Morningstar Magazine - August/September 2018 - 62

Investors

Aligning Interests
Boutique buys businesses run by
managers who have skin in the game.

UNDISCOVERED MANAGER

Laura Lallos

In every issue, Undiscovered Manager profiles
a noteworthy strategy that hasn't yet been
rated by Morningstar Research Services' manager
research group.
Tucked within Principal Global Investors,
which runs more than $450 billion of assets as part
of Fortune 500 company Principal, is equity
boutique Aligned Investors. There, chief investment officer Bill Nolin and director of research Tom
Rozycki oversee a $22 billion portion.
Most of that is in a successful mid-cap strategy
Nolin has run since 1999, which is closed to
new investors. The mutual fund version, Principal
MidCap PCBIX, earns a Morningstar Analyst
Rating of Silver. However, the lesser-known
Principal Blue Chip PBCKX applies the
process to larger-cap names and has been open
to newcomers since it launched in 2012.
Both strategies follow a long-term, bottom-up,
fundamental approach that distinguishes
them from Principal-branded equity strategies,
which have a more quantitative spin.
To signal that distinction, the team adopted
the Aligned Investors name when it was
officially carved out as an autonomous boutique
within Principal in 2015. The name alludes
to Nolin and Rozycki's preference for investing
in companies run by owner-operators
or demonstrating an owner-operator culture-
where management's personal interests
are aligned with those of company shareholders,
a deep knowledge of the business
fosters innovation, and a long-term perspective

Morningstar August/September 2018

predominates. "We contrast managers who have
real skin in the game with 'cash-paid' CEOs,"
Nolin says. "Someone with their family's net worth
in the company, who thinks about risk and
acquisitions differently. They aren't going to buy
back stock like Citigroup C did in 2007 and
then issue tons more in 2009, or make acquisitions
at the top of the cycle."
Building From the Bottom Up

The owner-operator angle is one of four
cornerstones underpinning the process. In addition,
the team seeks high-quality businesses with
sustainable competitive advantages; it evaluates
buyers, suppliers, and competitors to determine
whether a company enjoys barriers to entry
such as economies of scale, switching costs, and
distribution advantages. The team then employs
a valuation discipline to build in a margin
of safety before buying, forecasting financials
and running discounted cash flow models.
These three cornerstones help keep risk in check
by fostering careful buy decisions. The fourth
cornerstone is risk reduction. After purchase, the
team monitors holdings for adverse developments
that might signify fundamental change. Early
warning signals include disruptive technologies,
regulatory changes, and eroding barriers to entry.
As the funds' relatively low turnover suggests,
the process has identified picks worth holding
for the long term. Both funds have turnover ratios
well below the median for active funds in
their respective Morningstar Category, mid-cap
growth for the MidCap fund and large growth
for Blue Chip.
"Of the 40 companies in the Blue Chip portfolio,"
Nolin says, "18 were in there on Day One."

Similarly, nearly half of the companies in
MidCap's portfolio at the end of May were first
purchased more than five years ago, according
to Morningstar's data.
A Concentrated Take

The MidCap fund starts by screening the smallest
800 companies in the Russell 1000 for those with
high returns on investment capital and healthy
profit margins, and the Blue Chip fund expands the
process to the largest 200 stocks. The buy-andhold philosophy allows some firms to remain in the
MidCap portfolio after they grow into large-cap
territory, though at least 80% of assets must
be within the Russell Midcap's market-cap range.
(As of May 31, MidCap held nearly 60% of assets
in large-cap stocks by Morningstar's measure.)
The two funds had 23 holdings in common
at the end of May, representing about 55% of the
MidCap fund and 33% of Blue Chip. MidCap's
largest holding at nearly 5% was Brookfield Asset
Management BAM.A, which it has held since
2005. The company has a similar weight in the
Blue Chip portfolio and is among the top 10 names.
According to Nolin, the Blue Chip portfolio
breaks down roughly as one third companies that
are among the large-cap holdings in MidCap;
one third "graduates" of the MidCap fund, such
as Costco COST and American Tower AMT;
and one third "great companies like Berkshire
Hathaway BRK.B that we were never able to own
in MidCap."
The Blue Chip fund is more concentrated, with
about half the number of holdings; at last count,
that fund held 42 stocks to its sibling's 78.
"These companies tend to be dominant in their
field," Nolin says, "with good capital allocation,
very strong moats, and high recurring
revenues and free cash flow coming from several
parts of the world."
Blue Chip's top holding, Amazon.com AMZN,
clocked in at nearly 10%. The fund initiated the
position in early 2015, on weakness after the
disappointing introduction of the Fire phone. That
setback created a buying opportunity and didn't
detract from the company's long-term prospects with owner-operator Jeff Bezos at the helm.

http://www.Amazon.com

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