Innovation a Key Driver of Long-Term Growth

Alec Lucas: Hi, I'm Alec Lucas of Morningstar's Manager Research team, and I'm joined today by Amy Zhang, who is the portfolio manager of Alger Small Cap Focus.

Amy, thanks for joining us.

Amy Zhang: Thank you for having me, Alec.

Lucas: So, we've got macro topics, a couple of them, on the agenda. One of them is the U.S. economy. You're a bottom-up, small-cap investor. It gives you a unique vantage point to the U.S. economy. What are you seeing?

Zhang: Well, I think the underlying economy is pretty healthy, but we're in a late cycle after eight years of economic expansion. So, the economic growth going forward is probably going to be moderate. So, growth will be scarce. That's why I think the best way to generate growth will be through innovation. And as you know, innovation is a common theme of our portfolio, that we look for innovative small companies that can outgrow the economy by providing proprietary products and services with some powerful secular drivers behind it. They usually transform or create a market, a large and growing market, and gain a lot of market share with a wide moat. So, as such, innovation will be a critical factor to sustain the revenue and profitability generation that we look for over the long term.

Lucas: And are you finding a lot of innovative small companies relative to other times in your investing career right now?

Zhang: Yes. I mean, just like anytime, that we always try to find growth is not priced in, that company really has the potential. We're very futuristic. So, we spend a lot of time understanding the company, the products, and the services--whether they really have a very strong competitive advantage, and innovation, the company's attention to innovation. Their spend on R&D, for example, will propel them to sustain that advantage. As such, the company's competitive advantage keeps getting stronger and they can continue to gain market share and also, a lot of times create new markets for themselves and then expand their own addressable market. And that's what we call value creation, and stock price usually tracks value creation over the long term.

Lucas: OK. And so, the second topic is just the run-up in tech stocks. You've long favored tech stocks. Some investors have begun comparing this run-up in tech stocks to the late 1990s, early 2000s, the Internet before the bubble burst and the dot-com era and now we have the mobile era. Do you see any resemblances to what we're currently experiencing in tech and what we experienced in the late 90s?

Zhang: I would say no. I really feel it's not comparable both from valuation or a fundamental point of view for those two eras as we call it. If we call 1990s the Internet 1.0; now two decades later, it's Internet 3.0. In the Internet 1.0 era it was really about people dreaming the dream. So, I'll call it a dream versus reality now. That time the tide lifted all boats. Anything with a dot-com attached, they fetched a very huge multiple ...

Lucas: Pets.com.

Zhang: Yeah, exactly. There's no winners and losers. And a lot of companies are pre-revenue, right, and a very few companies actually have profitability. So, the valuation was definitely ahead of itself. It should be much more heavily discounted looking back.

So, fast forward to what is--there was a lot of hype then. Now, I think the fundamentals support the valuation, because it's no longer an R&D project, whether it's in cloud computing or in mobile devices. They both transformed people's lives, the way they live, people with work. And companies in those areas, they are usually data-driven software companies that they provide real-time intelligence that really, turning data into actionable information, increase efficiency and productivity for corporate America. So, the valuation now is really supported by the strong fundamentals.

Lucas: OK. And so, profits would be one way to distinguish the tech companies of the late 90s versus now--they are actually making money, right?

Zhang: Right. Definitely. And clearly, now we have the clear winners and losers. The companies we invest in are usually the dominant players in a niche market, that they have a very wide moat and that they can sustain that revenue and profitability by continuous innovation. So, sort of more winner takes all era now. So, to that extent, they should be warranted a higher valuation.

Lucas: And any areas of the market where you see valuations as being particularly worrisome, overextended?

Zhang: Well, from a short-term point of view, you see the tech run-up. But we really look at companies over the next three to five years or even 10 years. So, we really focus on a company's competitive advantage. As long as they can sustain that competitive advantage and keep expanding their addressable market, we're looking for compounders. So, if a company's competitive advantage keeps getting stronger, the multiples should stay or sometimes expand. But we really look for the earnings growth, the earnings growth should drive stock price over the long term. So, to that extent, I don't think it's that worrisome. But just like any market, there's correction and we try to take advantage of market volatility, really focus on intrinsic value of a company.

Lucas: OK. Thank you very much for sharing your thoughts on the current state of investing.

Zhang: Thank you, Alec.

Lucas: From Morningstar's Manager Research, I'm Alec Lucas.