At Wasatch Global Investors, we’ve always been a learning organization. That means we take an honest look at our mistakes and strive to learn from them. In our latest Market Scout, we share some of those mistakes and the lessons that sprang from those moments.
As Wasatch Global Investors approaches its 50th anniversary, we’ve been fortunate to share many successes with our clients and employees. But our mistakes have been just as crucial to our firm’s development.
We pride ourselves on being a learning organization. That means we empower our employees from the top down to be comfortable making mistakes, to have the humility to admit them, and then to learn from the experience. We’re fortunate to have a firm with experienced professionals and low turnover, which has given us the luxury to learn and ultimately benefit from these mistakes together through the years.
Those lessons run the gamut of topics, including how we evaluate business models, manage our portfolios, assess management teams, navigate extreme market environments and structure our organization. Below are a few highlights from some of our most experienced portfolio managers.
BUSINESS MODELS
Durable growth is more important than a relatively high growth rate. Early in some of our portfolio managers’ careers, they paid the most attention to companies that grew earnings at the fastest or highest rate. But we found that shouldn’t be the only filter for evaluating a stock. This became most evident during the tech bubble. The period was one in which Wasatch strategies generally did well. However, some of the companies we owned at the time were growing revenues at impressive rates but weren’t yet profitable. Those stocks performed well leading up to the bubble but were underperformers when the bubble burst.
What became evident after that period was that we can’t focus on a single factor like growth. We also needed to focus on returns on capital and the sustainability of those returns on capital for an extended period of time. With this insight, we put renewed emphasis on companies that we believe can withstand the test of time and earn a high return on capital while compounding earnings.
Large, transformative acquisitions don’t often provide the best pathway to growth. We’ve found that organic growth typically provides higher-quality growth than inorganic growth. But when a company does pursue growth through acquisition, we’ve found it is typically better for a firm to do bite-size, episodic transitions rather than large, transformative ones. For one thing, smaller acquisitions allow the company to digest and integrate the new businesses. But additionally, large acquisitions often come with a lot of debt. Even when some of our favorite companies make large acquisitions, if we think it adds too much debt to the balance sheet, we’ll often trim those positions instead of getting excited about it.
You don’t get paid extra for extra degree of difficulty. Some of our best investments at Wasatch have been businesses and business models that aren’t too complex. When we meet with these companies, the business descriptions in their slide presentations are the same we’ve seen for decades. They’ve simply grown by sticking to what they do best and staying disciplined about execution and efficiency.
Often, increasing complexity can mean more points for failure. It might be intoxicating for a portfolio manager or analyst to be right about a complex business they researched. But we’ve learned it’s usually better to resist the urge to get too confident about a very complex business model.
PORTFOLIO MANAGEMENT
Relative valuation isn’t an investment thesis. We’ve found little value in identifying two similar businesses trading at different multiples and buying the cheaper stock because it might make more money if its valuation gap closes. It’s more important to be right about the company’s growth potential and duration of growth. Simply put, we want to find companies that can double in size in five years and double again in the next five. We do pay attention to valuation and don’t want to overpay for a company. But we’ve found that if you’re right about the quality of a business and its duration of growth, it’s possible to pay a high price for the stock and still generate a market-beating return.
In fact, we learned our lesson about relative valuations the hard way. Several years back, we searched the database that stores information on all the stocks we’ve covered, singling out the stocks that mentioned relative valuation as part of the thesis. In hindsight, many of those stocks did not perform well.
There are very few great ideas. When you find one, put your weight behind it. Over time, the lists of stocks in Wasatch portfolios have become much shorter. Initially, we held a greater number of stocks in an attempt to diversify risk. However, a long list that doesn’t represent one’s very best ideas can be a distraction. We’ve found that investors are better served by finding the most special businesses, owning them at a sizeable weight, and then staying the course.
Our portfolio managers learned this lesson through their own introspection. Ajay Krishnan, a portfolio manager who has been with Wasatch for 30 years, conducted an analysis of the roughly 900 companies he invested in during his first decade at Wasatch. In looking at the return distribution, he found that about 90% of the returns came from 10% of the companies, reinforcing the value of owning those best companies at a higher wait.
CEO and Portfolio Manager JB Taylor, who has been with Wasatch for 28 years, realized the importance of concentrated portfolios through a separate analysis. He analyzed more than 20 years of data, evaluating the performance of positions across Wasatch strategies that were held at a weight under 1%. The team would establish some of these small positions as a way to get to know the company and stock better before potentially raising the position size later. But those small positions typically detracted from the portfolio’s performance. Perhaps just as bad, they were diluting the focus of portfolio managers. As a result, we ended up generally removing positions smaller than 1%, particularly in cases where the stock was a new position.
Don’t harvest winning stocks too soon. Trimming an outperforming stock too early can, of course, leave potential returns on the table—and those returns can be significant. In some cases, the gains we missed by selling stocks too early have “cost” more than actual losses from stocks we owned and were wrong about.
Conversely, if you’re wrong about a stock, be wrong early. It’s okay to be wrong. But if there’s confusion around a company or conviction is waning, we’ve learned it’s usually better to just move on from the idea rather than risk permanent destruction of capital. We don’t want a stock to be a “black hole.” What we mean by that is, when the stock falls and there’s uncertainty aboutthe business, we don’t want to throw additional capital toward the name simply because the valuation is lower. We’ve found that it’s often much better to just exit the position.
MANAGEMENT TEAMS
Be wary of the all-star CEO. In large-cap markets, a company’s stock price may rise substantially when the firm announces that it’s hiring a well-recognized CEO from a different firm. But among smaller companies, the all-star CEO with a great pedigree from a different industry doesn’t always create success. Instead, the new CEO may find that the tools they used before won’t apply to the new business model.
Don’t underestimate a leader who founded the business, even though they may not be flashy. One of many reasons we like investing in small-caps is that we can find a lot of companies that have been successful for a decade or more and are still led by the original founders. Founders tend to take a truly long-term view of their business. They genuinely care about the 10- or 20-year time horizon, which aligns with our style of investing. But unlike the all-star CEO one might find at a large-cap company, these founder-CEOs may not be as polished or flashy. They may have started with nothing, never aiming to be a Wall Street success, so they may not present as well to investors.
VOLATILE MARKETS
Do no harm. Our strategies generally performed well coming out of the financial crisis, but when we looked back at the data, the period still provided a valuable lesson. During the extreme downturn, there was a natural inclination to gravitate toward the highest-quality stocks in a portfolio and favor companies we thought had the best management teams. But in doing so, we sold out of some stocks that still represented high-quality businesses —but were not the very highest quality businesses in the portfolio. This was a mistake, as those names were down more during the downturn but then enjoyed the biggest rebound.
From this period, we learned to adhere to a “do no harm” mentality during market volatility. To us, this means resisting the urge to overreact in a downturn. If we’ve done the research and trust that these are good businesses, the best thing to do during an extreme market selloff may be to do nothing. We remembered this lesson when stocks were down at the onset of the Covid-19 pandemic, and by and large, holding onto our positions proved valuable.
ORGANIZATIONAL LESSONS
The best ideas don’t develop in silos. In its earliest years, Wasatch had only a few investment strategies and far fewer employees than today. The four portfolio managers would collectively discuss all trades for the firm’s four strategies together with the analysts. After the tech bubble burst in the early 2000s, we experienced an influx of assets and grew quickly. As the team grew, we became more hierarchical and less collaborative. We adopted a more traditional structure in which one portfolio manager oversaw a product, with analysts reporting up to them. Several years later, we did a deep dive into our performance to find out where we could be better. A key insight was that our experienced portfolio managers were spending too much time managing their teams in this hierarchical structure and not enough time collaborating together.
We made a departure from that model and adopted the organizational structure we have today. If you look across our strategies, you’ll see multiple portfolio managers with many years of experience together, and they’re supported by a team of analysts who also support other strategies. We refer to this as our “multiple eyes” approach, which we consider crucial to our investment process.
Culture is transmitted by stories and examples. Culture is paramount to Wasatch. We find that an effective way to promulgate our culture is through storytelling and tradition. When we started, there were a few stories that were always told and are still passed on today. One was about our founder, Sam Stewart. He would start every day with a cup mixed with Diet Coke and Fresca, filled to the top with ice. He made a point to refill the ice trays himself and let everyone else know that regardless of title, they were also responsible for filling the ice trays. Even today, the phrase “filling the ice trays” at Wasatch is shorthand for the idea that all employees should operate with a sense of accountability and teamwork, no matter how small the task.
Another story that gets retold is about one of our marketing professionals, who found that multiple boxes of his presentations had accidentally been thrown in the trash the night before an investor conference. He went to the trash dump, sifted through the garbage and located those materials for the next morning’s conference. It’s one of those stories that demonstrates dedication at the employee level to make things happen and get it done. Stories such as these reinforce certain values we have at the firm.
Formally codifying Wasatch culture reinforces its importance to our success. Storytelling is a great way to personify and relay our culture to newer employees. But we believe Wasatch’s culture is one of the firm’s most important differentiators from other investment firms. As such, we’ve formalized our cultural principles in a written document that is shared with all employees. The document outlines the cultural principles that guide our interactions as employees—or teammates, as we think of ourselves. Aligning with the firm’s cultural principles serves not only to better our workplace, but our work product as well. We introduce the culture document to new employees and ask employees to revisit it as they think about their annual reviews.
RISKS AND DISCLOSURES
Information in this document regarding market or economic trends, or the factors influencing historical or future performance, reflects the opinions of management as of the date of this document. These statements should not be relied upon for any other purpose. References to individual companies should not be construed as recommendations to buy or sell shares in those companies. Past performance does not guarantee future results, and any market forecasts discussed may not be realized.
Investing involves risk, including the potential loss of principal.
Wasatch Advisors LP, trading as Wasatch Global Investors, ARBN 605 031 909 is regulated by the U.S. Securities and Exchange Commission under U.S. laws which differ from Australian laws. Wasatch Global Investors is exempt from the requirement to hold an Australian financial services licence in accordance with class order 03/1100 in respect of the provision of financial services to wholesale clients in Australia.
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