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   Interview

    Guest Interview:

   Wedgewood Partners, Inc.

    9909 Clayton Road, Suite 103
    St. Louis,MO 63124

    Telephone: 314-567-6407
    Fax: 314-567-0104
    E-mail: wedgewood@asapas.com

 

    Interview Quarter: 4Q2012

 David A. Rolfe

 Chief Investment Officer

  Dave, let’s begin with a brief history of Wedgewood Partners.  
  My partner Tony Guerrerio founded Wedgewood Partners in 1988. I joined Tony in the spring of 1992 after the retirement of our former Chief Investment Officer.  
  So your current investment strategy began in 1992?  
  Right.  
  Tell me more about the firm and your team?  
  Tony and I have managed our single strategy since 1992. Along the way Tony and I have been very fortunate that two others on our investment team - Dana Webb and Michael Quigley – are both long time employees at Wedgewood. They have both enhanced our strategy in their own unique way. We are all partners in the truest sense of the word in that we are all owners of the firm.  
  And the firm?  
  Wedgewood currently manages about $3 billion in our single strategy. Our strategy is offered pari passu in both separate accounts and UMAs, as well as in the RiverPark/Wedgewood Fund. The Fund is offered in a retail share class (RWGFX) and an institutional share class (RWGIX).  
  Who are your clients?  
  We have a mix across a wide spectrum – individual, family wealth office, various Wall Street wire houses and institutional relationships such as foundations and endowments.  
  Who is RiverPark?  
  RiverPark Capital is a New York based money management firm, as well as the investment advisor of the RiverPark mutual fund family. The founding members of RiverPark were the first portfolio management team and president at Baron Capital from the early 1990’s. They founded RiverPark in 2006 and launched their mutual fund family in 2010. Wedgewood is sub-advisor of the RiverPark/Wedgewood Fund.  
  When compared to a benchmark like the S&P 500 you seem to be consistently beating the index. What do you attribute that to?  
  It all comes down to our philosophy, process and behavior – and the interaction or synthesis of all three. To be a successful investor one must philosophically identify some market inefficiency and have a process and the right emotional temperament to exploit it.  
  What is your investment strategy and investment philosophy?  
  Our strategy is Large Cap Focused Growth. Our investment philosophy is the synthesis of the three pillars of our philosophy – Growth, Value and Culture – all through the lens of a business owner.  
  Why do you talk about both “Growth” and “Value?”  
  In our view, “Growth” and “Value” can never be mutually exclusive. Price is what you pay for a stock, but “value” is what you get. Furthermore, the “value-creation” inherent in true “growth” companies is paramount in the long-term, multi-year compounding of growth stocks. In addition, while the long-term success of investing in stocks is largely determined by the multi-year growth of a company, the success over shorter periods of time, say one quarter to as long as eighteen months is largely determined by the initial valuation at which a stock is bought.  
  Which is more important, “Growth” or “Value?”  
  Well, I gotta call foul on that question – or at least rephrase it. Again, successful investors know that while the two concepts can be time sensitive, or time separated, you can’t ignore either.  
  What do you mean by “time sensitive?”  
  The success of any common stock investment over a short time frame of say one month, one quarter and twelve to eighteen months is largely, if not exclusively determined by valuation. So any successful investor must be a good “value” investor. In addition, the success over a multiyear time frame is largely determined by the underlying growth of the company. That’s why we focus on terrific growth companies.  
  Is Wedgewood a long-term investor?  
  Certainly. Our portfolio turnover averages about 20-30% - a fraction of most Large Cap Growth investors. In fact, including the 22 companies in our current portfolio, we have owned little more than 75-80 other stocks over the past 20 years.  
  That’s it?  
  That’s it  
  Why is your portfolio turnover so low?  
  It has been our +20 year history of investing that outstanding growth companies are a rare breed. A key foundation of our new idea generation process is recognizing that great growth companies are few and far between. We focus our research efforts on a small subset of approximately forty companies – including the twenty or so in our portfolio.  
  What does the “structural advantage of focus” mean?  
  We believe it means that we have the advantage to be very picky on the types of companies we choose to invest. It also means that we have the advantage of being very picky on the valuations in which we choose to pay for the growth companies we own. The stock market is very efficient. But it is a huge leap to assume that the market is perfectly efficient. We believe a focused portfolio of 20 stocks has a significantly better chance to repeatedly find 20 underpriced growth companies than say a 50 or certainly a 100 stock portfolio. The ends to the means of being a focused investor is that it should yield fewer, but better, more impactful decisions.  
  Can you elaborate more on your philosophy, particularly on this concept of investing as a “business owner?”  
  Sure. This concept of investing as a “business owner” is absolutely key to understanding what we do at Wedgewood. It first starts with our application of growth investing. First and foremost, we are growth investors. Very picky growth investors. We invest, for the true long term, in a focused portfolio of approximately 20 exceptional growth companies. However, and this is where our application of “value” plays a vital role, we will only invest in these exceptional growth companies if they are currently valued on our terms – they must be priced right. Many investment management firms claim the mantle of investing as business owners. Warren Buffett has preached this concept for decades yet we believe too many firms use it as a throw away line in a marketing pitch.  
  Why do you think that?  
  I’ll try to answer that by explaining how we approach and apply this concept. The two key elements in our application of investing as business owners is our view of risk, and our behavior and temperament as investors. In our view, risk is best defined as the permanent loss of capital. This point is most critical. Risk mitigation is embedded in everything we do at Wedgewood – the types of elite companies we choose to invest in, the picky valuations that trigger our purchases and sales, and our investing culture. We think that most investment management firms view “risk” as “volatility.” Said another way, such firms try to mitigate risk by managing – indeed, over-managing – the inherent volatility of the stock market. Specifically, the most common way other managers attempt to reduce the volatility of a portfolio is by over diversifying.  
  Isn’t diversification the cardinal rule of prudent investing?  
  Of course it is. But our view is that a portfolio of “only” twenty or so very different businesses is not only all you need – and is quite prudent too. On the other hand, over diversification severely mutes the impact of a managers best ideas – and quickly leads to the dreaded “closet indexation.”  
  Why do you think so many firms “over diversify,” as you say?  
  Good question. We think the two biggest reasons are career-risk at the portfolio level, and at the business level, the goal of building a big money management firm and focus investing must be mutually exclusive.  
  How so?  
  Well, investing tens of billions in a focused portfolio is quite difficult when you inevitable reach the point that you begin to move the stocks too much by your own buys and sells. For portfolios in the hundreds of millions of dollars, invested in a twenty stock portfolio is of course impossible. You could possibly, build such a portfolio over time, but any attempts to quickly exit a position would crush the stock. A related issue is that there is a limited appetite for both institutions and individual investors for a twenty stock portfolio.  
  Why do you think that is?  
  Simple. Most view a twenty stock portfolio as inherently risky.  
  You, of course think just the opposite?  
  Precisely.  
  Tell us about your Concentrated Large Cap portfolio. What are the key characteristics you would like to see in the companies you hold?  
  The overriding characteristic we demand of our invested companies is to be competitively advantaged. Said another way, we want to only own profit powerhouses. Characteristics that describe such competitive advantages include high and sustainable returns on equity and capital. We want own companies with differentiated products and services, unlevered balance sheets, leading market share, scalable businesses that can successfully keep competitors at bay.  
  Is your research only concentrate on the underlying fundamentals or do you use any technical analysis?  
  Strictly fundamental analysis.  
  What are the key elements of your research and portfolio management process?  
  Given our focus, our investment process is decidedly not a “new idea generation” process. Again, we focus on a relatively short list of what we believe to be outstanding businesses. We ask ourselves two interrelated questions – do we understand what made a company great in the past, and do we have a high enough conviction that it will be great in the future. Our process revolves around analyzing a potential holding on five key factors that are important markers for a favorable risk/reward opportunity necessary for portfolio inclusion. Three of these are at the company level and include superior competitive advantage(s), financial strength and at least double-digit growth. First we look to uncover companies that possess sustainably superior profitability relative to competition. We analyze the effects that a company’s suppliers, rivals and customers have on long-term industry profitability and then decide if a company’s value chain is unique enough to withstand those pressures. Next we want our portfolio companies to exhibit significant financial strength, which includes cash rich balance sheets, plus regular free cash flow generation as well as revenues that do not require regular debt financing. Lastly any portfolio holding must also possess the potential to grow profits at a double-digit rate over a full business cycle, which we believe typically spans three to five years.

The fourth is valuation. Simply put, we will not buy a stock unless it is undervalued. We look for the stock to trade at compelling valuations, based primarily on historical, relative and absolute price ratios, but also using discounted cash flow models and sum-of-the-parts analysis.

The last attribute is portfolio management. A company must have a business model with limited overlap with our existing portfolio holdings. Said another way, we seek to own companies that derive the vast majority of profitability from sources that are substantially different from profit sources of other portfolio holdings. We believe that this is a more thoughtful approach to diversification than simply making the holdings in the portfolio more numerous. Every company in our portfolio must exhibit all five of these factors or else they are avoided or sold.
 
  What do you do to protect yourself from negative surprises and bear markets?  
  Of all of the wisdom we have learned from Warren Buffett over the decades the most important has got to be his constant admonition to read and reread chapters 8 and 20 of Benjamin Graham’s book The Intelligent Investor. First published in 1949, chapter 8 introduces the concept of “Mr. Market.” Graham describes “Mr. Market” as an unforgiving, volatile emotional task masker that constantly prices individual stocks between the extremes of fear and greed. Graham says that the key is to understand that the stock market is there to “serve” investors, not to “instruct” them.  
  Can you clarify what that means?  
  The singular trait of unsuccessful investors is that they chase performance. They tend to buy what is hot and sell what goes cold. Mr. Market is “instructing” their behavior. People feel good when their stocks go up. They feel rotten when their stocks fall. It is both emotionally and intellectually easy to buy a stock or invest in a hot mutual after it has already risen. If your investment decisions are based too much on emotion and following the crowd, Mr. Market will do his best to ruin your investment performance – and make you miserable.  
  How does Wedgewood deal with “Mr. Market?”  
  We try our best to understand that the stock market is there to “serve” us. Great investment opportunities are usually “served” up with many problems attached. Great opportunities are never served up when everything is rosy. Far too many investors want perfection in stocks. Perfection is usually served up with rosy priced valuations too. Intelligent investors think and behave differently than the crowd. This ideal is hard for most investors to practice but at Wedgewood try to embody it as much and as best we can.  
  What about chapter 20?  
  Chapter 20 deals with the all-important concept of Margin of Safety. Risk mitigation pervades everything we do at Wedgewood. Competitively advantaged firms are inherently less risky than their lessor competition. And buying stocks at a discount to their fair value is even less risky. Diversifying a portfolio with differentiated business models that do not compete with each other further mitigates risk.  
  Your performance was quite poor in 2006. What happened?  
  Well. In 2006, we experienced our worst calendar year of under-performance in our +20-year history relative to the Standard & Poor’s 500 Index, as well as our benchmark, the Russell 1000 Growth index. We committed the “ultimate sin” in the investment business - we posted negative returns in an up-market! Actually, our under-performance continued into early 2007 as well. Our underperformance in 2006 was borne of two variables - some poor stock picking and a very poor environment for high-quality stocks. Recall that the period from 2002-2007 was five consecutive years when the stocks of lower quality companies outperformed higher quality companies. 2006, and early 2007, would ultimately prove to be the last gasp of the cheap-and-easy credit bubble, which ended of course in dramatic fashion. We affirmatively chose not to chase the then out-performing lower-quality cyclical stocks. We remained steadfast in our conviction that, despite significant short-term under-performance pressures, the notion that the then “new, new” economic environment greatly favored lower-quality stocks was not secular, but cyclical.

Then, in the early summer of 2007 when Bear Stearns’ hedge funds blew up, a negative sea change in the macro credit environment greatly favored higher-quality strategies. We swiftly reversed our relative under-performance and not only regained our performance in short order, but went on to post competitive performances over the ensuing 2 to 3 years. 2006 chronicled the amazing easy-credit, commodity-price profit boom and bubble. It actually went farther than we thought. It went farther than many thought. The profit boom was so great that the Morgan Stanley Cyclical Index posted a 35-year relative high versus the S&P 500 Index in late 2006. To give you an idea how out of favor our strategy and style was, throughout the dismal period 2005-2007 we didn’t own one constituent member of the Morgan Stanley Cyclical Index. A new era was upon us – shades of 1998-2000. Corporate profit margins soared to 50-year highs. Never before was the “average” company so stunningly profitable. And to the bane of our portfolio then, rarely has the superior business model been rendered so very “average.” All that suddenly changed when the credit bubble burst in the spring of 2007. Incidentally, the ensuing bear market of 2007 to 2009 was one of the best relative performance periods in down markets in our firm’s history. Our application of margin of safety served us well.
 
  What gives you the conviction to be successful investors in the future?  
  We believe that we will be competitive in the future because very few resources in the Large Cap Growth space (and equity management in general) are dedicated to managing focused portfolios. As a result managers often funnel sub-optimal amounts of assets into the best ideas in their respective portfolios. We believe this in turn allows our strategy to succeed without the opportunities getting competed away. There are also a handful of institutional imperatives that prevent the large majority of equity managers from following a focused strategy. First, as we have discussed, focus investing and assets under management are inversely related after a certain level of assets are under management have been reached. Again, we do not think it is feasible to have +$20 billion in assets across a twenty stock portfolio. In addition, many investment management firms are dedicated to asset growth so that any sort of focus eventually gets diluted. Another reason for the lack of focused products is that there is a lack of appetite (demand) due to diversification requirements from clients and regulators. Lastly, while all firms must consider their relative competitive advantage in information gathering, the collective IQ of the investment team, as well as the behavior and temperament of each respective team, we earnestly believe that the first two attributes are actually commodities in this business. If they are not, then the repeatability is limited. Again, the most important and repeatable attribute of successful investors is behavior and temperament.  
  What is the ownership structure of Wedgewood Partners?  
  Tony Guerrerio is a 55% owner. I am a 45% owner. Dana Webb and Michael Quigley, the other two members of the investment team, have been extended incentive compensation offers in the amount of 5% each of the firm’s value.  
  Where can we get more information about Wedgewood and do you have periodic commentaries that would be of interest to our readers?  
  Both at our website www.wedgewoodpartners.com.  
 
 
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