Strategy spotlight. Q&A with Mike Smith: Reflecting on one year at the helm. Fundamental Growth Equity. Wells Capital Management.

Transcription

1 Wells Capital Management Strategy spotlight Fundamental Growth Equity June 2017 Q&A with Mike Smith: Reflecting on one year at the helm through the period. We operate around core values that emphasize collaboration, honest communication, unity, and, above all, putting the client first in everything we do. Some outside of our group were watching for shifts in style or execution, but we chose to intensify the focus on our core strengths. We were extremely motivated to prove to ourselves and to the investment community that our existing people, applying the same investment process, could achieve superior results for our clients. Mike, a year has passed since you became managing director and senior portfolio manager of the Fundamental Growth Equity team. Can you share your thoughts on this experience? First off, time has really flown by! The support we ve received from so many people has really made the leadership transition feel seamless. On a more personal level, I have often felt gratitude toward my teammates and a great sense of excitement. I had worked with my predecessor and mentor, Tom Pence, my entire investing career. Over the course of nearly twenty years, he frequently gave me a variety of opportunities to take on leadership and portfolio management responsibilities. I am now particularly appreciative of how those experiences prepared me for this opportunity. I should add that Tom and I continue to be close friends. We also received tremendous support during the transition from our parent, Wells Fargo Asset Management (WFAM). From the start, senior leaders at WFAM expressed confidence in our team and backed it up with the firm s resources. The client facing professionals across the organization also rallied behind us and communicated very effectively with our clients. The power of the platform was on full display, allowing our team to stay laser-focused on managing portfolios. Yet, beyond my personal observations of the past year, I believe this transition has really showcased the strength of our team and investment process. Efficient execution is critical to meeting clients objectives and does not rely on any one individual. We ve always said the star of our team is the investment process. The last year has once again proved this to be the case. Tell us more about how your team responded to events of the last year? Considering that the leadership transition occurred in the midst of a challenging market environment, it s fair to say we faced some adversity. There are a number of ways an outside observer might have expected the team to respond, but I was confident that the strength of our culture would provide the focus and cohesion to guide us Chris Warner, in particular, has been a vital part of this transition. Chris is an astute, decisive investor who, after several years co-managing our Mid and SMID cap growth strategies, was elevated to portfolio manager on all strategies. Like me, Chris was promoted from within the ranks of the team after spending several years as a research analyst. So, from a leadership standpoint, Chris and I have both walked many miles in the shoes of most everyone on our team. While there are clear delineations among roles, Chris and I have always put a high value on working collaboratively with our analysts. Working in the trenches doing bottom-up research is the backbone of our process, and the leaders of this team have always been passionate about doing it. I think the familiarity of working together and executing upon each step of our investment process has made for a really smooth transition. Furthermore, it s been a great opportunity for professional growth for everyone involved. Though the investment process is well established, did you identify any areas for enhancement or improvement? There are key aspects of our investment process that are timeless. But, for the last 20-plus years, our team has prided itself on striving for continuous improvement, and the last 12 months have been no different. Any enhancements or changes we make will always be evolutionary in nature. This is in recognition that any investment process must be adaptable to changing conditions for it to remain successful. I think this translates into a need to consider all tools and ideas that can enhance how we serve clients. The leadership transition gave us a chance to take a fresh look at ways to improve execution. A key realization from this review was that some complexities to our business had built-up over the years. I m a big believer in simplification, so, to the extent we could reduce complexity, streamline communication, and play up our existing strengths, I felt our clients could experience stronger investment results. For example, feedback from our internal portfolio risk management and analytics team revealed a historical pattern of positive contribution from our highest quintile of active positions, but less consistent alpha generation from our smaller active weights. By modestly pruning the

2 name count and boosting concentration at the margin in our higher conviction names, we felt we could improve the overall risk/reward profile of the portfolios. We ve also evolved from a product standpoint by closing an incubated global growth portfolio and launching the Fundamental Small Cap Growth Equity strategy, which we are very excited about. We have a long history of success with the Fundamental SMID Cap Growth Equity strategy and felt that extending these capabilities further into smaller capitalization names was a natural extension of the team s core strengths. We consider both of these decisions simplifications that have more closely-aligned our investment process with our product offering, and which ultimately will benefit our clients. Let s turn to the investing landscape was a challenging year for bottom-up fundamental mangers with macro and political events dominating headlines. Yet 2017, so far, has seen a strong rebound in growth stocks in general and your portfolios in particular. How do you feel your team has navigated this environment? I think it s safe to say the last 18 months has been a healthy stress test of our process. Calendar year 2016 was unusual, bookended with vastly different macro and political conditions. The year started heavily risk off based on fears around a hard landing in China, followed by a calmer period of climbing the Brexit wall of worry, and then ending on the Trump reflation beta rally that took us through year-end. These events represented three unique market environments within the course of one year! Exhibit A: Forward P/E ratios of growth stocks near historical lows Fwd P/E Spread, Growth vs. Market '80 '84 '88 '92 '96 '00 '04 '08 '12 '16 Source: JP Morgan US Equity Strategy & Global Quantitative Research. Top quintile forward P/E spread minus Median forward P/E spread of S&P 500 Index constituents, January 1980 through February A key test for us occurred during the post-election rally. Trump s surprise victory temporarily made darlings out of companies with high tax rates, domestic sales, and high regulatory burdens, pushing valuation multiples of higher growth stocks to historical discounts (Exhibit A). While it was frustrating to end the year behind benchmarks, we wrote to clients cautioning about reacting to this speculation. We spoke extensively about the strong fundamentals of our holdings, and how the Trump trade had left our portfolios with attractive valuations. We described many holdings as beach balls held under water, and believed that once the election sentiment shifted, they would float back to the top. It turned out to be an unusually good set up to end the year, but one that tested our patience and discipline. That patience has been rewarded in 2017, particularly so in our SMID Cap Growth Equity strategy (Exhibit B). As political reality set-in and growth expectations moderated, equity market leadership has rotated back to companies with durable fundamentals. Most notable was the return of the market s appreciation for stocks in the information technology sector. Earnings growth has been very strong, which investors just could not ignore any longer. Exhibit B: SMID Cap Growth Equity composite performance As of May 31, 2017 (%) YTD 1 YR 3 YR 5 YR 7 YR 10 YR Fundamental SMID Cap Growth Equity (Gross) Fundamental SMID Cap Growth Equity (Net) Russell 2500 Growth Source: Wells Capital Management. Performance is preliminary. NOTE: The complete GIPS compliant presentation can be found at the end of document. While I m pleased so far, we still have a long way to go. There s been a peculiar development I ve had my eye on recently both investor optimism and uncertainty are rising together. This is unusual and not likely sustainable, so I expect volatility to edge up. Our approach, as always, is to remain extremely focused and use our core investment discipline as our guide through periods of uncertainty. Looking forward, what are some themes that you expect to play out favorably for your portfolios? Scarcity is a key theme we have conviction in. Before I discuss why, let me paint the backdrop for equity markets in general. From a high level, I think there are reasons to remain constructive. Bull markets usually end from inflationary pressures or recessions. Neither seem likely in the near-term, which is generally supportive of equity multiples. For the time being, inflation expectations have overcome deflationary fears. An environment marked by steady, if unspectacular, earnings growth and modestly higher interest rates seems plausible. This might result in an elongated business cycle, extending the allure of equities as an asset class. It does not, however, look like we are entering a new phase of sustained, high levels of global growth. Recent market data indicate as much, with interest rates falling and much of the reflation trade unwinding. There are real improvements in some foreign economies, but off a base of low expectations. Against this global backdrop, the U.S. economy does seem poised to expand, but at more sluggish rates than many of us would like. 2

3 My main point is, in this tepid macro environment, there are fewer companies that can produce strong organic growth (Exhibit C). I think the market is starting to look past companies whose growth may have been engineered. So it seems rational to us that the companies with truly innovative products and secular growth opportunities those companies that can grow in spite of cyclical conditions should command a scarcity premium. Exhibit C: Scarcity of growth Number of S&P 500 stocks with top line growth greater than 15% (5 yr) As is normal, we have identified a number of unique, pro-cyclical Developing Situations, but we are more constructive on the secular growth found in Core Holdings. This theme is currently expressed by our positioning in certain e-commerce, global digital payments, online advertising, video gaming, and cloud software holdings. In many of these companies, there is an attractive gap between our expectations for future growth and what is priced into current valuations. We have an investment process built around exploiting that gap, with discipline, one stock at a time. We are determined to seize opportunity for our clients! Thank you Mike! Source: Cornerstone Macro, October

4 GIPS compliant presentation Period Gross Annual Net Annual Primary Index Comp 3 Yr Primary Index Internal Number of Composite Total Firm Return (%) Return (%) Return (%) Std. Dev. (%) 3 Yr Std Dev (%) Dispersion (%) Accounts Assets ($-mm) Assets ($-mm) , , , , , , , , , , , , , , , , ,912 Primary Index = Russell 2500 Growth 1. Wells Capital Management ( WellsCap ) claims compliance with the Global Investment Performance Standards (GIPS ) and has prepared and presented this report in compliance with the GIPS standards. WellsCap has been independently verified for the periods from January 1, 1997 through December 31, Verification assesses whether (1) the firm has complied with all the composite construction requirements of the GIPS standards on a firm-wide basis and (2) the firm s policies and procedures are designed to calculate and present performance in compliance with the GIPS standards. The Fundamental SMID Cap Growth Equity Composite has been examined for the periods from December 1, 2000 through December 31, The verification and performance examination reports are available upon request. 2. WellsCap is a registered investment adviser and a wholly owned subsidiary of Wells Fargo Bank, N.A. Since the firm s creation in 1996, the firm has acquired a number of investment teams and/or assets through mergers and acquisitions. These include assets and/or investment teams from Norwest Investment Management Inc., Sutter Advisors, LLC, Montgomery Asset Management, Benson Associates, Strong Financial Corporation, Evergreen Investments, First International Advisors, LLC, Metropolitan West Capital Management, LLC, EverKey Global Partners and ECM Asset Management Limited. In addition, Analytic Investors, LLC was added to the firm at close of business March 31, In all cases, the investment teams involved in each acquisition and merger remain autonomous teams within WellsCap. 3. The Fundamental SMID Cap Growth Equity Composite ( Composite ) includes all discretionary accounts managed in this style. The Composite contains accounts investing primarily in the equities of small and medium capitalization securities that trade at reasonable valuations. Accounts in the Composite will typically invest the majority of assets in securities within a market capitalization range between $50 million and $10 billion dollars. Investment results are measured versus the Russell 2500TM Growth Index. On March 21, 2011, James Leach, Co-Portfolio Manager, left Wells Capital Management. Effective May 26, 2016, Michael T. Smith, co-portfolio manager, became the senior portfolio manager for the Fundamental Growth Equity team. Thomas J. Pence, former lead portfolio manager, remained as a senior portfolio manager thru August 31, 2016, and left the firm on September 30, 2016.The Composite creation date is The Composite inception date is December 1, Composite returns are net of transaction costs and non-reclaimable withholding taxes, if any, are expressed in US dollars, and reflect the reinvestment of dividends and other earnings. Gross composite returns do not reflect the deduction of investment advisory fees. Net composite returns are calculated using a model investment advisory fee, which is the maximum annual advisory fee based upon the fee schedule in effect during each respective performance period. Any changes to the fee schedule are reflected in the calculation of the net composite returns beginning with the period in which the fee schedule is revised. Actual fees may vary depending on, among other things, the applicable fee schedule and portfolio size. WellsCap s fee schedules are available upon request and may also be found in Part 2 of Form ADV. The published fee schedule for this strategy is 0.95% for the first $25mm, 0.85% for the next $25mm, 0.80% for the next $50mm and 0.75% over $100mm. Additional information regarding WellsCap s policies for valuing accounts, calculating performance and preparing compliant presentations are available upon request. 5. Internal dispersion is the equal weighted standard deviation of the annual gross returns of all accounts included in the composite for the entire year. For years where there are 5 or fewer accounts in the composite for the entire year, dispersion is not presented as it is not a meaningful statistical calculation. The 3-year annualized standard deviation measures the variability of the gross composite returns and the index returns over the preceding 36-month time period. 6. Index returns are provided to represent the investment environment existing during the time periods shown and are not covered by the report of independent verifiers. The Russell 2500TM Growth Index measures the performance of the small to mid-cap growth segment of the U.S. equity universe. It includes those Russell 2500TM Index companies with higher price-to-book ratios and higher forecasted growth values. For comparison purposes, the index is fully invested, which includes the reinvestment of income. The returns for the index do not include any transaction costs, management fees or other costs. 7. Actual performance results may differ from composite returns, depending on the size of the account, investment guidelines and/or restrictions, inception date and other factors. Performance for some accounts in this composite may be calculated by third-parties that use different security pricing and performance methodologies. Past performance is not indicative of future results. As with any investment vehicle, there is always the potential for gains as well as the possibility of losses. Our registration as an Investment Adviser does not imply any level of skill or training. For a complete list of WellsCap composite descriptions, please see 4

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