Amy Zhang, manager of the Alger Small-Cap Focus Fund, has greatly improved the mutual fund’s performance since she joined Fred Alger Management in February 2015.
The Alger Small-Cap Focus Fund
has grown to $804 million in assets from only $14 million when Zhang took over. The fund was holding 49 stocks at the end of January, about half that of three years earlier when Zhang came aboard.
In the literature it provides to financial advisers, Fred Alger Investment Management talks about “investing in dynamic change,” and buying shares of companies that are either “coming of age” or going through a “positive life cycle change.” It is the first group that Zhang focuses on, following a ”high-conviction” strategy she has used for 16 years.
Zhang described her approach as “index agnostic,” while also saying it was fair to compare the fund’s performance to the Russell 2000 Growth Index
“We don’t own household names. We believe this is an excellent portfolio diversifier for our clients,” she said.
She also emphasized the diversification of companies owned by the fund.
“They are not correlated in terms of sources of revenue,” she said, making the fund “generally less volatile than the index.”
Here’s an edited version of Zhang’s conversation with MarketWatch:
MarketWatch: Can you describe the typical company that is “coming of age” that the fund invests in?
Amy Zhang, portfolio manager of the Alger Small-Cap Focus Fund: We are looking for high unit volume growth. Usually there is a large, growing, fragmented market. We also look for pricing power, or at least not significant pricing pressure. That’s where innovation comes in.
For us, it is really about sustainable, robust top-line growth. The key words are sustainability and durability of unit growth. This will correlate with EPS [earnings per share] growth, which ultimately drive stock prices.
MarketWatch: So you do not simply hunt for bargain small-cap stocks?
Zhang: At the initial point of investing, we look for companies with durable business models but operating revenue of less than $500 million. The sweet spot is probably $100 million to $200 million. We look for companies to double revenue within three to five years.
We are not looking for stocks to shoot up 20% to 30% in this portfolio. We are looking for a stock to grow two, three, four, five or 10-fold over a long period. We invest in long-term, value-creating engines. That’s how alpha is generated.
MarketWatch: You have also said you were looking for companies to be led by managers with “long-term vision.” Can you elaborate on that?
Zhang: Small companies do not grown in a straight line. Our investment horizon is three to five years and beyond.
Vision is also not linear. I generally favor companies that have founders as CEOs with substantial stakes in the companies. They generally have a long-term strategic vision that goes beyond quarterly results.
Small companies usually have limited resources, so how they allocate capital and resources is very important. It is also important for us to have a CFO with very strong financial discipline to balance the vision of the CEO. We don’t want a company to grow merely for the sake of growing. It is important for them to balance growth and profitability.
MarketWatch: Which metrics do you look at before diving in for closer analysis?
Zhang: We look for high growth, but I also spend a lot of time looking for financial quality to provide downside protection. Our companies have very strong balance sheets and high cash-flow-generating abilities.
So if we look at our portfolio as of Dec. 31, the weighted median debt/total capital ratio was only 2.6% versus the Russell 2000 Growth Index, which was 28.3%.
We have a combination of high quality and high growth. Our estimated three- to five-year compounded annual EPS growth rate for companies in the portfolio is 19% compared to 14.3% for the Russell 2000 Growth Index.
The weighted median net margin for our companies was 11.1% for 2017, compared to 5.8% for the index.
Our ROIC [return on invested capital] number was 14.7% versus 11% for the index.
We generally don’t invest in biotech companies, because we are trying to avoid companies that face binary outcomes.
MarketWatch: Such as clinical trials for drugs?
Zhang: Yes, that’s a good example.
MarketWatch: Can you describe any painful lessons you have learned about selecting companies for investment?
Zhang: Very early in my career, I used to think if a company had a fantastic product that anyone would be able to run it. I knew of a company that had great products but didn’t know how to sell them at a profit. This particular company just wanted to grow for the sake of growing.
They basically were selling at a discount. I talked to the CEO, who was supposed to be a visionary but didn’t know how to sell. We sold the stock and later on the company was acquired at a minuscule price.
It is about being differentiated — knowing how to sell and to do it profitably. I am very wary of hyper-growth companies. We have to make sure companies have sustainable growth with profitability. If they are not currently profitable, we have to see a clear path to profitability.
MarketWatch: Do you believe the problem of “short-termism” among investors and the financial media has gotten worse? It seems money managers are being held to impossible standards, as long-term strategies can take years to play out.
Zhang: Nobody has ever asked me this question before! It is such a critical question. A lot of it is about instant gratification. That creates anxiety. I am sure you can cite so many unhealthy behaviors, based on behavioral science. I go back to what Benjamin Graham said: Over the short-term, the market is a voting machine. But over the long term, the market is a weighing machine.
Short-termism also creates opportunities for investors like me. We are investors, not traders. The power of compounding should outshine any short-term trading, in my experience.
If you sell a stock with a gain of 20%-30%, then you have to find another one. We look for exceptional small companies and don’t find that many. We look for gems. That’s why I run a focused portfolio.
To use a garden analogy, we are planting the seeds to see the flowers blossom in three to five years. Eventually it will be beautiful. We spend a lot of time differentiating. A lot of people react and over-manage to quarterly results. We spend a lot of time understanding the bumps in the road.
It is very important to let the market serve us. I actually get excited when there is a big disconnect between the fundamentals and the stock price.
Owning a relatively small number of companies enables us to become experts on those companies. That leads to high conviction, bigger position sizes and potentially more alpha generation.
MarketWatch: Can you name a company held by the fund that you are particularly excited about?
Zhang: Veeva Systems
was the fund’s top holding as of Jan. 31. The company started in 2007 and went public in 2013. They provide cloud-based software for the pharmaceutical and life-sciences industries. They started with customer relationship management (CRM) software through a long-term partnership with Salesforce.com
and are now the market leader for CRM in the life sciences industry.
Soon after their IPO, Veeva invested in Vault, which is a content-management platform that was initially for the life-sciences industry.
A lot of key people in 2015 were skeptical that Vault could be successful. But I felt it was a very critical area and that Veeva was a very innovative company. I believe in their ability to make it successful.
We started to invest in 2015 because we thought they had the potential to be dominant in that life-sciences CRM space. The total potential market for Vault, just for life sciences, is over $4 billion.
Now they are expanding into other regulated industries through Vault. They call it Quality One. It is for industries, such as chemicals, cosmetics and manufacturing.
Another new product coming to market is called Vault Safety.
So total TAM [total adjustable market, or potential market size] for the company is about $9 billion. The company’s revenue is still less than $700 million.
The company has a GAAP operating margin of 23%, which is the highest in the SaaS industry [software as a service], which includes Salesforce.com. They have no debt. They have $762 million in cash.
We expect the margin to continue to expand because Vault has higher margins. Vault is now providing 39% of total revenue and that has continued to grow very rapidly because the potential market for Vault and Quality One is a very fragmented, paper-based market waiting to be disrupted.
This is why it is our top holding.
Veeva is a cross between health care and technology. It represents our portfolio and my philosophy very well.
Here are the fund’s top 15 investments (of 49) as of Jan. 31:
|Company||Ticker||Share of fund||Industry||Total return – 2018 through April 10||Total return – 2017||Total return – 3 years||Total return – 5 years|
|Veeva Systems Inc. Class A||
|Cantel Medical Corp.||
|3.0%||Electronic Production Equipment||-17%||93%||99%||412%|
|Tyler Technologies Inc.||
|2.9%||Data Processing Services||20%||24%||70%||255%|
|Guidewire Software Inc.||
|2.9%||Information Technology Services||10%||51%||52%||120%|
|OraSure Technologies Inc.||
|Canada Goose Holdings Inc.||
|2.4%||Information Technology Services||-29%||-14%||-17%||79%|
|Paycom Software Inc.||
|Sources: Morningstar, FactSet|
Share classes, expenses and performance
The Alger Small-Cap Focus Fund has five share classes, most of which are distributed through brokers and investment advisers. Most share classes have minimum initial investment requirements. However, these can be lower depending on the relationship between your broker or adviser and Alger. The Class A shares have a 5.25% sales charge but the sales charges can be reduced depending on the amount of money you invest. The Class C shares have a 1% deferred sales charge on shares that are sold.
It’s important to be familiar with all the fees, charges and account minimums for every share class before you invest. You can find this information about any mutual fund in its prospectus and if you are investing through an adviser, take the adviser’s own fees into consideration.
Here are the annual expense ratios for each share class of the Alger Small-Cap Focus Fund:
Some expenses are waived for extended periods but the waivers can end. That’s another reason to read the prospectus for any mutual fund you consider.
Here’s how the five share classes have performed against the Russell 2000 Growth Index
The performance figures are net of expenses but exclude sales charges. They also don’t reflect any additional annual fees you pay your adviser:
|Fund share class||Ticker||Total return – 2018 through April 10||Average annual return – 3 years||Average annual return – 5 years||Average annual return – 10 years|
|Russell 2000 Growth Index||
|Morningstar Small Growth Category||2.3%||8.5%||12.2%||10.0%|
All share classes of the Alger Small-Cap Growth Fund are rated four stars out of five (the highest) by Morningstar, with the exception of the Class Y shares, which have no rating, and the Class C shares, which have a three-star rating and the highest annual expenses.
The table above includes average annual returns, but a higher average return can really add up over time. For three years through April 10, the Class C shares (the ones with the highest expenses) returned 39%, compared to a return of 28% for the Russell 2000 Growth Index.