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   Interview

    Guest Interview:

   WCM Investment Management

    281 Brooks Street
    Laguna Beach,CA 92651

    Telephone: 949.380.0200
    Fax: 949.380.0819
    E-mail: duffdaniels@wcminvest.com

 

    Interview Quarter: 4Q2007

 Peter J. Hunkel

 Portfolio Manager – Focused Growth International

  Peter, give us a brief overview of your organization.  
  WCM Investment Management was founded in 1976. Today we manage about $2.6 billion, which includes corporations, private individuals, public funds, Taft-Hartley plans, endowments and foundations. Our flagship products include a large-cap domestic growth and a small-cap value portfolio.  
  Tell us about your new international strategy.  
  It’s a concentrated international (non-U.S.) portfolio which focuses on high-quality, large-cap growth businesses.

Our goal, as you’d expect, is to significantly outperform the non-U.S. indices over an extended period of time. We’re convinced such a goal is reachable only if we construct our portfolio distinct from the international indices, so we concentrate the portfolio in 20 to 25 holdings.

Those 20 to 25 holdings will all be companies that dominate their respective industries and are likely to continue that domination well into the future. That’s why we have a minimum time horizon of three to five years.
 
  How has your performance been?  
  It’s really been excellent, both relatively and absolutely, despite a tough environment.  
  What do you mean, “tough environment”?  
  The portfolio started in November 2004, at a time when value had been (and was) substantially outperforming growth. Given our tilt toward traditional growth areas like consumer and technology, we frankly expected to struggle. And it turns out those growth sector allocations did detract from results because we weren’t holding, for example, natural resource names. But because our process is strongly driven by stock selection, we’ve still been able to outperform the broader international indices, even with a sector “headwind.” In fact, the strategy has outperformed for three consecutive years since its inception, putting it well ahead of its benchmark—22.7% annualized vs. 17.3% for the MSCI EAFE.  
  How do you construct the portfolio?  
  We want to own companies with simple to understand business models, superior growth prospects, high returns on invested capital and little or no debt. And most important: a durable competitive advantage—we like the “economic moat” metaphor for that one. We spend a lot of time analyzing the company’s competitive advantage. If it doesn’t have a moat, all other analysis is irrelevant.

We also differ from most managers in that we consider the qualitative elements of our businesses—like the corporate culture, and the strength, quality and trustworthiness of management. We think this is what distinguishes the great businesses from the merely good ones. Undergirding that qualitative stuff, we do a lot of valuation (DCF) work, plus we’ll avoid companies with limited or spotty histories.
 
  What advantage does this portfolio offer?  
  The advantage is simple to state: in high-quality, non-U.S. growth, concentration is your only chance for beating the benchmark. Let me explain: the non-U.S. universe is mostly value opportunities. For example, about half of the EAFE is made up of what we consider non-growth sectors, like basic materials, energy, utilities, and financials. Conversely, conventional growth sectors such as technology or healthcare are each about six percent of the benchmark. Those are less than half what they are in the S&P 500, and those low weights mean there aren’t very many names from which to choose!

So the diversified international growth manager (that owns, say, 100 names or so) almost has to buy the whole sector if they are going to 1) stay growth, and 2) stay diversified. The only problem is you’re not going to beat the benchmark that way, not to mention paying an active management fee for what is essentially an index fund. But in our concentrated portfolio, if we want to overweight technology, for example, we can choose the select few quality growth prospects from that shallow pool.
 
  Does it differ from other international growth managers?  
  Other international growth managers may own a host of natural resource or bank stocks. We prefer to invest in traditional or conventional growth since the definition of growth shouldn’t change once you leave the U.S. borders. Look at it this way: most investors divide their domestic large-cap and small-cap allocations into growth and value segments. In those examples, you wouldn’t want your growth manager to load up on value-oriented stocks like banks or natural resource companies, would you? But that is exactly what happens internationally. We think this limits opportunities and exposes investors to excessive risk.  
  Who should look at this strategy?  
  I think we’re a good fit for an investor seeking a top-quality portfolio with the best growth ideas from the non-U.S. universe, or an investor looking for an international growth portfolio without overlap to an international value portfolio’s holdings.  
  What gives a company a competitive advantage, or an “economic moat” as you called it?  
  A moat can come from having sticky relationships with clients, economies of scale, a lineup of brands or products which are difficult to duplicate, a “best in class” reputation, or a network effect. There are other examples, but these are some of the most common.  
  Can you give me an example of a wide moat in your portfolio?  
  Sure. ICAP is a good one. They are the world’s largest inter-dealer broker, holding 31% of the OTC (Over the Counter) market. It makes money by facilitating large transactions for investment and commercial banks. These transactions typically involve securities, commodities, currencies, or derivatives.

The company benefits from a classic network effect, which means its business becomes more valuable as more people use it. In ICAP’s case, buyers flock to it because it has the largest access to sellers and vice versa. This is an enormous barrier to entry, particularly in less liquid markets where the products are complex and pricing information is limited.

Think about it this way: if you were going to start your own inter-dealer broker, you’d have a hard time attracting any business because you might only have a few people to call if a client wanted to complete a trade. But with ICAP’s network of buyers and sellers, it can guarantee smooth execution and the besting pricing possible, which in the end is what customers care about.

The beauty of ICAP’s business is it makes more money when markets are volatile. While most financial stocks were under pressure in late 2007, both ICAP’s business and stock price excelled.
 
  Is this a purely bottom-up approach?  
  Well, “purely” is a strong word. I’d say mostly bottom-up because our main effort is researching individual companies. But we certainly employ a top-down thematic approach by looking for those sectors and industries that benefit from meaningful tailwinds and themes. The bottom line, though, is we are stock pickers, so this is what drives the process.  
  You mentioned some of the qualitative elements you look for. Why is culture important?  
  When you are investing in a business, you want to know what is going on with the lifeblood of the company. People make the difference. That point cannot be overstated.

When looking for superior cultures, we first want management teams who are honest, trustworthy, and candid. We want visionary leaders who can navigate through the best and worst of times. The reality is all businesses face tough times but great leaders successfully lead great companies through the inevitable storms.

Second, we want to see management cultivating an environment where employees like their jobs. Management must attract and retain talented people. This can come in the form of competitive compensation, flexible working environments, benefits, or a stimulating work environment. Happy employees want to work hard, save money when no one is looking, and promote good relationships with customers. No CEO can mandate this in a memo. That has to be a part of the company’s DNA.

We actually feel we have a special insight into what makes a superior culture because we’ve spent so much time and energy trying to build and cultivate a good culture at our firm over the years.
 
  How do you conduct your investment analysis?  
  First of all, you have to start with a simple-to-understand business. If you can’t understand the business, you can’t value it. Once we have an idea, we conduct an intensive evaluation which can take weeks or even months. During the analysis of the company’s financials, our analysts rigorously examine the firm’s business and financial strength, revenues, returns, and accounting policies.

The primary valuation technique we use is the discounted cash flow (DCF) method. Our analysts usually run at least five scenarios, varying the key value drivers such as top line growth, operating margin, and working capital. The result is that a range of a business’ intrinsic value is derived. When we need a single number for the valuation, we’ll qualitatively assess the likelihood of each scenario we ran and compute a probability-weighted intrinsic value.
 
  How important are screens in finding your investment ideas?  
  Screens are only one tool to assist us with our security selection. While they help us find potential candidates, if your database has bad or spotty data—and no database is perfect, especially internationally—a screen can also exclude good ideas.

Nevertheless, our initial screens—market cap of $3.5 billion or greater, financial strength, low/no debt levels, revenue, earnings, etc.—drop the size of the global ex-U.S. universe to approximately 1,000 names. Our growth screens—long-term ROIC of 10% or greater over five years or longer, growth rates, economic moat, sustainability, etc.—filter the list to about 100 names. We then whittle the list down to about 50 names we watch closely, evaluating the corporate culture and management.

Our analysts are responsible for developing specific company recommendations. Ideas can come from various sources, including independent research firms, industry publications, financial media, news events, or industry experts. For example, we learned about ICAP after studying the CME Group (Chicago Mercantile Exchange), which is attempting to expand into the OTC market. After talking to industry experts and doing our own research, it became clear that CME would have a tough time competing against the likes of ICAP, a fact that speaks to the quality of ICAP’s business and the strength of its moat.
 
  Give me an example of one of your long-term holdings. Explain how it fits your investment criteria.  
  Sure. Let’s talk about Novo-Nordisk. They’re the world’s largest insulin maker with 50% global market share. Domiciled in Denmark, the company is a relatively unknown specialty drug maker, but we consider it to be more of an innovative biotech because it produces more profitable analog, or manufactured, insulin and insulin alternatives. The company carries virtually no debt, exhibits high returns on invested capital and consistent revenue and earnings histories.

One tailwind which shows no signs of slowing is the Type II diabetes epidemic, brought on by poor eating habits, obesity and sedentary lifestyles. More than 170 million people worldwide have diabetes, and that number is expected to double to 366 million by 2030, according to the World Health Organization. If left untreated, diabetics can fall victim to serious health issues such as heart disease, blindness, renal failure, or peripheral neuropathy (poor circulation to the extremities). In the treatment of diabetes, doctors say they have too few options before putting patients on insulin, from which they can never be removed and which can require increasingly higher doses over time.

We like Novo-Nordisk because there are high barriers to entry to the diabetes market and it has few patent worries. Its manufacturing capabilities also give it an added competitive advantage, making generic attacks more difficult.
 
  What’s the stock worth?  
  Using some conservative assumptions for insulin volume, pricing, and market share, we think the stock was trading at about 75 cents on the dollar at the end of 2007. The beauty is you are barely paying for Novo’s promising new insulin alternative called Liraglutide, which may better control blood sugar levels and reduce patient weight. This drug is a once-daily manufactured version of the naturally occurring hormone GLP-1, which stimulates the pancreas to produce insulin. Helping diabetics lose weight would be a huge advantage because it would help break the vicious cycle of obesity contributing to diabetes, diabetes contributing to obesity, and so on.
 
  What’s the company’s culture like?  
  It is one of the more unique cultures we have ever seen. I encourage everyone to review its website, under the jobs section. That section is unlike anything you will read at other companies.

Here’s one tangible example of how desirable it is to work there: Novo expanded its U.S. sales force recently by posting roughly 600 job openings. It quickly received 38,000 applications! We believe that’s a good indicator that industry talent wants to work at Novo. Attracting and retaining talent is critical to a great company.
 
  So what do your portfolio sector allocations look like?  
  Our heaviest allocations are to technology, consumer staples/discretionary, and healthcare. We are very light in financials, mostly because the EAFE’s financial weighting is heavily comprised of banks, and that’s an area where we haven’t found much that looks attractive based on our investment criteria. But this did allow us to sidestep much of the credit crisis that disrupted worldwide financials starting in August 2007.  
  What are other qualities you look for in a holding?  
  We look for simple to understand businesses with a market cap of $3.5 billion or greater. It also has to be a quality company, as evidenced by a top stock or credit rating. Quality also shows if a business delivers high returns on invested capital—we like 10% or greater over a five-year period—and if it generates strong cash flow, has low or no debt and consistent earnings and revenue histories.

Most importantly, we want companies with durable economic moats. But even a moat doesn’t help if you don’t have a future of growth ahead of you—what we call a tailwind. We don’t want to own companies fighting a headwind. And since we look at culture, we want exceptional management teams.

Lastly, we like what we call “self-fulfilling growth.” For example, these are companies that say they will open a specific number of stores next year and then go out and do it.
 
  Give me an example of a self-fulfilling growth company.  
  I would have to say Hennes & Mauritz. It’s a Swedish company that is one of the best, largest, and fastest growing fashion retailers in the world. It operates under the popular H&M store name. The company owns and operates over 1,500 stores in 28 countries. It is methodically growing its store count between 10-15% per year. And it does this with no debt, refusing to sacrifice profitability to keep up with its faster growing rival, Inditex. That profitability has translated into consistently high ROICs and incredible gross and operating margins.

H&M is also extremely efficient at the concept-to-delivery process, so it can get trendy new designs to store shelves in just a few weeks. That means new items are stocked at stores everyday—in fact, in some stores, new items are stocked throughout the day. This limits fashion risk and keeps customers coming back. Limiting fashion risk allows the company to generate higher margins and returns on capital. You have to contrast this to a company like U.S.-based Gap, which relies on seasonal collections that eventually must be increasingly marked down to make way for new inventory.
 
  What has been your portfolio turnover?  
  Because of our long-term focus and bottom-up orientation, our portfolio turnover tends to be very low. We will average at about 15% per year.  
  Please describe your sell discipline. Do you let your winners run?  
  Obviously we will sell a name if the valuation is no longer attractive, or if the position size gets too big, or if we find a better name. But we will also sell if the company’s moat has been breached. This is a significant factor in our sell discipline. And certainly, given our emphasis, we’ll sell if leadership loses its way, or if the culture is challenged.

That said, we have no problem allowing our winners to run. As long as the company trades below its intrinsic value, we will hold it for as long as the investment thesis remains intact. When it exceeds its intrinsic value, we begin to trim or sell.
 
  Do you own emerging markets names and if so, how much?  
  Yes, we own emerging markets names but we limit our exposure at 35%. If we ever reached 35%, we’d require trimming.

But classifying stocks as emerging markets can be misleading. Some of the companies we own derive much of their revenue from the U.S. For instance, TEVA Pharmaceutical is based in Israel, but it gets more than 60% of its revenue from North America.
 
  With a concentrated approach, how do you control risk?  
  Besides our emphasis on quality at the company level, portfolio construction is critical to controlling risk. So, there will always be at least 15 global industries represented, with maximum industry exposure limited to 15%. Sector exposure is limited to 45%. New positions will start from 2% to 5% with maximum weightings of 10-15%. Lastly, as I mentioned before, emerging markets exposure is capped at 35%.

I should also add that we had 14 currencies and 16 countries represented in the portfolio at the end of 2007. While country and currency selection are not primary considerations in our investment process, we are well aware of our exposures and work methodically to diversify both.
 
  Do you hedge currencies?  
  No, we do not hedge currencies. We believe investors want exposure to other currencies. That’s a key reason for investing overseas. We also want to spend our time focusing on businesses. Since we mostly own multinationals, we leave it to management to hedge their revenues.  
  Can you explain why you are underweight Japan?  
  Mostly because there is an absence of economic moats and an abundance of companies with low returns on invested capital. Even when the Nikkei was rising in the late eighties, Japanese companies generated low ROICs.

To this day, there are only a handful of Japanese businesses that generate high ROICs. Of those names, few have durable, sustainable economic moats. We are cautious on ideas there.
 
  Explain why you believe energy is not growth. With oil hitting all-time highs, wouldn’t this be an attractive growth category?  
  The problem is that businesses in this sector are forever linked to the underlying commodity price. What will oil be in five years or ten years? We can’t know. Since this presents variables well beyond the control of management, we prefer to stay in sectors and businesses that offer higher degrees of predictability.

I worked at an international value manager when oil flirted with $10 a barrel in 1998-1999. You couldn’t give away oil stocks. Instead, investors clamored for “new economy” stocks like AOL, CMGI, or Excite@Home. Now, investors seem to want oil at any price.

Our view is that commodity businesses are inherently cyclical, and to argue that they have long-term growth characteristics is to fundamentally misunderstand their economics.
 
  Who makes the decisions on portfolio ideas?  
  All buy and sell decisions are made by our Investment Strategy Group (ISG). This team establishes portfolio guidelines for sector and industry emphasis and develops the model portfolio. In our meetings, we review the major trends in the global economy in order to identify those sectors and industries that are most likely to benefit. Typical themes include demographics, global trade, outsourcing, the growing global middle class, and the proliferation of technology. We then develop a portfolio strategy based on those considerations.

Our ISG meetings are often fluid. We challenge one another. We disagree. It is a great process because it keeps everyone sharp. Our biggest concern is when we agree on everything. That’s usually dangerous so we will step back to make sure we are not missing something.
 
  Who is on the ISG?  
  The ISG includes me, Mike Trigg, Kurt Winrich, and Paul Black.

Mike comes from Morningstar, where he managed their growth portfolio. Mike is a superb thinker and an exceptional analyst. Paul and Kurt are principals of the firm and offer decades of experience managing money. It’s a pleasure of mine to work with such talented individuals.
 
  What index is the best performance benchmark for this portfolio and why?  
  I already mentioned how different the non-U.S. indices are, so you’ll be hard pressed to find a benchmark that comes close to what we do. This is why we are fine with comparisons to the more common MSCI EAFE or EAFE Growth benchmarks.

The MSCI All Country World ex USA is another possibility because it includes emerging markets. However, people need to be cognizant of the fact that half of the market capitalization in BRIC nations (Brazil, Russia, India, and China) is comprised of basic materials and energy. So, in our view, all you’re getting is more natural resources.
 
  How can someone get additional information about your services? And why should someone consider WCM?  
  We are on the web at www.wcminvest.com. You can also email us at mmrinterview@wcminvest.com

We believe you should recognize a manager for its process, people, and philosophy. Good long-term performance flows from that, not to it. That’s the big one.

And with our headquarters in Laguna Beach, we also have the best location for onsite due diligence visits!
 
 
 
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