A Concentrated Solution at Artisan Small Cap

Greg Carlson: Hi, I'm Greg Carlson, a fund analyst at Morningstar. I'm joined here today by Craigh Cepukenas, the co-manager of Artisan Small Cap Fund.

Craigh, thanks so much for joining us today.

Craigh Cepukenas: Thank you for having us.

Carlson: Craigh, maybe we can talk a little bit about Small Cap Fund. It's been around since 1997. You have been a manager on the fund for a number of years; however, it has seen some changes in the last 18 months or so. Can you talk about first the transition in terms of the management team, and then we can talk a little bit more about the portfolio?

Cepukenas: Certainly. So in September of 2009, one of my associates retired, Marina Carlson, and at that point in time we decided to transition Small Cap Growth by merging it into our U.S. Growth Fund. So our U.S. Growth Fund had been managing two strategies, and we decided that adding Small Cap would allow a very deep analyst-based experience team the ability to manage across the U.S. market-cap spectrum.

Carlson: Right, so now you are part of a team that also manages Artisan's Mid Cap Fund as well Artisan Growth Opportunities?

Cepukenas: Correct.

Carlson: …which is a large-cap growth fund.

Can you talk about what that's meant and how the fund's strategy has changed?

Cepukenas: That's a good question. When we merged the two teams, what we promised our investors was that we would spend 12 months to 18 months actually taking that portfolio stock by stock and transitioning it into the process, which was similar to Small Cap Growth, into the process used by U.S. Growth. And that process very similar to Small was a focus on franchise companies, a focus on accelerating profit cycles, finding those profit cycles early, with valuations that were reasonable that we could understand.

And so much of 2010 was working through that process, taking each of those stocks, research-qualifying them. The way that we described the capital-allocation process across our three strategies is in a garden, crop and harvest, and so we've spent 18 months repopulating the garden and pushing capital into those names where we had the highest conviction.

And so what you've seen from portfolio statistics over the past 18 months: We've become much more concentrated, and I think if you look at the top 10 positions, we're running at roughly 30% of the portfolio; top 20, almost 50% of the portfolio, which is very much in keeping with how the other two strategies line up against Small Cap Growth.

Carlson: And just to be clear, with garden, crop and harvest, basically referring to different points on a company's or stock's lifecycle within the portfolio from starter positions, to positions you really like a lot that are bigger, and then positions that are ready to be sold ...

Cepukenas: ... Ultimately harvesting.

Carlson: ... hopefully due to valuation increases.

Cepukenas: Correct. And so, I think it's starting to show as we've got a very good start to this year, but importantly, we have probably added 30 to 40 positions last year into the garden, and we've I think done a very good job of getting our timing better and pushing position size up, so that we're getting capital behind those ideas that are going to generate alpha for us.

Carlson: And that's a big change, because that represents roughly over half of the total number of holdings in the fund?

Cepukenas: It is a big change, so I would say not much of a change from investment philosophy, better execution and the big change is actually getting much more concentrated and the thought process there over the years in Mid Cap and across the U.S. Growth team is, getting paid for all the work we do. We've got a very deep analyst bench alongside some proven decision-makers, and when we find a good idea, we want to get paid for it. So, for Small Cap Growth, we will take positions upon purchase, up until 3%. So, we're sort of fulfilling the mandate we laid out for ourselves, but really never took advantage of under the legacy Small Cap Growth team.

Carlson: What would you say is different about the companies that have come into the portfolio? I know the fund, in its past guise, was sort of an on-and-off performer. Are you expecting more consistency now, and what would you say about these new holdings?

Cepukenas: I would say consistency around the discipline, around the process, is one of the things to expect, and I would say the other is that getting our timing right. We're profit-cycle hunters, and I think that getting capital into those positions as we're seeing the accelerating profit cycle is something that's starting to show through with performance. So it's a very big difference.

If we went back five years ago, you would have found a portfolio that was much more equal-weighted in nature, and so I think that change has served us well, and that's really probably the biggest change.