Q: Michael, please briefly explain the investment styles your firm offers clients.
A: Emerging Growth Management focuses exclusively on small capitalization growth stocks. Within this sector we have three investment strategies- the Focused Growth (a long strategy), the Long/Short Hedged (a hedged strategy) and the High Yield Growth (a strategy of convertible bonds and stocks). Our goal is to seek high absolute returns in both good and bad markets.
Q: Why are you focused exclusively on the small capitalization sector?
A: The small capitalization sector contains several thousand companies, many of which will grow rapidly regardless of the overall economic conditions. EGM has the research staff and contact network to determine the highest quality companies that are both intrinsically undervalued and that have excellent growth potential. What role do new issues play? Most new issues come to market at valuations that we find unattractive as long-term investments. Very few will meet our investment criteria of growth and intrinsic value. About 80% of IPOs trade below their offering price 12 months after they become public. We have found that new issues are more interesting investments one or two years after they have gone public. This allows time for the companies to mature as a publicly traded entity and to build a business capable of sustaining long term growth.
Q: How is your research process different?
A: Well, for starters, we have an investment team of eleven people, which is a rather large number for the size of our asset base. We think they are one of the best teams in the business. Our typical portfolio will consist of 20 – 30 stocks on the long side and up to 20 short positions in the long/short strategy. At any one time EGM may be long 80 - 90 companies and short 20 - 30 companies throughout all the investment products. With six analysts this equates to less than twenty companies per analyst. Such a low ratio, we believe is a clear indication of the intense analysis and research we perform on each company in the portfolio.
Q: Where do your investment ideas come from?
A: They come from a variety of places. We often get some of our best ideas from conversations with the management of our existing holdings. We are in continuous contact with our companies to discuss industry dynamics and changes in the competitive landscape. In fact, we call all companies we own at least every other week. In doing so, we have generated many ideas on suppliers, distributors and competitors.
Our client base is another source for investment ideas. Over the past 30 years that Tom, Jacqui and I have been researching companies, we have developed a tremendous number of contacts. Many of them are now clients and include company managers, members of Boards of Directors and venture capitalists. I find this network especially important when we are investing in technology companies. Direct contact with individuals who are running companies and evaluating competitive products is most helpful in determining market potential.
We also generate ideas by attending industry conferences and trade shows. Finally, our contacts among the investment banking houses, especially the small regional firms, often serve as a valuable first screen.
Q: Explain the investment decision-making process you use in your hedge funds.
A: The EGM decision-making process is applicable to all of our investment styles. We look for companies that have three characteristics. First, the market valuation must be low relative to its intrinsic value. This means that the private market value must be higher than the current stock market appraisal of the business. Second, we look for companies with the potential for high rates of revenue and earnings growth over a multi-year period. Lastly, the stock must offer at least 50% price appreciation potential over a 12 - 18 month time frame.
Q: How do you go about doing this?
A: We start by focusing on only profitable companies in the $100-$850 million capitalization range. We eliminate companies that are unlikely to demonstrate continued high growth, which leaves us with about 1000 prospects. Often, these companies are in the growth sectors of the economy such as business service, communications, technology, health care, distribution and specialty retailing. Occasionally, we will find a company in an industry going through consolidation that also looks interesting.
From here our investment team handpicks stocks that they think may be interesting enough to warrant further investigation. Collectively, our investment team creates what we call our Weekly Focus List. This is a list of about 350 companies that are profitable, growing leaders in their industry. Through our intensive research process, we winnow these companies down to focused portfolios of 20-30 stocks which we believe have the best risk-reward characteristics. If an analyst decides he or she wants to pursue an investment idea they will develop a detailed spreadsheet. This spreadsheet projects the company's earnings and financial condition for the following eight quarters. We will then send this spreadsheet to the CFO or CEO for their review and comments.
I feel this does two things. First, it establishes our credibility with the company, and second, it provides a set of expectations against which we can track the company. Company managements realize that we have put a lot time and effort into understanding their business. This is invaluable in opening up the lines of communication.
Q: Do you ever run into companies that do not want to speak with you?
A: Sure, but there are many excellent small cap companies. If one refuses to communicate with us, we will simply move on to the next. Usually, smart managements desire to have good relationships with the financial community. It is a two way street.
Q: Have you ever missed a good investment idea because of this?
A: Certainly, we miss good ideas all the time, but the important point is that our process works for us. The key is to understand the business fundamentals of each company in which we invest and have confidence that management is working primarily on behalf of the shareholders and is capable of executing their business plan. This requires very good communication with senior management.
I would like to add a point on business plans. Once we have a set of projections that management has agreed are reasonable, we track results against this plan. Our tracking process is very rigorous. Company management is contacted at least every other week. In addition, we conduct interviews with customers, suppliers and street analysts to confirm expectations and clarify new developments. Our investment team meets daily to discuss research and review portfolio holdings.
Q: How do you construct your portfolios?
A: Portfolios are constructed from the bottom up. As we go through our extensive research process, we always have a backlog of companies that pass all three of our criteria (value, growth and appreciation). Often we will find several companies in the same industry which will increase our exposure to that industry. Among the 20 to 30 issues in the portfolio we diversify across eight to twelve industry sectors. Our portfolio weightings in each stock range from 2% to 8%, averaging 3% to 4% on the long side and 2% on the short side. The criteria you look for is an average price earnings ratio similar to that of the S & P 500.
Q: How realistic is it to find rapidly growing companies trading at average P/E's?
A: As I mentioned before, with all the small cap companies that have become public in the last few years, many great companies just don't get the attention they deserve. It reminds me of the 80/20 rule. Twenty percent of the companies in the small cap universe get eighty percent of the attention. These are the high flying, momentum stocks, or they may be stocks in an industry that happens to be in vogue. The other 80%, some of which are good growth companies, just don't get much attention. You need to remember that we are only looking for 25 companies to put into our portfolio. In fact, if we have difficulty in finding good ideas we will just let the cash build.
Q: What would you attribute to the success in the consistency of your long-term performance?
A: It has to do with our investment process, and having the people to execute this process. In strong markets, most managers who buy high beta stocks can do well whether or not they cut corners on research. However, in difficult markets, what makes the difference is owning high quality companies, having excellent information and adhering to strong sell disciplines. Our investors expect to make money in bad markets as well as good.
Q: How do your two hedge fund styles differ?
A: Our Focused Growth strategy is a long only strategy utilizing cash levels as its hedging mechanism versus our Long/Short strategy. In general, the Long/Short strategy has a net long market exposure of between 25% and 75%. Unlike some managers, we do not use options, derivatives or futures, but instead use individual short positions. Our shorts are designed to not only hedge the portfolio, but to make money on each position. In addition, we do not use much leverage.
Q: Tell us a little more about your shorts.
A: Our shorts are not valuation shorts, which in this market is very dangerous. There are many companies, which are clearly overvalued, but are not necessarily good shorts. For us to short a stock, it not only has to be overvalued, it also must be likely to disappoint Wall Street. This could come in many forms; an earnings disappointment, order delay or some other a negative announcement, that Wall Street has not anticipated. The point is, that before shorting a stock we will identify an event which will trigger a devaluation of the company.
Q: How does the volatility of your long/short hedged product compare with your focused growth product in both up and down markets?
A: As you would expect, the Long/Short strategy is usually less volatile than our Focused Growth (long) product because it has lower net market exposure. With the market reaching new highs, resulting in more market risk, we think our short positions should significantly reduce downside volatility going forward. Tell us about your High Yield Growth strategy. The High Yield Growth portfolios include convertible bonds and high yielding preferred and common stocks. We use the same fundamental research process as in the hedge funds.
Q: What do you mean?
A: EGM has a large investment team researching small cap companies. Some of these companies have issued high yield securities. Back in 1989, when I started this fund, the yield on some of these securities was very high. While the yield has come down over time it is still above 7%. I believe that this is an excellent product for trusts and foundations or any entity that has dual-purpose beneficiaries. Frequently in a trust or foundation one beneficiary needs income while another is looking for long term appreciation. Historic annual returns have been around 20% per year. We presently invest over $40 million in this high yield strategy. Our goal is to provide interest income and capital appreciation for a total return of 12% to 14%. Stability of principal is also a primary investment consideration.
Q: How much of an advantage has it been to be located in the San Francisco Bay area?
A: It is a tremendous advantage. There are hundreds of publicly traded small cap companies located within a short commute. In addition, many venture capitalists and investment banking firms which specialize in smaller companies are located in San Francisco. Small cap companies from outside the Bay Area frequently visit San Francisco to attend conferences or visit their investment bankers. Our research team members probably meet with at least five managements a day, in additition to company visits and numerous telephone contacts. These contacts put us in the center of a strong information flow, which expands our market intelligence on the companies, and industries we follow.
Q: In your listing of the types of companies you follow, is there a reason why companies specializing in biotechnology are not mentioned?
A: Historically we have not invested in biotechnology. The main reason is that they don't have earnings. I find it very hard to come up with an intrinsic value for a company that does not earn money. They may eventually make hundreds of millions or they may go bankrupt, but until a company has a product that is selling you really don't know. I consider most biotech companies to be public venture capital.
Q: How do you control risk in a declining market?
A: For us, the key to generating high compounded rates of return has been preserving our client's assets in difficult markets. The years 1990 and 1994 were prime examples. In 1990, the Russell 2000 was down about 20% while our firm composite was up 5%. In 1994, the Russell was down and our composite was up over 20%. Our history has been surprisingly consistent.
Our ability to protect portfolio value and control risk relates to our investment process. First, our value criteria keeps us away from overvalued stocks which can have huge downside risk during a correction. Second, our close contact with companies enables EGM to quickly uncover a breakdown in the fundamentals before the rest of the “street”. This has often allowed us to sidestep earnings disappointments. Third, we have disciplined sell procedures which force us out of companies when they are not performing as anticipated.
Individual stock risk control comes also from proper diversification. A typical portfolio contains 20 to 30 issues across eight to twelve industry sectors. Portfolio position weightings range from 2% to 8% and will be scaled back as they appreciate above 8%. No sector will exceed 25% of a portfolio.
Q: What criteria do you use for selling stocks?
A: Disciplined sell decisions are vital to successful performance. An investment will be sold for a number of reasons including: a negative change in fundamentals from our financial model, an investment reaching its target price, an investment declining 20% from its cost, or if we anticipate a change in fundamentals in a particular industry. While our research is extensive, we need to be disciplined enough to realize when the market is telling us we missed something. This is especially important on the short side. I think we all know short sellers who were so convinced that some company was a fraud or overvalued that they refused to cover the stock as it appreciated. In most cases they were probably right, in the long term, but not before they buried their clients as the stock continued to move higher.
Q: Please give us a brief autobiographical sketch of your investment background.
A: Prior to founding EGM in 1986, I served as General Partner of Hambrecht & Quist Equity Management. From 1972 to 1982, I was the senior portfolio manager at Baker Fentress & Company. In the 1960's, I worked both as an institutional analyst for Eastman Dillon, Union Securities and, subsequently, as the Director of Research for Wilmington Capital Management. Throughout my career, I have focused on the small capitalization sector of the equity market.
Q: Who are the other major players on your investment team and what are their backgrounds?
A: I believe that we have put together an exceptional investment team. Tom Henwood and Jacqui Keyser are the two other Managing Directors. Tom has been in the business almost as long as I have. He was an Institutional All-American analyst for 11 of the 15 years he was at First Boston. He then headed up the small cap portfolios at Chase Investments before starting his own firm. Tom was a few years behind in the development of his firm when I was able to entice him to the West Coast. Jacqui is more home grown. She worked at both Paine Webber and Montgomery Securities before joining us as an analyst. Since then she has established herself as an integral part of the management team and earned the right to become an owner and Director of Research.
Between the three of us, we have over 70 years combined experience researching growth companies. Together we head an 8-person investment team, who have all demonstrated the ability to excel professionally before joining our organization. Individual investors today seem to be more concerned about the tax consequences of their investments.
Q: How concerned are you about the tax consequences of your investment strategy?
A: All of the Managing Directors have significant amounts of their personal money in the investment partnerships and are very concerned about the tax consequences of our investment strategies both for our clients and ourselves. While the investment decision is the primary consideration, EGM strives to keep taxes down. Our realized capital gains tend to be split approximately evenly between long term and short term gains.
Q: Would you like to offer any final thoughts?
A: The pillars on which we manage our business are focus, quality and discipline. Be the most knowledgeable investor in our sector of the market, focus our portfolios on the best and highest quality investments and run a highly disciplined research process with well-defined purchase and sell criteria. If we continue to execute with excellence in these three areas, then we should continue to deliver high returns to our clients.