Tech Leaders on a Profitable Path
Wells Fargo Specialized Technology Fund
Author: Ticker Magazine
Last Update: Jan 23, 10:38 AM EST
|Managing a tech fund out of San Francisco has indisputable advantages owing to the eco system of information on new advances in technology. At the helm of the Wells Fargo Specialized Technology Fund, Walter Price invests in leaders with a portfolio focused on growth, value and GARP stocks in which the path to profitability is clear and the profit potential is substantial.
“We aim to capture the growth of the segment through the leader, because the leader tends to gain share over time both in consumer and enterprise technology. Even if the leader is priced with a premium to the second or the third company, we would pay more to capture that subsector growth.”
I would use the example of Okta, a San Francisco-based company, which makes sign-on systems for computers and user identification systems.
I was not convinced initially, because Microsoft Active Directory had 90% of the sign-on business and was moving it to the cloud. Okta clearly saw opportunities in coordinating the identity and the security associated with moving to the SaaS world. There are SaaS companies, which are not comfortable sharing their Internet sign-on details and software with the competitor Microsoft, so there was a need for a neutral party.
Okta had relationships with hundreds of SaaS companies. When adopting the Okta system, a company can use it with any SaaS vendor, so it made life simpler in terms of IT. We started monitoring the company and then the story grew more interesting because of the change in the security world, which played well with the single sign-on concept. Companies need to understand the security and to know exactly whom they are giving access to their data. So Okta evolved into a security company, while still being a single sign-on company.
Q: What other factors influenced the decision to invest in Okta?
The competitive landscape is another important factor.
Understanding how the company competes and fits in the landscape is an important part of our process. We dig deeply; we don’t just visit the company, but we also talk to customers and competitors. We have a grassroots organization that does parallel customer research. These are some of the elements of our fundamental research work.
Q: How do you justify owning the stocks of companies that are not profitable?
We have to understand the longer-term potential, model and valuation. The key aspect is to understand the path to profitability and the size of the potential profitability, so we develop different scenarios. However, that issue is less relevant today because these companies are starting to make money and their business models are becoming clearer.
Overall, we try to find the stocks that we believe in and we trade them depending on the circumstances, their profitability, and the supply/demand aspects of the stock price. When evaluating the stock price, we develop our own earnings forecast and examine it relative to other people’s forecast. The stock position is based on psychology and fundamentals, but the fundamentals are the main driver of our long-term core positions.
We build our own revenue model and then we examine how profitable that revenue will be, what free cash flow the company will be generating, what multiple can we expect and what the target price is. If there is a big gap between the target price and the current price, we consider if we are too optimistic or if there is a lot of appreciation potential.
Q: What is your portfolio construction process?
We manage a focused portfolio of 50 to 100 stocks. We aim to own the best company in an industry or a theme, but we may have several companies in the same theme if they are differentiated enough. We aim to beat the tech benchmarks over time through buying higher-growth companies at reasonable valuations. At this point, only 20% of the tech companies are growing over 15% a year, so our investable universe is a small percentage of the tech universe.
Once we decide that we like a company, we overweight the stock compared to the benchmark. Amazon and Microsoft represent large portions of our portfolio, because they are large portions of the benchmark and because we like them more than we like the index or other companies. Overall, we aim to overweight the companies, if the portfolio constraints allow it, because we are aware that we need larger positions in the favored companies to beat the benchmark.
The idea is to build a portfolio of great companies, so our research and portfolio construction processes are about positioning us in areas with significant potential appreciation over the next few years, not just over the next six months. My partner Huachen Chen, who is an expert at evaluating near-term supply/demand, forecast and recent stock performance, makes tactical adjustments to the positions to further enhance the returns.
Q: When would you decide to sell a stock?
A key reason for selling a stock would be the sector dynamics. For example, the semi-conductor industry is 6% of our portfolio, while a year ago it was 30% and two years ago it was 11% of the portfolio. There are cyclical supply and demand trends that cause semiconductor stocks to be volatile and to be in and out of favor. Fundamentally, we like the sector, but we understand the cyclical influences. If we believe that the sector is going to underperform, then we will take it out or take it down relative to the benchmarks.
Another reason to revisit some of the higher-growth companies is valuation. Overall, we consider the limits, the valuation, the price targets and where the stock is compared to the intermediate-term price targets. Then we consider the cycles and the relatively advantaged and disadvantaged companies.
Q: How do you define and manage risk?
The factor risk of mid-cap growth plays a role in our relative performance in a particular year. The biggest issue is that we are focused on higher-growth companies, which are predominantly mid caps, because that’s where the growth is. When there is a period of underperformance, as in 2016, it is usually because mid-cap stocks are not performing as well as large-cap or value stocks.
We manage that risk by cutting back the stocks when they have done really well, but we are always going to have that factor risk. Also, we have increased our percentage in value stocks from 10% to 20% to 30% of the portfolio, because most of the universe now consists of value or GARP stocks. Philosophically, we can invest in value, when there is a company development that allows the multiple to expand or the earnings to accelerate. In these lower-multiple stocks, we look for a potential acquisition, a management change or a product change.
The GARP exposure represents a way to stabilize the portfolio. The category varies based on our view of the opportunity and the valuation of growth companies. We tend to increase the GARP category when growth companies get more expensive or when we are concerned about interest rates and valuation. These stocks become relatively more attractive in periods when growth is decelerating in many companies.
Initially, when we started the fund, we were holding 40% to 50% in cash as one of the ways to manage risk. That approach worked for a while but I think it stopped working after 2003 and we decided to decrease our cash position to 5% to 10% of the portfolio.
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