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Investing
in the small-cap sector requires
industry and company knowledge.
In addition, investors have
to be nimble and ready to
withstand daily trading volatility.
Investors in Delaware Trend
Fund have enjoyed steady returns
over the last several years.
In the following paragraphs
you will learn how Lori Wachs
and her team work with the
goal of achieving consistent
returns.
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Q: Would
you start by giving us an
overview of your investment
style and general philosophy?
A: We are
a small-cap growth fund that
invests in rapidly growing
companies that we have identified
as being the leaders in their
respective industries. The
fund uses a team management
approach with dedicated specialists
in four broadly defined sectors:
technology, business and financial
services, healthcare, and
consumer. Each sector has
a team of two people that
is responsible for all the
investments within that sector.
The teams
are charged with identifying
strong, fast-growing companies
in fast-growing industries.
Before a stock is recommended,
the team conducts detailed
fundamental research on the
company and the specific sub-sector
of the industry where it competes.
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Q: What
criteria do you use to identify
a fast-growing company and
how large does a company have
to be for it to be included
in your small-cap universe?
A: Since
the definition of “fast growing”
varies by sector and sub-sector,
as well as over time, each
team has its own yardstick.
For the consumer sector, we
generally look at companies
that have top and bottom line
growth of at least 20%.
Within
the consumer sector, you don’t
get really crazy swings in
valuations even when a stock
is doing well relative to
its industry. For a 25% growth
rate, you may get 25 times
earnings when the sector is
in favor.
In the
financial services area, you
don’t find companies with
growth rates that are that
high - especially in banking.
But if you look at smaller
niche areas, you can sometimes
find financial-related companies
that have nice growth rates.
One metric
we use across all sectors
is enterprise value: how much
would the reasonable investor
pay for this company? That
is an important determinant
for us in evaluating companies.
Another test we use is free
cash flow. We look for companies
that have a strong enterprise
value-to-cash flow ratio.
In terms
of size, we consider companies
with market caps less than
two billion dollars to be
small caps. We may go as low
as 400 million dollars, but
for many obvious reasons that
is about as low as one would
want to go.
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Q: Could
you explain a little bit about
your investment process and
how you select a specific
stock from among 10 companies
that are growing at a 20%
rate?
A: We look
for companies that are not
only growing rapidly, but
are also leaders in their
respective industries. That
leadership could be based
on a superior product, a proprietary
technology, or even unique
services offered. The company
should have strong market
share in the industry, and
market share should be increasing.
In the
retail space, we look for
companies offering unique
and differentiated products.
For example, there are many
companies appealing to the
teenage dollar, but we are
putting our bet on companies
like Urban Outfitters that
offer a unique shopping experience
and proprietary products.
We also
look for companies that successfully
erect barriers to entry such
as companies that have insulated
themselves from Wal-Mart because
it’s very difficult to compete
with Wal-Mart.
Look at
the difficult time the supermarket
industry is having. We focus
on the long-term outlook for
companies rather than how
they are currently performing.
We try to determine how the
companies will perform over
a 3-5 year time horizon.
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Q: Once
you have identified companies
that meet your requirements,
what is the catalyst that
drives your decision to buy
or sell?
A: By the
time we are satisfied that
a company is fully qualified,
the team has already accumulated
a substantial amount of background
information, research, and
related analysis on the company.
That information gives us
a solid basis from which to
decide if their top line or
bottom line is fully reflected
in the multiple. If we think
they are close to a peak,
we will watch from the sidelines,
but if we believe that they
have the potential to increase
growth, we may bite.
We also
use various technical tools
to help us in the buying decision.
Our trading teams are very
experienced in the growth
space. They are on top of
the markets and very good
at helping select the best
points to buy and sell.
While we
use computer modeling, we
don’t rely on models to make
decisions. Instead, we develop
our own sense of what is likely
to occur, and use the model
results as a reality check.
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Q: Turning
now to your research process,
most managers seem to start
with a screening procedure
supplemented by fundamental
research to generate a primary
buy list. Is your process
similar to that?
A: No,
we do not use screens. Instead,
we rely on the experience
of our team members. They
have been working in their
area of expertise long enough
to intimately know all the
companies in that space. They
talk with analysts, attend
conferences and IPO meetings
and are on top of what is
happening in the industry.
While the team members each
follow an extensive list of
companies, they don’t need
a screen to identify the ones
that are interesting.
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Q: What
happens when there is a disagreement
within the team whether to
buy or sell a stock?
A: Within
each team there is a very
healthy level of respect for
each member’s views; but there
are certainly times when one
of us will feel more strongly
about a particular decision
than the other. In most cases,
we generally go with the person
who has done the work.
We always
have two people covering each
sector and often they will
have differing views. Our
experience has been that having
someone challenge your views
usually results in better
decisions. Ultimately, it
is the chief portfolio manager,
Jerry Frey, who is responsible.
He continuously monitors the
process and makes sure it
runs smoothly. Jerry has a
strong background in the healthcare
and technology sectors.
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Q: There
are two kinds of structures
that I have seen in fund management
companies: one where the analysts
do their work and make a case
to the portfolio managers
who make the buy and sell
decisions, and one where the
analysts are the portfolio
managers and make the decisions.
Which structure most closely
describes your team approach?
A: Before
we put our team structure
in place, our process was
similar to your first case.
We had a group of analysts
who were trying to find ideas
to pitch to one of the portfolio
managers. It was the portfolio
manager who would decide if
the name went in or out, and
the analyst lost ownership
of the name at the playing
time. Our current process
is just the opposite.
We have
eight people conducting research.
Six of the eight act as both
portfolio managers and analysts.
Two are analysts working with
the portfolio managers. Everything
about the consumer sector
is completely controlled by
the two portfolio managers.
The team as a group conducts
the research, works closely
with the traders, monitors
positions, and decides what
to buy or sell. Overseeing
the process is someone who
makes sure the process runs
properly. In addition to playing
that role, Jerry also is responsible
for diversification and risk
management. He acts like a
traffic cop to make sure that
the portfolio meets its diversification
objectives and is in line
with the portfolio’s benchmarks.
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Q:
Is this fund measured against
any specific benchmark or
yardstick?
A: We use
the Russell 2000 Growth Index
as a benchmark.
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Q: Would
you describe and discuss your
approach to diversification?
A: We generally
diversify along the broadly
defined sectors. Since we
use a bottoms-up approach
and are not tied to a specific
sector, the names we own tend
to be spread out among the
sectors. We strictly adhere
to our 5% rule — no more that
5% of the portfolio can be
held in a single name.
Distribution
among the sectors and sub-sectors
varies from month to month.
We look at the returns by
sector on a daily basis, and
run a very detailed report
by sub-sector weekly using
weighted returns. We want
to know if our performance
is the result of stock selection
or sector selection.
We normally
average about 80 stocks in
the portfolio and have a turnover
rate that is more than 70%.
“We strictly
adhere to the 5% rule meaning
that not more that 5% of the
portfolio can be held in a
single name.”
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Q: To
better understand your approach,
could you give a couple of
specific examples of how you
picked a specific stock, what
thinking went into the selection,
what happened with the stock,
and then how you ended up
selling it.
A: An example
in the consumer sector might
be Coach (COH). At this point
we still have the name in
our portfolio, so I don’t
have the end of the story
yet. We first saw the company
presented at a conference
three years ago. The company
had been spun out from Sara
Lee a few months before. They
were transitioning into a
fashion accessory business
and had just launched their
first logo collection. Within
a few weeks of opening the
line in Japan, sales of that
line had grown to 10% of their
total sales. We saw the potential
of the line as they moved
into their other markets,
and believed that it should
be able to really move the
needle. It has proven to be
one of the great success stories
in retailing in recent history.
While we
did not predict how successful
the company would be, as the
story unfolded, each step
got better and better. They
keep expanding market share
tremendously and widening
their appeal all the way from
teenagers to grandmothers.
They have designer customers
that are trading down to their
bags, and customers that don’t
typically go into the affordable
luxury space trading up.
The company’s
operating margin is more than
30 percent and continued growth
has given it increasing economies
in scale. They still have
a lot of room to grow. Even
in Japan, where they grew
85% last year, they still
only have a 4% market share.
The company believes they
can expand that to an excess
of 10% market share.
So at this
point the stock has done well
and has very healthy multiples;
but you pay for scarcity value.
There is not another consumer
product company out there
that has margins over 30%.
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Q: And
why do you continue to own
it?
A: When
we look at the continuing
sales growth and see numbers
in the high 20s and lower
30s, it suggests the company
still has tremendous momentum
behind it. We have seen their
new collections and feel that
they should resonate well
with customers.
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Q: Do
you have an example in the
non-retail sector?
A: Protein
Design Lab (PDLI) in the biotechnology
industry would be a good example.
The company specializes in
monoclonal antibodies. While
they didn’t have their own
pipeline, they had the technology
to humanize antibodies. It
is a company that we believe
has a terrific future. Historically,
antibodies used in the manufacturing
process were from mice and
can sometimes cause an adverse
reaction because they weren’t
human. Protein Design Lab’s
technology humanizes the antibodies
to make them acceptable to
humans.
Although
the stock had a good run back
in 2000 when it peaked just
above $80, it has been below
$20 recently. Many investors
gave up on the company and
were not willing to wait the
years necessary to bring a
product to market, but they
were shortsighted. While the
company doesn’t have its own
drug yet, it has been using
its technology in partnership
with other companies. They
receive a royalty on drugs
that are developed using their
technology. One drug that
has recently been approved
is Avastin, which is a colorectal
cancer drug developed by Genentech.
While PDLI gets only a small
royalty, it goes right to
the bottom line.
PDLI is
also working on their own
pipeline. They have a few
early stage drugs that are
promising but it will take
a long time to determine their
value.
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Q: Maybe
you could describe a stock
for which you had high expectation
that did not work out, and,
specifically, how you reacted
to the situation?
A: Often
times we take a long-term
approach and hold on to stocks
even though they are not performing.
But when it is clear that
the company’s situation has
changed, we don’t hesitate
to sell.
A good
example would be American
Italian Pasta. They are a
pasta manufacturer, but don’t
run restaurants. They recently
gave guidance that their outlook
had become cloudy due to the
low carbohydrate diet craze.
We had already started questioning
the potential impact of low
carb diets, and the management
warning was icing on the cake.
We sold out. While we still
believe in the company, we
just felt that there was a
better place for our clients’
money than waiting for the
diet craze to end or for the
company to reinvent itself.
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