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Time of Sands

As Frank Sands Jr. prepares to formally take the reins of the concentrated-growth boutique founded by his father, he is vowing to keep the firm independent. His top priority: reversing a dramatic recent slip in performance and a spree of client defections.

Until recently, Frank Sands Jr., president of Sands Capital Management, has enjoyed an enviable track record. Not only did he successfully steer the boutique money manager founded by his father through the technology stock collapse and the ensuing bear market, he also grew assets roughly 20-fold, from $946 million in 2000 to $19 billion at the end of 2005. Since the firm’s inception in 1992, Sands Capital has topped the Russell 1000 growth index every year except 1993 and 1997, when it fell only slightly below its benchmark.

Lately, though, the Arlington, Virginia–based firm’s reputation has suffered. Like many boutiques, Sands Capital grew in part by undercutting its competitors with low fees. But last year the firm raised prices on two large pension fund clients, The Florida State Board of Administration and the Teachers’ Retirement System of the State of Illinois. Both terminated Sands Capital, withdrawing a total of $1.5 billion. Then performance slumped. During the first six months of this year, Sands lost 9.1 percent net of fees, falling 8.2 percentage points below the Russell 1000 growth index. Clients closed 73 more accounts and withdrew some $300 million in additional assets. “This year’s performance has been the most difficult year-to-date relative results we have ever had in our history,” admits the firm’s president. Still, the 39-year-old money manager says he doesn’t regret raising fees.

These setbacks come at an awkward time for Sands Capital. A critical succession strategy is unfolding that will have taken five years to execute when Frank Sands Sr. retires as the firm’s chief executive and chief investment officer on September 5, 2008, his 70th birthday, and passes those titles to his son. During this transition large money managers are eyeing the 46-person firm as an acquisition target. “We have been approached by all sorts of groups,” says the younger Sands, who declines to name his would-be suitors.

Nonetheless, Frank Sands Jr. is determined to keep the family firm independent. His immediate priorities are to land new accounts and to regain Sands Capital’s once-stellar performance edge without diluting the investment approach that has served the firm so well until now. If successful, not only will Sands Jr. be well positioned to continue going it alone, he may also reach the firm’s goal of $25 billion in assets by the time his father retires, at which point Sands Capital plans to close to new investors. That milestone would mark a level of success and generational continuity that boutique money management firms rarely achieve.

With just 27 stocks in its portfolio, Sands Capital runs one of the purest forms of bottom-up, concentrated-growth investing in the country. Every day the 11-member investment team meets for hours about the portfolio, discussing stocks they have considered buying or selling for months — or even years. All of the firm’s holdings are companies that the team has agreed fit six loosely defined criteria: sustainable above-average earnings; leadership in a promising business; significant competitive advantage; clear mission and value-added focus; financial strength; and rational valuation relative to the market. Current holdings include retail giants Lowe’s Cos. and Walgreen Co., Internet plays Google and Yahoo!, biotechnology leaders Genentech and Genzyme Corp. and medical technology companies Varian Medical Systems and Zimmer Holdings.

Because the team evaluates performance on a rolling five-year basis, annual turnover is just 16 percent, compared with an average of 65 percent for growth equity funds, according to the Investment Company Institute. Still, low turnover doesn’t diminish the flow of ideas. “We debate and take action, but sometimes the action is to do nothing,” says the younger Sands.

The firm’s concentrated-growth style reflects the investment education of Frank Sands Sr., who began his career in finance in 1969 as an oil industry analyst at Loomis, Sayles & Co. (now part of CDC IXIS Asset Management North America) after earning an MBA from the University of Virginia’s Darden Graduate School of Business. In 1972, he moved to David L. Babson & Co. (now Babson Capital Management, part of MassMutual Financial Group of Springfield, Massachusetts), where his approach took shape during an 11-year career under the tutelage of the firm’s namesake, a legendary growth-stock investor. The gospel was simple: “Companies that grew at an above-average rate were companies that you wanted to hold for the long term,” says the elder Sands. When Babson’s principals began buying value stocks — essentially chasing performance — he quit.

After a brief, unhappy sojourn on the sell side in the mid-1980s, Sands Sr. became chief investment officer of Washington-based money manager Folger Nolan Fleming Douglas, part of Capital Group Cos., in 1986. Six years later he went solo, returning to his hometown of Arlington, Virginia to launch Sands Capital Management with $60 million in assets from former Folger Nolan institutional and high-net-worth clients.

At his own firm Sands Sr. added the adjective “concentrated” to his growth-stock credentials. “We improved upon it in the margins,” he says. “We went from having 75 stocks to 25 to 30 stocks. Once you get up into the high 20s, it’s ‘deworsification.’”

Despite good performance, by the late 1990s, Sands Capital was struggling to attract big pension funds and family offices. Sands hired a marketing firm, Alpine Partners, which crafted a strategy and began introducing the firm to investment consultants on the prowl for growth managers. Although the emerging dot-com fever suited the firm’s growth pitch, the consultants refused to bite because Sands Sr., then in his early 60s, had no succession plan. The concern, he says, was that “the founder stays until he drops, and then the firm closes.” In July 2000 he hired his son and began introducing him as Sands Capital’s heir apparent.

FRANK SANDS JR. WAS 33 WHEN HE JOINED THE

firm as director of research. One of three children, he had long had a desire to enter the money management business. In 1994, after earning an MBA at Darden, his father’s alma mater, he joined boutique money manager Fayez Sarofim & Co. in Houston, where he showed promise as a concentrated-growth manager. He rose quickly during his six years there, from technology stock research analyst to portfolio manager to principal before resigning to join his father’s firm back in Arlington. A former colleague at Sarofim who asked not to be named remembers him as being “energetic and inspired” — and ambitious.

Very ambitious, in fact: Sands began moonlighting for his father — and exerting control over key decisions — at least a year before he formally joined the firm. In July 1999, for example, the younger Sands interviewed Scott O’Gorman Jr., the first of seven loyal portfolio managers he would hire over the next six years.

Once formally on board, the son lost no time in scaling up the business in anticipation of the new assets he was determined to bring in. Under his direction, the firm invested in new information technology and streamlined its marketing, buying out Alpine’s portion of a revenue-sharing contract and forming a new, in-house marketing department.

Like all growth investors, Sands Capital lost money from 2000 to 2002. Nonetheless, the firm beat its benchmark in all three years thanks to its focus on resilient growth stocks viewed by the market as good long-term bets. Sands Capital also added to its appeal by pegging its fees “a basis point or two below” the competition, recalls Stan Rupnik, chief investment officer of the Illinois Teachers’ Retirement System.

In 2001, Sands Capital hooked its first substantial account: Florida’s State Board of Administration, which invested $517 million. It was a watershed event. “People decided, ‘This is a big enough firm,’” says the younger Sands. Other big clients followed, including Ikano Funds of Luxembourg and a few family offices, all of which opened accounts in excess of $200 million.

The following year, armed with what was by then a ten-year track record of beating the Russell 1000 growth index net of fees nearly every year, the firm won mandates from pension funds such as General Motors Asset Management and the Public Employees’ Retirement Fund of Indiana. To publicize the firm’s name, Sands Capital began to subadvise the Constellation Sands Capital Select Growth Fund, a retail mutual fund that now offers two share classes, for Constellation Funds Group of Cincinnati, part of Touchstone Advisors. (In 2005, Sands Capital would also begin subadvising the Constellation Sands Capital Institutional Growth Fund.) From the end of 2001 to the close of 2003, Sands Capital’s total assets nearly quadrupled from $1.45 billion to $5.46 billion despite the bear market.

With the stock market rebounding in 2003, the firm returned 36.26 percent net of fees, beating its benchmark by 6.51 percentage points. Frank Sands Sr. seized on his firm’s positive performance to substantiate his succession plan. On October 24, 2004, he sent a letter to clients and consultants announcing that his son had been promoted to president of the firm and would take over as CEO and CIO in 2008. Sands Capital more than doubled its assets, to $11.42 billion, by the end of 2004, then nearly doubled them again, to $19.26 billion, by the end of 2005.

With assets pouring in, the CEO and the president moved to cement employee loyalty with an equity compensation plan. In 2005 they changed the firm from a Subchapter S corporation to a limited-liability company, enabling them to sell employees about 15 percent of the stock. “If anything, they have overengineered this thing,” says consultant Michael Rosen of Angeles Investment Advisors, a Santa Monica, California, firm that has steered clients to Sands Capital. “It’s clearly working.” To date, not a single member of the investment team has left Sands Capital since the firm was founded.

Last year, with assets continuing to flow in, the firm reached another critical juncture. Some consultants questioned whether an 11-member investment team could competently manage assets approaching $20 billion. But the junior Sands had no intention of expanding the firm. He reasoned that remaining faithful to his father’s concentrated-growth philosophy — and staying nimble — meant limiting the portfolio to its current complement of 27 stocks. That’s why he and his father plan to close the firm to new clients when assets hit $22 billion and to cap new money, even from existing clients, when assets reach $25 billion.

This plan helps explain the recent loss of the Florida State Board of Administration and the Illinois Teachers’ Retirement System. Knowing that the firm was on track to close to new money, the younger Sands went about “culling clients,” as an official of one public pension fund phrases it, sending letters to the Florida and Illinois funds that threatened to terminate their accounts if they didn’t pay higher fees. The two funds had signed on at below-market fees and now balked. “You don’t bid to beat your competitors and then raise fees two years down the road,” says Illinois Teachers’ CIO Rupnik. “It has never happened to us.”

The ill will came at a bad time. In the first half of 2006, 25 of the 32 total positions that the firm owned underperformed the Russell 1000 growth index. The poor climate for growth stocks was partly to blame. But Sands Capital also fell prey to a common pitfall of the bottom-up approach, says consultant Rosen: Members of its investment team became emotionally attached to stocks in the portfolio, an error that was probably exacerbated by the firm’s loosely defined stock-picking criteria.

In January, for instance, the team finally sold Dell in two batches, at $29.89 and $28.41 a share, after a long slide from about $42 at the end of 2004. “We’ve had a couple of mistakes this year,” admits David Levanson, a senior analyst and a member of the investment team. “We had companies that were great investments and stuck around a little too long. They just matured. They started to not meet sustainable, above-average growth for the future.” As performance fell the firm watched an additional $300 million in client assets walk out the door, though the younger Sands dismisses the defections as “normal turnover.”

Sands Jr. isn’t contemplating major changes to his investment process. As Robert Puff, vice chairman and a director of Sands Capital, puts it: “That’s the equivalent of taking some kind of poison. That’s exactly the kind of thing that would lead to a firing.” Rosen agrees. “There’s a balance you want to achieve between changing it and improving on it,” he says.

And that’s what the young president intends to do. His investment team is “looking for ways to innovate and improve” how it applies its investment criteria and is considering some changes to the portfolio, such as selling Wal-Mart Stores and Microsoft Corp. and buying organic grocer Whole Foods Market.

For now, Sands Capital’s solid longer-term record has bought it some breathing room. Rosen, for one, is telling the investors he advises to stay the course. And the younger Sands is landing new clients. North Carolina Retirement Systems opened a $750 million account in September, and the firm plans to announce that it has signed up a university endowment and two pension funds that collectively have more than $250 million to invest.

With a few more wins and a turnaround in performance, Sands Capital’s heir apparent should be well positioned to replay the victories he has scored over the past six years — and to write the definitive book on the art of staying independent.