysis, we may see these ancillary or adjacent opportunities that aren’t being priced in.

Q: What is your portfolio construction process?

A: We believe that active managers should be active. Each of our clients made the choice to go with an active strategy instead of an index manager. We attempt to maintain a high active share across each of our portfolios. As a result, we’ve agreed to take on a fair amount of tracking error and volatility versus the index. To combat that volatility, we intentionally diversify our investments across three different types of growth stocks – core holdings, developing situations and valuation opportunities. 

The idea is that it is possible to maintain a high active share and do well in different market regimes. We don’t try to time the market or to establish a strong view on its direction. We are long-term investors and the value proposition for our clients is long-term compounding, but we are sensitive to the consistency of that experience over time. I believe that the diversification across three different types of growth stocks is an opportunity to smooth out returns over time.

Typically, we have between 60 and 80 holdings in the Enterprise Fund and our benchmark is the Russell Midcap Growth Index.

Q: Do you have limits to your maximum exposure to a stock or a sector?

A: The guardrails are often determined by our clients and their consultants ahead of time. Nevertheless, we consider a large position to be around 4% or 5% of the capital. An average position tends to be about 1.5% overweight versus the benchmark and we do have smaller positions. For the stocks with a wider range of outcomes, we manage the volatility by maintaining a smaller position sizes.

From a sector perspective, we don’t go over two times the benchmark weight. The complexion of our indices have changed over time and certain sectors have become quite large. It would be unusual to be two times overweight in technology or in a sector that is 20% or 30% of the benchmark. While we are aware of our sector exposure, we don’t manage it. There is no input to our process that aims to achieve a specific sector overweight or underweight. Instead, we focus on making great decisions one stock at a time and populating the portfolios with individual stock decisions. 

Nevertheless, during the portfolio construction and risk management process, we meet as a management team once a month to review the risk metrics, including our sector weightings, to make sure that we haven’t moved outside of these guardrails.

Q: What is your sell discipline?

A: We would sell a stock sell for three reasons. The first reason is achieving the upside price target if we don’t see further upside or a favorable risk/reward situation. The second reason is if a stock gets displaced by a new and better idea. Since we are fully invested at all times, we need to sell something to buy something new and there is competition for capital between the ideas. The third reason is if the thesis being no longer accurate or intact. Our discipline is to move on from these situations and redeploy the capital into different opportunities.

Q: How do you define and manage risk?

A: The definition of risk means that more things can happen than will happen. A big part of our process uses the collaborative effort of a large and smart team to imagine all the things that can happen, to assign probabilities to those scenarios, and to weight them as we do our research and analysis. This process, combined with measuring the upside versus the downside, enables us to achieve our objective of long-term performance with no negative surprises for our clients.

We are sensitive to risk through every step of our process, starting with the crucial first decisions of where we allocate our attention and where we allocate our time. We were hired to increase the clients’ assets and to take risks, but to take intelligent risks and to maximize the risk/reward opportunity.

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