Artisan Partners is a global investment management firm headquartered in Milwaukee. Craigh Cepukenas, James Hamel, Matthew Kamm, and Jason White are the portfolio managers for the Artisan Partners Growth Team, and together they manage the Artisan Global Opportunities Fund, the Artisan Mid Cap Fund, and the Artisan Small Cap Fund. The first of these is rated five stars by Morningstar and has generated annualized returns of 10.7%, compared with 6.5% for the MSCI All Country World Index, since its inception on Sept. 22, 2008.
Motley Fool analyst John Rotonti interviewed the team about accelerating profit cycles, external versus internal catalyst-driven growth, power alleys, their garden/crop/harvest strategy for portfolio management, and much more. You can read more about their investing process and find their quarterly commentaries and numerous white papers on growthy topics here.
John Rotonti: How do you define a high-quality business?
Artisan Partners: Our approach is designed to find high-quality businesses we can invest in over a long period of time. We define high-quality in terms of durable franchises that are trading at valuations we can understand and are either on the cusp of or in the early stages of an accelerating profit cycle.
JR: What characteristics are you looking for in a franchise business?
AP: In identifying franchises, we're looking for companies operating from a strong foundation-- which we typically define as companies with low-cost production capability, a defensible brand, dominant market share and/or a proprietary asset that is difficult to replicate. We believe companies possessing some combination of these characteristics are companies capable of creating a competitive moat around their businesses, increasing the likelihood they can sustain compelling, long-term profit cycles.
JR: You aim to invest in companies with accelerating (or emerging) profit cycles. Can you explain what you mean by that?
AP: We often call ourselves profit-cycle hunters -- at our core, we are bottom-up, fundamentally driven stock-pickers. We believe that over time, stocks follow profits, which means that in order to be successful over a full market cycle, you need a repeatable process to identify good-quality businesses that can drive compelling levels of profit growth.
I'd also point out that many growing companies see natural up and down cycles in profit growth. Our aim as profit-cycle hunters is to invest capital in quality franchises early in a new profit cycle so we can capture the price appreciation that typically accompanies profit growth -- while watching for signs that the cycle is maturing or ending so we can reinvest accordingly in new opportunities.
JR: How do you identify profit growth cycles?
AP: Profit growth will come from either internal catalysts, external catalysts, or some combination. We seek to identify what those catalysts are, how durable they are and what we think the likely outcome will be. External catalysts are factors like changes in regulation, technological breakthroughs, demographic trends, etc. Internal catalysts are factors more directly in a company's control, like new management teams, new products, strategic acquisitions or divestitures, or margin expansion, cost-cutting or some other strategic initiatives. External catalysts are often more obvious, but internal catalysts are just as compelling to us--companies capitalizing effectively on internal catalysts may be in better control of their own destinies, which can be an attractive proposition during those times when profits are not being aided by a macro tailwind. Companies benefiting more heavily from internal catalysts may not necessarily experience explosive top-line growth (though some certainly might). However, as mentioned, we consider ourselves profit-cycle hunters--not strictly revenue hunters--and therefore are just as happy to uncover a compelling margin expansion story.
JR: In terms of external catalysts, what are some of the long-term tailwinds that excite you the most right now?
AP: Contrary to popular conception, external catalysts need not be predicated on a strong macro environment. We believe we've identified a number of secular trends that can transcend the macro environment, including health-care innovation, next-generation data analytics, industrial process innovation, emerging-markets consumers, newly investible financials, and the shale revolution.
JR: How do you think about position sizing and portfolio diversification?
AP: We think about capital allocation in terms of where we think a holding is in its profit cycle. We build position size according to our conviction, with an aim of being right in a bigger way than when we're wrong. As a result, we develop our portfolio holdings through three stages: GardenSM, CropSM and HarvestSM.
GardenSM investments are situations where we believe we are right, but there is not clear evidence that the profit cycle has taken hold, so our position size is smaller. We typically have more GardenSM holdings in our portfolios than CropSM holdings--though they're also smaller positions since they're early in their profit cycle development.
CropSM investments are holdings wherein we've gained conviction in the company's profit cycle, and so positions are often larger. Our CropSM tends to be the minority of positions but the majority of capital, and through time, we believe this is where we derive the majority of our returns.
Finally, HarvestSM investments are holdings that have exceeded our estimate of private market value or holdings where the profit cycle is maturing or decelerating. HarvestSM investments are generally being reduced or sold from the portfolios.
JR: Are there any industries you tend to prefer? Or avoid?
AP: We aim to find growth wherever it is occurring globally, and so we don't specifically avoid any countries or sectors when it comes to our research process. That said, given the disciplined, repeatable nature of our approach and the types of characteristics we're looking for in potential investments, we find that we more often uncover opportunities in some areas of the economy than others. We refer to these areas as power alleys, and they include industrials, consumer stocks, healthcare, and technology.
However, one of the advantages of our process is we don't limit ourselves to those areas alone -- we are truly agnostic in our hunt for profit cycles. Right now is a good example of a period in which we're finding growth in areas outside our traditional power alleys, including the financials and the energy sectors. Currently in our global portfolio, we hold companies like Visa (NYSE: V) and S&P Global (NYSE: SPGI). We also hold some of the more traditional banks, such as Bank of America (NYSE: BAC) and State Street (NYSE: STT) -- an area that for some time hadn't yielded profit cycles that were of interest to us due to multiple headwinds following the global financial crisis.
JR: What do you find attractive about Visa and S&P Global?
AP: We believe Visa and S&P Global are capitalizing on some attractive secular trends within financials. Both companies fall into a category broadly referred to as fintech --companies that are rapidly transforming the technology on the back end of many typical financial transactions.
Visa specifically is capitalizing on secular trends tied to the solid growth of digital payments and increasing demand for transactional security, where Visa has capitalized on first-mover advantages. India's recent demonetization, which has helped push its economy toward a cashless one, has also benefited Visa as transactions have risen meaningfully. We expect these trends to continue and for Visa to maintain its competitive advantage.
Meanwhile, S&P Global (SPGI) is benefiting from its strategic efforts over the last several years. Its management team has executed well on a clear plan to simplify the business by selling non-core assets, resolve the legal challenges that followed the global financial crisis, and drive higher margins and efficiencies across SPGI's business. It is also beginning to realize meaningful synergies from its acquisition of SNL Financial--a mid-size but fast-growing provider of data and information services to the financial services industry.
JR: What about energy? What companies are you finding of interest?
AP: Noble Energy (NYSE: NBL), which we first purchased in our global portfolio in January 2016, is an energy E&P that currently fits our criteria for franchise quality and profit-cycle potential. Noble has top acreage in the Permian Basin, which arguably contains the US's highest-quality and richest shale deposits. We believe the quality of Noble's acreage remains underappreciated and anticipate Noble can benefit as several recent headwinds have just lifted -- including a regulatory overhang regarding a Mediterranean gas play and a handful of failed referendums that would have hamstrung Noble in the DJ Basin area of Colorado. Noble's mid-2016 IPO of its midstream business not only freed up some capital, but should also provide a financing mechanism for future growth. We also believe Noble is in the early stages of capitalizing on its recent acquisition of Rosetta Resources, whose drilling and fracking techniques should allow Noble to drive better-than-anticipated extraction rates from its high-quality acreage.
We also hold Concho Resources (NYSE: CXO) in our mid-cap portfolio. Like Noble, Concho has top acreage in the Permian and is on track to maintain production despite a meaningful reduction in spending, a remarkable feat that's been driven by innovative new drilling technologies, and it expects to expand production further in 2017, funded by internal cash flows. While we can never predict future commodities prices with a high degree of certainty, Concho appears to be in the early stages of an accelerating profit cycle, even if oil prices remain at or below $50 a barrel.
JR: What are your thoughts on current stock market valuations?
AP: When we assess valuations of our holdings, we think about private market value (PMV) -- through our fundamental research, we estimate the amount a private market buyer would pay to buy the entire company and own all the future cash flows. Because we operate in public markets, not private markets, we will consider for investment those companies that are selling at a discount to that PMV estimate. However, we are less interested in the absolute discount we pay than the potential for the PMV to rise over time.
That said, we believe valuations for high-quality franchises that meet our threshold remain compelling -- particularly following the sharp, late rotation to more value-oriented companies at the end of 2016. That swift rotation served to bring down the valuation of some of our highest-quality companies, while their fundamentals and longer-term outlook largely remain intact. We capitalized on the opportunity to actually add to those positions whose valuations became more interesting as the market shifted following the U.S. election, which seemed to catch many investors off-guard.