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Mutual Fund Q&A: 
Durable Franchises
William Blair Mid Cap Growth Fund
Management: Robert C. Lanphier

Author: Manish Shah
Last Update: 3:23 PM ET December 23 2011


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What makes investing in midcaps especially lucrative is the prospect of growth for years to come that many companies in this sector possess. What is more, they also have the financial wherewithal to realize this potential. Robert C. Lanphier and David Ricci, portfolio managers of the William Blair Mid Cap Growth Fund, invest in favorably priced companies that are structured and positioned to deliver earnings growth for at least three to five years ahead.

 
Q:  What is the history of the William Blair Mid Cap Growth Fund?

A : Robert Lanphier was one of the three co-founders of the William Blair Mid Cap Growth products in 1997, and David Ricci joined the firm in 1994 and has been a Mid Cap Growth team member for six and a half years.

The Mid Cap Growth product became a more broadly available mutual fund on February 1, 2006. Our goal is to build a portfolio of companies that are enjoying sustainable earnings and sales growth and are valued between $1.5 billion and $18 billion.

Currently, the mutual fund has $135 million and the midcap investment strategy has $2.7 billion in assets under management.

With the help of the investment philosophy and stability of the organization, we have managed to attract and retain talented analysts over the last 14 years, many of whom are focused on the same strategy and market sector. In addition, our network of contacts in the industry and the strict adherence to our philosophy have helped us develop our investment knowledge.

Q:  What are the advantages of investing in midcap companies?

A :
Over the last three decades, the midcap sector has been a source of outperformance vis-à-vis the broader market on the back of superior earnings growth. We believe that on average midcap companies have opportunities to grow at a faster rate.

Midcap companies can be great investment vehicles for investors seeking a fund with above-average return possibilities without bearing the risk of small caps. Also, the midcap space can provide them with returns that are higher than large companies or broader market indexes.

What is more, midcap companies generally have a breadth of management and can have strength in the balance sheet. Small caps have binary fates. For instance, a small biotech company may be dependent on any one event such as a successful phase III clinical trial in order to move to commercialization and prosper, or it may go out of business if the trial fails.

Midcap companies, on the other hand, tend to have a diversified customer base and tend not to be dependent on a specific product. They generally have a broad presence in many parts of the United States or in some cases even worldwide.

Q:  How would you describe your investment philosophy?

A :
We are traditional quality growth investors. We look for companies that can not only grow at a faster pace than the average company, but also sustain that earnings growth for a longer period.

There are three places where we find opportunities to generate additional returns by exploiting market inefficiencies. First, we look for companies that are growing but where investors are not focused on earnings beyond the current year. Second, we search for companies that are out of favor as a result of short-term issues. And lastly, we aim to discover companies that are on the cusp of becoming more well known to Wall Street as quality growth investments.

As a general rule, Wall Street is obsessed with the earnings growth in the next quarter and at the best in the next 12 months. However, we believe that it is much more important to focus on the earnings growth over the next three to five years, especially starting from the second year onwards. In our opinion, investors pay less and less attention to the longer-term sustainability of earnings, which we call a time horizon inefficiency.

Thus, while Wall Street is focused on short-term earnings, we are more concerned about the durability of the earnings in the medium to long term. We can exploit this inefficiency in the market by focusing on companies that have durable franchises rather than looking at the current darlings as perceived by Wall Street.

To better illustrate how we consider the long-term sustainability of earnings, I would like to cite an example of a company called Netflix, Inc. It is an Internet subscription service streaming television shows and movies.

When we looked at Netflix a couple of years ago, we were very impressed with its highly differentiated DVD-by-mail rental model and the way the company was aggressively addressing the shift to online digital streaming. Still, we were not impressed by the sustainability of the model once it got to streaming, because we were concerned about the new competition from Amazon.com, Inc., Google Inc., and Microsoft Corporation. We felt that Netflix would not have a differentiated offering and ultimately the cost of its content would be bid up as the company started facing more competition for content. On the whole, we were not convinced that the profitability of the streaming model was sustainable.

As far as out-of-favor companies are concerned, we generally scour our investable universe for names affected by temporary issues that put off investors. We strive to find companies that have a durable franchise but are suffering from transient issues related to markets, products, or customers. However, if we believe that the long-term viability of the franchise is intact and the valuations are favorable, we will often purchase them.

Lastly, we also look for quality growth companies that are not only likely to sustain their growth in the next few years but may enjoy accelerated earnings growth as well. Since such companies either have undiscovered catalysts in place or are not that well understood by investors, they happen to be on the cusp of delivering higher earnings growth. We will certainly follow this kind of company and try to learn the hidden strengths that the market has not discovered or understood yet.

Q:  How do you identify a durable business franchise?

A :
We define durable business franchise as a business with strong management, a sustainable business model, and solid financials.

When evaluating the management team, we look qualitatively at management’s record of success, its alignment with shareholders, and whether it has significant equity ownership. We assess qualitative aspects of that management team in terms of its proven ability to reinvent the company, whether there are signs of a solid corporate culture that will sustain it in good and bad times, and whether it is building a leadership team below the top executives that should be able to execute against those growth goals. Those are the types of characteristics we take into account when assessing a management team.

In terms of the business model, we look for a very open-ended market opportunity. We prefer companies that are leaders or emerging leaders that have clearly differentiated and value-added products and services, preferably with high barriers to entry, which permits the company to have some flexibility on the pricing front.

And then, within financials, we scour for high returns on capital, superior cash flows, and recurring revenue models. We have a preference for more predictable earnings.

In addition to the balance sheet and low debt, we also look at high return on capital invested before putting all that together to make a qualitative assessment of whether this company has a truly durable franchise that can sustain earnings over the long haul.
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