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April 24, 2018, 3:15 a.m. EDT

How to find ‘coming of age’ companies whose stocks could rise 10-fold

Amy Zhang has led a big turnaround at the Alger Small-Cap Focus Fund by finding innovative companies

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By Philip van Doorn, MarketWatch

Fred Alger Management Inc.
Amy Zhang, manager of the Alger Small-Cap Focus Fund.

Amy Zhang, manager of the Alger Small-Cap Focus Fund, has greatly improved the mutual fund’s performance since she joined Fred Alger Management in February 2015.

The Alger Small-Cap Focus Fund /zigman2/quotes/207263247/realtime AOFAX +4.04%  has grown to $804 million in assets from only $14 million when Zhang took over. The fund was holding 49 stocks at the end of January, about half that of three years earlier when Zhang came aboard.

In the literature it provides to financial advisers, Fred Alger Investment Management talks about “investing in dynamic change,” and buying shares of companies that are either “coming of age” or going through a “positive life cycle change.” It is the first group that Zhang focuses on, following a ”high-conviction” strategy she has used for 16 years.

Zhang described her approach as “index agnostic,” while also saying it was fair to compare the fund’s performance to the Russell 2000 Growth Index /zigman2/quotes/210598133/delayed XX:RUO +3.09% .

“We don’t own household names. We believe this is an excellent portfolio diversifier for our clients,” she said.

She also emphasized the diversification of companies owned by the fund.

“They are not correlated in terms of sources of revenue,” she said, making the fund “generally less volatile than the index.”

Here’s an edited version of Zhang’s conversation with MarketWatch:

MarketWatch: Can you describe the typical company that is “coming of age” that the fund invests in?

Amy Zhang, portfolio manager of the Alger Small-Cap Focus Fund: We are looking for high unit volume growth. Usually there is a large, growing, fragmented market. We also look for pricing power, or at least not significant pricing pressure. That’s where innovation comes in.

For us, it is really about sustainable, robust top-line growth. The key words are sustainability and durability of unit growth. This will correlate with EPS [earnings per share] growth, which ultimately drive stock prices.

MarketWatch: So you do not simply hunt for bargain small-cap stocks?

Zhang: At the initial point of investing, we look for companies with durable business models but operating revenue of less than $500 million. The sweet spot is probably $100 million to $200 million. We look for companies to double revenue within three to five years.

We are not looking for stocks to shoot up 20% to 30% in this portfolio. We are looking for a stock to grow two, three, four, five or 10-fold over a long period. We invest in long-term, value-creating engines. That’s how alpha is generated.

MarketWatch: You have also said you were looking for companies to be led by managers with “long-term vision.” Can you elaborate on that?

Zhang: Small companies do not grow in a straight line. Our investment horizon is three to five years and beyond.

Vision is also not linear. I generally favor companies that have founders as CEOs with substantial stakes in the companies. They generally have a long-term strategic vision that goes beyond quarterly results.

Small companies usually have limited resources, so how they allocate capital and resources is very important. It is also important for us to have a CFO with very strong financial discipline to balance the vision of the CEO. We don’t want a company to grow merely for the sake of growing. It is important for them to balance growth and profitability.

MarketWatch: Which metrics do you look at before diving in for closer analysis?

Zhang: We look for high growth, but I also spend a lot of time looking for financial quality to provide downside protection. Our companies have very strong balance sheets and high cash-flow-generating abilities.

So if we look at our portfolio as of Dec. 31, the weighted median debt/total capital ratio was only 2.6% versus the Russell 2000 Growth Index, which was 28.3%.

We have a combination of high quality and high growth. Our estimated three- to five-year compounded annual EPS growth rate for companies in the portfolio is 19% compared to 14.3% for the Russell 2000 Growth Index.

The weighted median net margin for our companies was 11.1% for 2017, compared to 5.8% for the index.

Our ROIC [return on invested capital] number was 14.7% versus 11% for the index.

We generally don’t invest in biotech companies, because we are trying to avoid companies that face binary outcomes.

MarketWatch: Such as clinical trials for drugs?

Zhang: Yes, that’s a good example.

MarketWatch: Can you describe any painful lessons you have learned about selecting companies for investment?

Zhang: Very early in my career, I used to think if a company had a fantastic product that anyone would be able to run it. I knew of a company that had great products but didn’t know how to sell them at a profit. This particular company just wanted to grow for the sake of growing.

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