Amy Zhang has been one of America’s best-performing fund managers for quite some years now. What’s the secret behind the success of the manager of the Alger Small Cap Focus Fund? ‘Most of my peers sell too early, which is the biggest single cause of underperformance. We let our winners run as long as we believe there is still a significant and long runway for growth,’ says Zhang.
Zhang mentions ecommerce company Shopify as an example. ‘I bought it in 2016 and only sold in Q4 2020 when it had become too big for the fund.’ In the meantime, the share price had risen from less than $50 to over $1000.
Underperformance is obviously not a worry for Zhang. In the Covid-stricken year of 2020 the Sicav version of her fund made a return between 49.53% and 51.21%, depending on the share class. This was considerably higher than the phenomenal +34.6% return of the Russel 2000 Growth Index, the fund’s benchmark. Over the past three years, the fund has also outperformed the index by a large margin, with an annualised return of almost 30%.
Healthcare and IT
Shopify is, however, more an exception than the rule for Zhang’s fund. Not only was the sheer size of the firm exceptional, with a market cap of over $100 billion at the moment of sale, Zhang’s traditional focus is also more on the likes of what she calls ‘stable growers’.
‘We do not typically have hyper-growth companies in our portfolio, but have a preference for innovative companies with strong cash flows.’ The real secret to Zhang’s long-term outperformance therefore seems to lie more in her ability to identify companies with a unique market position. ‘We only invest in companies that do something unique, which can translate in very high margins.’
This kind of companies can mostly be found in the healthcare and IT sectors, which have been dominating her portfolio for years. Moreover, more than half of the fund’s assets are invested in the former. In recent years, healthcare has become the largest sector within US small caps, followed at some distance by IT, but Zhang has a strong overweight to both.
`By far the most innovation in the US small and mid-cap sector takes place in healthcare and IT,’ notes Zhang as she explains her preference for the two sectors. ‘Healthcare is a very diverse sector, which has strong tailwinds because of demographics. But we really get our alpha from stock selection, not from sector bets. Strong cash flows, high margins and sustainable sales growth are what count for us. We prefer to invest in companies can that control their destiny. Therefore we generally do not invest in biotech companies, for example. I do not like binary investments. This is also why our beta is generally below 1.’
Zhang invests, among others, in companies that produce precision medicine for cancer and in firms that develop diagnostic tests for all kinds of diseases. ‘The big problem of the American health care system is the high expenditure on medicines. We invest in companies that are part of the solution to this. It is of course much better, and cheaper, to prevent disease than having to cure it, by intervening at an early stage.’
Diagnostic tests are also a segment that has received additional attention due to the Covid crisis. One of the largest positions in Zhang’s fund is Quidel, the first company to develop an antigen Covid test. Until a few months ago, this was even the largest position in the fund, but after the company’s share price almost doubled in a few weeks’ time last autumn, Zhang took profit.
Valuations a misleading metric?
There is a downside to the success of the companies Zhang invests in. The average price-earnings ratio of the companies in her fund, at 51 times earnings, is more than twice the index average.
But the meaning of valuations is often misunderstood by investors, she believes. ‘The price/earnings ratio is a misleading metric. The level of P/E may meaningfully impact returns if fundamental growth rates are low or holding periods are short, but the faster the growth and the longer the holding period, the more it comes down to fundamental growth of the business,’ she notes, adding there are also accounting issues. ‘Growth companies that invest in intangible assets like research and development on software algorithms or new drugs are expensed, serving to depress earnings. By contrast, investments in tangible assets like property or plant and equipment are capitalized and hit income slowly over time. Finally, many of the companies we invest in have a lot of recurring revenue. That’s not reflected by a P/E-ratio either.’
Many investors are predicting a rotation from growth stocks to value stocks this year, which would benefit from improving economic growth and inflation. But Zhang disputes that the companies in her portfolio would be affected by this very much. ‘Our companies will continue to do well when inflation rises, because they usually have pricing power and low fixed costs. And as long as real interest rates do not rise sharply, the impact on valuations will also be limited.’