(280) the dias focused growth portfolio – under the hood
1. This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion or our investment managers
at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no
indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private
Capital is an SEC Registered Investment Adviser.
Thought for the Week (280):
The DIAS Focused Growth Portfolio – Under the Hood
Synopsis
Equity markets were stuck in a “risk-on/risk-off” mode from 2009 to 2012, which made stock picking difficult for active managers because stocks were trading too closely together.
We are beginning to see company specific fundamentals move stock prices instead of the equity market moving as a group, which should benefit stock selection vs. investing in index funds.
The DIAS Focused Growth portfolio is designed for capital appreciation by holding equities that are poised for continued sales and/or earnings growth.
Stock Picking is Back
An active manager’s worst nightmare is when stocks don’t trade on fundamentals, which was the very situation that U.S. equity markets faced from 2009 to 2012. During this time period, the phrase “risk- on/risk-off” became prominent in the media as an explanation for the phenomenon where stocks were being bought and sold as a group for reasons unrelated to the fundamentals of the companies.
For example, let’s say that an active manager did her due diligence and determined that a company was poised for strong growth fueled by the introduction of a revolutionary new product. Her analysis led her to purchase a large position in the portfolio, which is benchmarked against the S&P 500 index.
Six months later, the manager’s thesis proved to be accurate, and the earnings for the company increased materially. However, during this period, investors were mostly purchasing index funds as a way to gain broad equity exposure vs. individual stocks simply because fear still ruled the markets. Even though she was correct, the stock price moved in a muted fashion.
Although this portfolio manager, company, and innovative product are all fictitious, the environment described was very real – one that cost many experienced managers their jobs because they were unable to generate any alpha.
NOTE: Alpha is defined as the returns from an active manager above his/her benchmark. If the S&P 500 returned 10% in a year and a manager benchmarked against the S&P 500 returned 12%, then the manager delivered 2% of alpha that year (12% - 10% = 2%). Portfolio managers are paid to deliver alpha.
There are several reasons for this extended risk-on/risk-off environment, many of which can be traced back to aftershocks from the financial crisis, but what we have begun to witness over the past 12 months is that fundamentals are starting to drive equity returns again, and that’s a very good thing for investors.
Much discussion and several Thought of the Week reports have been published on the DIAS Conservative Income Portfolio (CI) in the past, and given that stock picking is returning, we felt that now is a good time to go under the hood of the DIAS Focused Growth (FG) portfolio and explain how it works.
Let’s Look Under the Hood
Focused Growth is a portfolio designed for capital appreciation by selecting investments that we feel will grow substantially over the long run. When comparing Focused Growth to Conservative Income, there are three key differences:
2. This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion or our investment managers
at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no
indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private
Capital is an SEC Registered Investment Adviser.
1. Little to no income: CI is designed to generate income and will most likely not fully participate in a major market rally. FG may generate some income, but this income would be nothing more than a byproduct of its goal of participating in a rising equity market.
2. Benchmarks: CI is an absolute return vehicle with a benchmark of zero, meaning we strive for capital preservation over an 18-month time horizon. FG is benchmarked against the Russell 1000 Growth Index, which measures the performance of the large-cap growth segment of the U.S. equity universe, and we attempt to outperform this index annually.
3. Pure equity: CI maintains an allocation to fixed income whereas FG is a pure equity portfolio. The increased expected return associated with the higher equity exposure also carries greater risk, and therefore, FG should not be considered a “core” holding for most investors.
We look for stocks that have an extended runway for future growth where the stock price could double over the long-run. Focused Growth typically holds between 40 and 50 stocks, and although we tend to prefer individual stocks, we will occasionally hold an exchange traded fund (ETF) if we feel that the ETF is the best way to play a trend.
Since the portfolio is constructed with stocks that have firm-specific growth opportunities rather than part of a broad market or sector call, we feel that it is best to explain FG by inspecting a sample of its holdings. Therefore, let’s walk through three stories currently in FG in order to shed light into how we analyze and subsequently include investment candidates.
Google (Ticker: GOOG)
Google’s core search business is high margin and extremely profitable, which is nothing less than “blood in the water” in the eyes of competition. For all intents and purposes, Google’s market share on internet search volume should have been competed away years ago, but it hasn’t.
Furthermore, there are effectively no switching costs associated with being a Google customer. Meaning, if a competitor came along and built a better search engine, then none of us would really lose anything by immediately switching to that competitor.
NOTE: An example of high switching costs is with Apple and iTunes. If a better iPod hit the market then many consumers would not be able to switch simply because they had already invested so much money into music and movies that only work on Apple devices.
Now Google has had its fair share of competitive attacks, most notably from Microsoft, AOL, and Yahoo!, however, each attempt at stealing material market share has failed. How can a company with high margins and no switching costs continue to maintain such dominance?
The answer lies in the fact that Google’s core competency, internet search, is incredibly sophisticated. In fact, it is so complex that in their 14-year history as a company, nobody has been able to even come close to achieving their level of success in the field.
We own Google because their competitive advantage is their people, and this is an asset that is extremely difficult to replicate. They hire the best and brightest talent, and their managers have created a culture where innovation is rewarded. Instead of resting on their laurels, as Microsoft has done since the late 1990s, they continue to deliver cutting edge products and improve upon their core search product, thus widening the gap even further from any potential competition.
Workday (ticker: WDAY)
3. This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion or our investment managers
at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no
indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private
Capital is an SEC Registered Investment Adviser.
Workday is a firm that has created easy-to-use software that manages their customers’ human relations (HR) departments. Workday is tiny compared to the incumbents, most notably SAP and Oracle, but we feel that these “800-pound gorillas” should be very worried over Workday’s explosive growth.
The old way of HR requires software to be installed within a customer’s IT network, which can take 18 months or more to be operational, and upgrades are expensive and burdensome. Workday’s solution, on the other hand, lies in the “cloud” and can be operational in a matter of weeks.
“Cloud Computing” may sound fancy, but most of us use it every day so let’s take Amazon.com as an example. A customer does not need to install software on a computer to buy from Amazon. Rather, Amazon hosts their website on servers controlled by Amazon, and customers can access their software via a web browser. Amazon makes updates to their website internally instead of having to rely on all of their customers to download and install updates.
The same principle applies with Workday. They can upgrade their software efficiently, and customers do not need to buy expensive servers to use Workday’s products. Therefore, the customer’s total cost of ownership is substantially lower.
We own Workday because they have a highly “disruptive technology” that is changing the way companies think about HR. Their management team understands the business of HR, and they continue to eat away at legacy players who appear to be doing business as usual.
Lululemon Athletica (Ticker: LULU)
Lululemon (Lulu) is a high-end retailer selling even higher margin athletic clothes. Yoga pants, for example, often exceed $100 for a single pair, yet their products are so in demand that customers will often purchase clothes for the sole purpose of flipping them on eBay for a profit.
We talk to Lulu customers regularly, and the first two questions we ask are:
1. After trying a Lulu product for the first time, were you able to go back to your old workout attire?
2. If money were no object, would you buy anything other than Lulu products?
The answer to these two questions is overwhelmingly skewed to “no.” Once customers try their products, they keep coming back for more, and this simple fact tells us that their growth is sustainable as they continue to open more stores both in the U.S. and overseas.
Furthermore, sales associates in their stores are extremely knowledgeable, and they cycle through inventory in a way where certain products are only available for limited times and quantities (this strategy creates loyal return customers who will even line up hours before a new product hits the shelves).
NOTE: Building a brand is exceptionally difficult and its success is often observed indirectly. Lulu makes clothes meant to withstand intense workouts, yet walk down the streets of NYC and you will see locals, who tend to be more style conscious, wearing Lulu products at brunch and while shopping. Lulu is no longer about looking good and performing well in the gym – it’s now become a fashion statement.
Lulu sells high quality products, their stores are brilliantly managed, and their brand is exceptionally strong. We see future growth for Lulu both here and abroad and continue to own their stock as their fundamentals remain intact.
Focus on the Fundamentals
We discussed an internet media giant, a cloud computing disruptor, and a high-end retailer, which are three very different businesses. However, the one commonality across each of these investments is that the decision to purchase each stock was purely based on fundamental factors that point to future growth.
4. This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion or our investment managers
at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no
indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private
Capital is an SEC Registered Investment Adviser.
Stock prices often rise for reasons that are not fundamentally sound, and the risk of owning such stocks is quite high. Therefore, we follow three strict guidelines when analyzing growth stocks for FG:
1. Focus on sales and earnings: Back in 1999, internet stocks were rising from unfathomable valuations fueled by irrelevant factors such as the growth in the number of website visitors, despite sales being nonexistent. Euphoria often drives stocks to meteoric highs, and when these stock prices are not supported by either sales or earnings, we choose to pass.
2. Look for sustainable growth: Growth attracts investors but it also attracts competition. Companies that grow fast must have a defensible strategy (think Google) to protect its growth or else their high valuations can compress quickly. A sharp focus on the competitive positioning of a company and proper financial management is critical to sustain high growth.
3. A path to profitability: How a growth company spends capital is important to monitor because they may spend in ways that are less than optimal, which can hinder future growth or require additional capital. It is important to ensure that as the company spends to fuel growth that there is a viable path to profitability at some point in the future.
The bottom line is that we look for companies whose stocks can double but also are valued based on sales and/or earnings, because in the long-run, valuation is dependent upon one or both of these metrics.
Implications for Investors
We continue to believe that we are at the beginning of a secular bull market that could persist for several years, delivering steady equity returns along the way. However, given that stocks are trading less as a group and more on individual merits, capturing gains from a bull market will require a change in strategy.
Whereas index funds benefitted from the high correlations in the markets over the past three years, we expect these funds to come under pressure as the dispersion in performance of the stocks within them rises. Simply put, the strategy of buying an S&P 500 index fund and holding it will likely deliver less than impressive returns.
Active management should continue to come back, however, certainly not all managers will outperform. Given that we are long-term fundamental investors, we will continue to look for stocks where the valuation is driven by sales and/or earnings. The stocks that get headlines because they pop 50%+ in a day may be exciting to watch, but we prefer to focus on risk-adjusted returns.
Lastly, the risk of owning a pure equity portfolio tends to be higher than a more balanced one, so we strongly urge consulting your advisor before considering an investment in Focused Growth.