Q: Would you tell us about the history and the mission of the fund?
A: During the past 20-plus years, Judy Vale and Bob D’Alelio have been the fund’s co-managers, employing a consistent investment philosophy and process. We have a well-resourced and experienced team, with nine individuals who, on average, have more than 20 years of industry experience
Our investment philosophy is based on applying a consistent approach to high-quality investing across market cycles. We use a research-intensive process that ensures a thorough understanding of not just prospective holdings, but even those that have been in the portfolio for several years. The process continues to be refined, and is repeatable.
We believe frequent contact with management teams is crucial to the process and truly sets us apart from our peers; in a typical year, we have over 300 direct interactions with the companies we own or are considering for the portfolio. Ultimately, our goal is to find high-quality businesses that we believe can grow their earnings on a sustainable basis.
Q: What core principles guide your investment philosophy?
A: The fund seeks to deliver superior, risk-adjusted returns on a long-term basis. We focus on companies with consistent and solid free cash flow generation, high returns on capital, and strong balance sheets.
First, companies that generate consistent and solid free cash flow are attractive because they can self-fund their operations and growth. This is critically important for smaller businesses which do not always have easy access to the capital markets like their larger-cap peers might have. Consistent free cash flow can also add to a company’s sustainable returns through tuck-in acquisitions, share repurchases, and dividends.
Second, businesses with high returns on capital typically have business models that are differentiated – products, services, or offerings that have meaningful barriers to entry. Such companies are in a better position to deliver sustainable growth.
Third, companies with strong, conservative balance sheets are in position to enhance shareholder returns through acquisitions, share repurchases, and dividends. Conservative balance sheets also mitigate the downside risk if our fundamental analysis proves to be incorrect.
Our high-quality approach means we often trail in up markets. However, we have tended to outperform meaningfully in down markets, and have historically generated positive relative returns through full market cycles.
Q: Would you describe your research process?
A: We combine both a macro view and bottom-up approach. Our macro view shapes our view about sector positioning. For instance, in 2005-2006, the portfolio was underweight financials due to our concerns about bank underwriting standards as well as a bubble in the housing market.
There are some sectors we avoid because they are inconsistent with our investment philosophy. We do not own small-cap biotech companies because they are speculative in nature, are generally unprofitable and need access to the capital markets. Also, we generally do not buy real estate investment trusts (REITs) because they typically need continuous access to the capital markets and their business models are often not particularly differentiated.
Most of our research and focus is on bottom-up analysis; the majority of our time is spent analyzing individual securities in the portfolio as well as prospective names, through reading, analyzing, modeling, and extensive meetings with company management.
Our research process is quite intensive. Before putting a new idea into the portfolio, we will examine the company’s relevant SEC filings (the 10-Ks, 10-Qs, and the proxy statements), read transcripts of recent earnings calls, and look at any investor presentations the companies might have. We build models that forecast what we estimate to be the company’s sustainable earnings and cash flow growth.
Meetings with senior management are critical to the research process, as they allow us to thoroughly pressure test all elements of the investment thesis. We go through each segment of a company’s overall business to understand long-term growth, competition, profit margins, free cash flow, and how the free cash flow as well as balance sheet might be used.
These conversations also provide us with vital information about how management views their business model, risk factors, capital allocation, and shareholder interests.
Finally, time is spent on understanding the metrics used to determine management compensation. Are they measured simply on top-line and bottom-line growth? Or are their financial rewards also based on a return-on-capital metric?
If an idea gets into the portfolio, we continue to examine our investment thesis over time. It is not unusual for us to meet with companies in the portfolio multiple times in a year.
Q: Would you cite an example to illustrate the process?
A: Pool Corporation, one of our top-ten holdings, is a good example. Pool is a boring company with a very powerful franchise.
The company is the leading wholesale distributor of swimming pool supplies in the U.S. With roughly a 45% market share, Pool is 10 times larger than the next biggest player. The company has been able to consistently increase revenue at a mid- to high-single digit rate, increase operating profit at a mid-teen rate, and over the last six years, earnings-per-share growth has been close to 20%.
Pool is a classic example of what we want to own in our portfolio. The company is a dominant player in a growing market, and has a durable business model with significant recurring revenues – 80% to 85% of its revenues are recurring in nature.
Even though we have owned this company since 2011, we spoke with the CEO a few weeks ago and met with its CFO in our offices last week. We stay in close contact to always make sure we understand what we own, and remain comfortable with the investment thesis.
Q: What kind of barriers to entry does a wholesaler like Pool Corporation have?
A: In this case, the barriers are largely related to its scale advantages. From a purchasing standpoint, the company can buy product more cheaply than any competitor. With its leading market share and greater resources, Pool can also provide services to customers that no one else can.
For instance, Pool can offer merchandising programs to its retail customers. The company can help its retailers understand how to better allocate shelf space to products or provide them with IT systems to more efficiently manage their inventory.