Interview With Quoc Tran of Tran Capital

Quoc Tran is co-founder, chairman, and chief investment officer of Tran Capital. From 2017 through 2021, his Partners Strategy generated 32% annualized returns, beating the market by an average of 4 percentage points per year. Let's find out how Quoc generates such attractive returns for his clients.

What follows is an interview conducted over email with Motley Fool senior analyst and service lead John Rotonti.

John Rotonti: Tell us about Tran Capital.

Quoc Tran: Tran Capital Management is a boutique, concentrated long-only investment firm. Our predecessor firm was founded in 1974. In 2017, we successfully led a management buyout to form Tran Capital Management. We are based in the San Francisco Bay area.

Rotonti: What is your investing philosophy? What types of businesses do you try to buy stock in?

Tran: We invest in companies that provide an incredibly valuable product or service, earn a high return on capital, and are selling at a reasonable price. We think these businesses often have a long runway of growth due to management's superior capital allocation. Many of our companies reinvest capital in high-returning opportunities, make logical acquisitions, and return excess capital to shareholders in the form of share buybacks or dividends. Time and compounding work in our favor. We are especially interested in companies where their incremental margins are higher than the company's current margins. This may be because of a product extension or an expansion into a new market. For instance, when Danaher purchased GE Healthcare's bioprocessing business in 2019, we believed that GE's bioprocessing business would help Danaher accelerate their revenue growth, as well as contribute to margin expansion. It was a delight to witness this play out over the subsequent two years. 

We also invest in undiscovered growth companies. We often find these in corporate spinoffs. These companies are often undercovered on Wall Street, led by a management team who have control of the company's direction for the first time and because it may take a few years for these strategic priorities to develop, are attractively valued.

We value primary research, and our team analyzes our investment candidates through the lens of a private business owner. We seek to understand how the business works and ask ourselves, "If we could, would be buy the whole company?" We are not traders seeking short-term appreciation.

Shortly after our management buyout, we implemented two process improvements. First, a strategic moat review, and second, we added a layer of ESG analysis to all our investments. 

Prior to our buyout, we performed a five-year look back at our buys and sells. What we found was that our buys were pretty good, over 75% of them fulfilled our thesis. However, our sells were 50-50. We had never spent much time analyzing our sells. A 50% success rate was unacceptable. Sometimes we would sell a stock out of frustration only to see it recover and fulfill our thesis. Sometimes we sold a stock because it reached our price target. While we made a good investment, many of these stocks kept compounding and in retrospect, we should have trimmed the position rather than sell it. We thought that if we can improve our selling process, then we could improve our returns. After a lot of work, research, and conversations with other practitioners, we incorporated a moat review as part of our research process. Now, twice a year, I meet with our analysts to classify our companies into categories where the moat is weakening, stable or strengthening. Adding this lens helps us sell companies whose moats are weakening faster and keep companies whose moats are strengthening longer.

Additionally, we've enhanced our research process with our proprietary ESG analysis where we score our investments on a 1-5 scale on their environmental, social, and governance work. We supplement this work with external ESG data sources. This has helped us identify risks that we may not have previously focused on and zero in on companies whose products and services enjoy a secular tailwind like materials recycling or electric and autonomous driving.

We believe the research process and team have never been stronger. The first four years after our buyout, our Partners Strategy compounded over 32% a year, beating the market by about 4% a year.

Rotonti: What is your portfolio management philosophy? How many stocks do you own? How do you determine weightings? What percentage of your portfolio is in cash?

Tran: We believe constructing portfolios with about 20 stocks allows us to invest with conviction. We typically start positions at 1%-2% and build them up to 5%. Our top 10 stocks generally make up about 60% of the portfolio due to appreciation.

Rotonti: How do you think about risk management?

Tran: We take several steps to manage risks. First, by focusing on leading companies with strong balance sheets, we minimize liquidity risks. Second, as we are fundamental investors, our research tries to identify companies whose prospects are improving. Third, we are valuation sensitive. We don't own the highfliers, rather we invest in growing companies whose valuations are at reasonable prices. Fourth, we analyze our portfolio through the Bloomberg U.S. equities risk factor model. These factors include revenue, EPS, ROE, dividends, momentum, trading, and value. We compare our portfolio characteristics vs. various indexes to gauge how our portfolio is positioned. This helps us identify where we're taking the most active exposure. Fifth, twice a year, we evaluate our portfolio through our moat review.  Ultimately, we are stock pickers and hope to underwrite and invest in the best opportunities we can find.

Rotonti: How do you analyze and measure management quality? What are you looking for?

Tran: Assessing management quality is a critical component of our research process. We study where senior management has been and how successful their prior engagements have been. We study their incentive structures to see if it aligns with creating shareholder value. We especially like management who act like owners and in fact own a significant amount of shares. We also like management teams who are willing to sell assets when market prices are higher than its intrinsic value and purchase assets when it's out of favor. For instance, 2022 has been a terrible year for almost every sector. In this environment, we find it noteworthy that about a quarter of our portfolio companies have purchased or are in the process of buying competitors or expanding into a new market. They are taking advantage of the current market weakness.

Rotonti: Do you incorporate a macro view into your stock picking and portfolio management? If so, what is your current macro outlook?

Tran: We have historically not incorporated a macro view into our stock picking, but this year has been dominated by macro factors. So, we've been spending more time on various macro risks. One point we'd highlight is one of expectations. At the beginning of year, market participants were only expecting one 25-basis-point rate hike from the Fed. Clearly the Fed has been much more aggressive and have raised rates by 375 basis points through November. More importantly, market expectations now incorporate another 50-basis-point tightening in December and another 25 basis points in January. We think that current market expectations may better reflect what the Fed will do and thus higher rates are now discounted into current prices. This is an important point, because if true, then fundamental factors like revenue, earnings, and return on equity may drive future stock prices rather than macro factors. 

Rotonti: What are all the ways that you factor interest rates into your stock picking and portfolio management?

Tran: Higher interest rates affect our research in many ways. The long-term average P/E for the market is about 16x. As interest rates increased this year, we've seen the market multiple contract from 21x forward earnings to 16x currently. Over the past year, we have been adjusting our models to reflect higher interest rates. This can express itself in a lower multiple for our estimate of a company's intrinsic value. If the company has debt, we assume that when they refinance the debt, that they'll have to take that on at a higher rate. In interest-rate-sensitive businesses, like Wells Fargo's mortgage origination, we assume a dramatic drop in loan demand, but higher net interest margin for the bank. Fortunately, all of our companies generate free cash flow and generally have a lot of options on how to allocate their capital. This has enabled many of our companies to grow through these volatile times. 

Rotonti: What is the ultimate role of an equity analyst and stock investor?

Tran: The goal of our research team is to find outstanding businesses for us to invest in. Our research goes beyond estimating future earnings and cash flow. Our active research and engagement with management enables us to develop a deeper understanding of the drivers of the businesses, as well as how management reacts to unforeseen events. Often, the most attractive price of a stock is when the near term is most uncertain. However, if we have conviction in the business and management, then that is precisely when we sow the seeds of superior future returns. When volatility increases, investors' time horizon shortens. Environments like today are precisely the times when we find some of the most compelling opportunities.   

Rotonti: How often do you hear stock pitches and what are your analysts expected to deliver during a stock pitch?

Tran: We have three stages of research. The first stage is an overview of the company, why it's interesting now, and identifies some of the risks and further areas to understand. These initial pitches are presented about twice a month. If the candidate passes to stage two, then we take a deeper dive into the drivers of the business, the competitive landscape, any customer concentration risks. We also build out the financial model to quantify the growth rate, margin opportunities, and estimate its intrinsic value. We also model out different capital allocation scenarios. It is also during this stage that we analyze the investment candidate through our ESG lens. Does management treat all stakeholders responsibly? Stage three is when I want to add the company. Here we look at sourcing, so which stock should we trim or sell to make room for the new company. We also look at how adding this company may influence the overall portfolio characteristics. Will our growth rate increase? Will our P/E decrease? Will this stock add to or reduce the overall beta of the portfolio? These factors help inform how we size the new investment.

Rotonti: How often does your team discuss existing positions in the portfolio?

Tran: We have daily team meetings and discuss a couple of our existing positions almost every day. This can be episodic around news events or earnings periods, but rarely does a day go by without us discussing one of our companies.

Rotonti: Please remind us of your definition of a high-quality business and how does business quality factor into your decision-making process?

Tran: There are several factors that we look for in determining whether an investment candidate operates a high-quality business. Some of these include high recurring revenue, high return on equity, high operating margin, and high incremental margin. Reasonable debt levels are especially important. We look for companies that can sustainably generate and grow free cash flow. Leadership in their industry in market share, technology, or operating discipline. These factors are critical in our decision-making process because inevitably, our companies will face challenges and having these factors helps them sustain and grow through these challenges.

Rotonti: Can you please remind us what valuation tools and metrics your team uses? Do you build discounted cash flow (DCF) models? Do you look at P/E ratios and free cash flow yields? Something else?

Tran: We use a variety of valuation tools, including DCF, sum of the parts, enterprise value/EBITDA, P/E, P/E relative to its peers, and private market values of peers.

Rotonti: What is your investment thesis in AerCap?

Tran: AerCap is the leading airplane leasing company. AerCap has operated successfully over several decades and had the opportunity to purchase GE's airplane leasing business in 2020, making them the largest airplane leasing company in the world. This gives AerCap benefits of scale which means significant discounts from Boeing and Airbus, global relationships with airline operators, and a deeper access to capital markets. AerCap's cost of capital is lower than their customers, so they can purchase airplanes at advantaged prices, obtain financing at favorable rates, and lease planes to a diversified customer base. Many of our companies exhibit their strength during periods of uncertainty. AerCap demonstrated that characteristic during COVID. At the beginning of COVID, air travel dropped over 80% and airlines were focused on preserving cash to weather the storm. AerCap helped their customers by enabling their customers to lease rather than own their airplanes. And it doesn't matter if the planes are full or if there is only one passenger onboard, the lease payments must be made.

Air travel is back to about 85% of pre-pandemic levels, so AerCap's cash flow has been very strong. Additionally, many fleets are now over 20 years old, and it makes economic sense to upgrade operators' fleets. New aircraft are more fuel efficient, fly further, and seat more passengers. AerCap will benefit from this multiyear upgrade cycle. AerCap should be able to grow earnings in the mid-teens over the next 5-7 years. Additionally, as air traffic continues to recover, we suspect AerCap will have a lot of opportunities to deploy excess capital. We wouldn't be surprised if the company repurchases over 10% of their shares next year.  Currently, the company is selling at 0.7x book value and 7x '23 EPS. Over a cycle, AerCap typically trades at 1.2 book and 10-12x EPS.

Rotonti: What is your investment thesis in Ball Corp?

Tran: Ball Corp is the leading aluminum can manufacturer. Aluminum is 100% recyclable and routinely takes share over plastic. Additionally, over 50% of Ball's volume is in specialty cans, which generates higher revenue and margins relative to the 12 ounce can. Many of our investments are suppliers or "picks and shovels" to a growing industry. Ball certainly fits that description. They supply critical cans to the beverage industry. Without the cans, their customers' products cannot be sold. We believe Ball can grow volumes in the mid-single digits. This coupled with pricing and margin expansion should enable the company to grow earnings double digits for the next three to five years. Management has a demonstrated track record of thoughtfully allocating capital, and we believe this year's macro headwinds is one of the reasons this high-quality company is selling at 15x '23 EPS. 

Rotonti: What is your thesis in Sherwin-Williams?

Tran: Sherwin-Williams is the leading coatings company. Sherwin is vertically integrated, meaning they manufacture their paint and operate over 4,500 Sherwin-Williams stores. Because of this dynamic, Sherwin's North American segment enjoys wholesale and retail margins, not dissimilar to Apple's retail model.  In a typical project, the cost of paint is about 10% of the cost of the job. Labor is a much bigger component. Sherwin is levered more to the maintenance and remodel market than to new construction. Nevertheless, rising interest rates have de-rated the entire housing industry. While this is understandable, the fundamental drivers of Sherwin continue to be robust, with margin expansion in 2023. We suspect the market is giving us one of the best entry points into Sherwin-Williams now.

Rotonti: What does Halozyme do and why do you like it?

Tran: Halozyme is a leading drug delivery company. In 2019, the company had a pancreatic cancer drug that failed their phase 3 trial. After this event, Halozyme's management and board decided to stop competing on drug discovery and instead to focus on their proprietary enzyme, Enhance.  When combined with an intravenous (IV) drug, the combination can change the method of delivery to a 5-minute sub-cutaneous injection instead of an IV line. Most IV drugs are oncology drugs that are lifesaving. Now, Halozyme partners with companies like Johnson & Johnson, Roche, and Bristol Meyers to combine their IV drugs with Halozyme's Enhance. In doing so, patients can receive the combo drug in minutes rather than several hours. Additionally, the new drug combo often receives a new Food and Drug Administration (FDA) patent, which extends the life of Halozyme's partners' patents. Halozyme receives milestone payments as the drug progresses and once in the market, Halozyme receives about a 4% royalty on the price of the drug. Halozyme has over 10 partners' drugs currently on the market and over a dozen in the pipeline. With just the drugs on the market, Halozyme's revenue should grow from about $260 million in 2020 to over $1 billion by 2024. Royalty revenue generates about 90% incremental margins. Earnings and cash flow should grow at a very attractive rate.      

Rotonti: What do you say to those that say Halozyme is a one-product company facing a patent cliff?

Tran: Halozyme's European and U.S. patents expire in a few years. However, this is already contemplated in their contracts. Many of these contracts are for 10-plus years, regardless of the patent expiration. In other cases, their contracts have a step down in rates. Finally, Halozyme is not resting on their laurels and continues to sign new partnerships and add new capabilities. We believe you have a lot of optionality with Halozyme. 

Rotonti: As of Oct. 31, 2022, Progressive stock is basically at a 52-week high. Why has the stock held up so well and is the valuation still attractive to you?

Tran: Progressive is a leading auto and homeowners insurance company. Auto insurance is required by law. We like that. We believe Progressive is a leader in using data to acquire customers and underwrite profitable policies. Progressive has about a 13% market share in auto insurance but only about 1% in homeowners insurance. We think they can grow 10%-12% organically just by cross-selling their core auto policy holders to homeowners. However, that's not all. About 35% of Progressive's net income is from their investment portfolio. Last year, Progressive's investment portfolio was earning about 2% with a short duration. As interest rates rise, Progressive can reinvest their portfolio at higher rates without any incremental costs. Hypothetically, Progressive can reinvest in 2-year U.S. Treasuries and earn over 4.5%, or double their current returns. We think Progressive's core business is durable and growing at an attractive rate. The increase in net interest margin should accelerate earnings over the next couple of years. They absolutely benefit from a rising rate environment.

Rotonti: What are your current thoughts on Wells Fargo?

Tran: We first purchased Wells Fargo in November 2020 at $22.50. As Wells Fargo addressed their prior aggressive marketing, the company's efficiency ratio ballooned to 80%. Best-of-breed peers like JPMorgan and Bank of America's efficiency ratio is in the mid-50s. We believe that there are many ways to win with Wells Fargo. First, as they clean up the company's culture, their expenses should decline. Second, their net interest margin (NIM) was under 2% last year and as the Fed raises interest rates, Wells Fargo's NIM will increase meaningfully. On the flip side, Wells Fargo originates about 1 out of every 3 mortgages. With 30-year mortgages now over 7%, the bank's mortgage business is down significantly. We do think they are adjusting their cost structure to level set with current demand. Third, Wells Fargo has a lot of excess capital and has repurchased over 10% of their market cap over the past 18 months. We think Wells Fargo can earn $7.50 per share in a couple of years. If you apply a 10 multiple to that, Wells Fargo can reach $75, or more than 50% upside from current prices.

Rotonti: You own a lot of tech companies including Alphabet, Amazon, Microsoft, Salesforce, and Palo Alto Networks. Which do you think offers the best risk/reward and why?

Tran: Technology companies make up about 30% of our portfolio. This group has hurt our performance this year. This has been frustrating for sure, but their moats continue to be strong. Each of these companies are leaders in their field and have a business where the incremental revenues are very high. Over the past two years, each of these companies have also expanded their addressable market through acquisitions or product extensions, so we think there is a long runway of growth. I think Alphabet is one of the most compelling values right now. It's selling at a market multiple and is growing EPS 12%-15%. They also have a great balance sheet with a net cash position. We believe that Alphabet and all of our technology investments will emerge from this volatile period even stronger.