MASTERCLASS: Mid Cap Investing - February 2016

Mid Cap stocks have histrionically delivered better returns than small or large cap equities. Amid market turbulence and slow growth will that trend continue? Watch as three experts discuss the merits of Mid Cap equities.

  • Derek J. Deutsch, CFA - Managing Director, Portfolio Manager at ClearBridge Investments

  • Bryce Lee, CFA - Senior Institutional Consultant at The Optimal Service Group

  • Malcolm E. Polley, CFA - President & Chief Investment Officer at Stewart Capital Advisors, LLC

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  • 01 hr 00 mins 07 secs
Mid Caps MC Audio Transcript

Courtney: Derrick, mid caps have historically delivered better risk adjusted return than their small and large cap brethren, why do you think this is?

Derrick Deutsch: So it’s definitely true that that’s been the case, especially if you look longer term. So if you look out, you know, 10/20 years, the returns in the mid cap segment of the market have bested that of both small and large cap, both on an absolute basis and on a risk adjusted basis. And so I think one of the main reasons that that’s been the case, when you think about what is a mid cap company. It’s a company that sort of graduated if you will, from its more risky startup phase, yet still has many years of growth before becoming a mature enterprise. And so they’re really in that sweet spot of their growth cycle if you will. And so that’s when you see companies expanding into new markets, perhaps offering new products and services on top of the original ones that they might have developed and really kind of exploding in terms of their growth potential. And so we see it as a part of the market where you can get access to companies that are really thriving and have many years before they’re likely to be mature.

Courtney: They saw that big runway for growth, but on the other hand they’ve got less volatility and more access to debt, better management teams, would you agree?

Malcolm E. Polley: Yes, very much so. From our perspective it’s kind of interesting because mid caps kind of straddle both sides of the fence. You’re buying the larger end of the small cap space and smaller end of the large cap space. And if you think about a large cap manager where they increase the return potential in your portfolio without going out of their space is you buy the lower end, conversely, for a small cap manager, reduce the risk, you buy the upper end of that space and mid cap by definition does both. So you get less risk than small cap, better returns than large cap and by and large it’s translating into very good long term rates of return.

Courtney: And how do you define the Mid Cap space? A lot of times we see 2-10 billion in market cap, how do you see it Bryce?

Bryce Lee: Yes, that’s the traditional definition, is somewhere in that 1-2 billion on the low end, all the way to 10 or 12 billion on the upper end. But I will say it’s been unique the last several years, the Russell Mid Cap Index which is a common index used of course, has 97 securities that are larger than 10 billion dollars. Coming into the year of course everything has come down dramatically as we’ve started 2016. But coming into the year there were five securities that were larger than 30 billion dollars in the Russell Mid Cap Index. So clearly we’ve seen there are some very large companies that are within that index. But that’s historically been the common definition for mid cap.

Malcolm E. Polley: Yeah, our definition that we use is a billion to 10 billion dollars. So very much within the range that Bryce was talking about.

Derrick Deutsch: So I guess my definition’s a little more flexible, because we’ll look at what the constituents of the mid cap indices are. So we look at both the S&P 400 and the Russell Mid Cap Index. And we’ll kind of define the universe by the smallest constituent that resides in those two indices and the largest. So formally we’ll go up to 30 billion, but we would never initiate a position anywhere near that size. But we could let them appreciate up into the largest kind of constituent of the Russell Mid Cap Index.

Malcolm E. Polley: Yeah. We certainly let ours appreciate. We won’t take them out simply because they’ve exceeded the 10 billion dollar space.

Courtney: Right, which is a good problem, right?

Malcolm E. Polley: Right, I guess so.

Courtney: And so Malcolm, do you see mid caps as more of a domestic player? I mean with all the preoccupations that investors have had around oil, China, strong dollar, how do you see it?

Malcolm E. Polley: Well, we are by definition domestic only managers. So if it’s traded in this country and we can get its financials on US GAAP, we’ll look at it. Most of what we own is domestically focused although Mid Cap companies do have international exposure; many of them have some small overseas offices, that they have sales overseas; you do get some of that exposure. And particularly over the last few months, really second half of 2015, it really hasn’t mattered how big or how small you are, China and energy and all that kind of stuff have really flowed over into our space. So it really hasn’t made all that much difference.

Courtney: It hasn’t made a difference. Do you see the same thing?

Derrick Deutsch: I mean I think the reality is, is that Mid Cap companies do have exposure to overseas markets because it’s a global economy that we’re in. And they’re often serving markets
outside of the US. And that makes a lot of sense because they’re trying to maximize their opportunities. You know, and I think the pendulum shifts. So when, you know, the international markets are doing better and China is on a roll, everyone wants that international exposure. Right now when we’re seeing a little more volatility and slowdowns in some of the emerging markets, you know, people want to insulate themselves from that exposure. I think, you know, relative to large caps, you’re going to have less international exposure typically with mid caps, but probably more than you would with small caps.

Courtney: Well, is there more opportunity right now in mid caps, I mean because when you talk about that insulation [inaudible], less visibility around earnings and growth, maybe is that more applying to the large caps, the mega caps than it is to small or mid caps?

Derrick Deutsch: Yeah, I think, you know, whenever you have cross currents in the market from a macro perspective, whether that’s, you know, a slowdown in China or currency movements that can be quite, you know, impactful when you’re translating to US dollars. The impact is going to be felt I think, you know, across the board, whoever has that type of exposure is going to feel it. I think large caps perhaps to the extent that they have a greater portion of their business from those types of markets, might have greater uncertainty. But if you look at sort of historically, you know, if you use like earnings surprise as a proxy for visibility if you will, you tend to see lower surprises with larger companies, you know, a little more so with mid cap and much more so with small cap.

Bryce LEE: I think you’d be surprised to see that international small cap and mid cap was one of the better performers in 2015, that’s an asset class that even most investment professionals don’t spend a lot of time in. And I think we saw … where you saw what was going on, especially with the emerging economies, the developed countries a little bit better. But nonetheless to see positive returns in 2015 from the international small cap, and I think it goes back to your point Derrick about they’re more insulated from issues that might be happening outside of their borders.

Courtney: Well, was this mostly developed ex US not … because emerging markets have really got hit.

Bryce Lee: Yes, definitely developed.

Courtney: And then what about when you are looking at domestic based mid caps, when you’re evaluating those funds, are you seeing a lot of look through as far as international exposure?

Bryce Lee: Yeah. So that’s a common question that when we’re interviewing managers, we really want to understand how they look at their companies and do they really understand their companies? So I’ve seen some statistics as high as 30% of the Mid Cap Index, could be getting revenue generated from overseas, may not apply to every security obviously in the Mid Cap Index, but could be there. It’s not important to us whether a manager has that exposure or doesn’t, it’s really understanding, do they know their companies? Do they understand what’s going to happen to their companies in different environments? And so that would be the question that we want to know ahead of time and then be able to challenge them later on in terms of, you said this was going to happen and then something else played out. You know, what went on in that situation?

Malcolm E. Polley: And there’s certain industries that tend to lend themselves more toward international exposure. So if you’re a transport company that [inaudible] limits your international exposure in terms of ownership, if you’re a railroad company or mid cap railroad company or mid cap railroad service company, you’re not going to have sales overseas.

Courtney: Yeah. So it’s very nuanced?

Bryce Lee: It is.

Courtney: By sector?

Bryce Lee: Yeah.

Courtney: And I do want to get into sectors later. What do you guys think was the key catalyst that really drove performance for your particular mid cap portfolios in 2015?

Malcolm E. Polley: For us it was two things. If you had exposure to energy and materials in any way, shape or form whether it was direct or guilt by association, that really [inaudible] your performance down, for us what really helped performance was acquisitions. And that tends to be one of the reasons we lose a name in a portfolio which is great for mid cap, I mean mid cap is prime breeding ground for M&A activity because they are larger companies. But we tend to lose more companies due to acquisition because of what we own. And that was definitely the case in 2015, we lost quite a few of them to acquisition which means we have to find more to replace them with, a good problem to have.

Courtney: And it was a better year for M&A as well in 2015.

William E. Polley: Most definitely.

Derrick Deutsch: Yeah. So our portfolios actually did quite well last year, at least on a relative basis. I mean we’re in positive territory in terms of return. And I think one of the reasons for that is we really tend to focus on higher quality companies. And since 2009, it’s been a period where higher quality has been more of an impediment than a help in terms of investment returns. And I think there’s a lot of reasons why that might have been the case, we think the primary one has just been the monetary environment that we’ve been in since the financial crisis. And so we saw that start to wane in late 2014. And by 2015, we started to see quality really start to outperform as an attribute. And so when I talk about quality, I’m talking about stocks that have high returns on capital, good free cash flow generation, strong balance sheets. And those types of companies did better than the lower quality companies last year, which has been true for most of the time periods that you would look at. There’s really been kind of two periods where that hasn’t been the case, when you had five year rolling returns, it’s been the late 1960s was really the last time up until this most recent period. Other than that you see high quality companies really outperforming low quality companies on a pretty consistent basis to the tune of maybe 700 basis points per year. So you know, I think having a high quality orientation last year was definitely beneficial.

Courtney: [0:10:00] And you mentioned the monetary environment, dig a little deeper and explain how that impacted mid caps?

Derrick Deutsch: [0:10:07] Yeah. So when you’re in an environment where money is cheap and easy, having leverage for instance is not a bad thing, it’s a good thing, right, because you’re paying very low debt service cost on that extra, extra capital that you have. And so it’s an environment where you tend to see, you know a rising tide lift all boats to use a common analogy. And so it doesn’t matter whether you’re a low quality or high quality and often in many cases lower quality tend to do even better in that type of monetary environment. So that’s kind of been a struggle I think for active managers and certainly those that focus on quality companies for the last, you know, several years up until recently. And so that’s sort of the phenomenon that we’ve been kind of dealing with and trying to manage.

Courtney: Yeah. Do you think there’ll be a change though, that this is becoming a stock picker’s market or we’re going into one?

Malcolm E. Polley: I think that’s very much the case. There are certain sectors that by and large we don’t think are going to do very well. We’ve been very underweight financials for a long time. You know, a lot of people think financials would do well in a rising rate environment. And eventually they will. But what tends to happen, as rates start to rise margins contract, they don’t widen initially. And as they contract, most financials are going to be hurt. So we’ve chosen to step away from, which is kind of odd for a value manager. But we tend to steer clear of sectors that we think there are problems in, financials, energy we’ve really reduced our holdings in because of the huge supply demand imbalance that exists there. And we really don’t see an end to that in the near future.

Courtney: Well, digging in with financials, I mean that’s an interesting case because, you know, we were supposed to see or we’re supposed to see four rate hikes, supposed rising net interest margin, if we don’t see that, that the virtues of financials may be attenuated there, also you know, there’s a lot of sale side chatter that a lot of sovereign wealth funds have helped financials, and that’s kind of been giving them a hit. So there’s a lot of interesting dynamics, how do you see financials?

Derrick Deutsch: Yeah. So I mean in general our approach is to actually take a relatively sector neural approach, so a little bit different than what Malcolm is talking about. And so the reason for that is we believe that we can really add the most value by selecting stocks. We feel that our sort of competitive advantage is really getting to know businesses well, valuing them and having that reflected in the portfolio. Once you start taking big sector over and underweights, it does sort of reflect a more macroeconomic view than you’re reflecting in your portfolio. And we feel that our chances of being right in terms of calling interest rates or oil prices or GDP growth, it’s just lower than that of finding individually miss-valued securities. So all that being said, within financials we do tend to be a little bit underweight right now, and that’s mainly because of REITs. And so REITs have become a pretty large component of the financials benchmark within mid cap. And so that’s an area where we’re just not seeing much value to tell you the truth. We are seeing banks that are attractively valued and I understand that a rising rate environment is maybe under a little bit of uncertainty right now because we’re seeing slower economic growth and The Fed might not raise rates as quickly as we think they will. But we’re still seeing a lot of banks that are trading below tangible book value, which to us is very good value. And so we do own some banks, we do own some diversified financials. We own some asset managers. We own a boutique investment bank which is doing very well. So we’re really just kind of picking our spots within financials.

Courtney: So it seems like the flipside, the good case for financials in the mid cap space is that probably none of them are SIFI, none of them are systemically important financial institutions therefore they don’t have those arduous Basel III capital requirements, that their mega cap or large cap peers would have, is that weighing into it?

Derrick Deutsch: No, I think that’s true. I think that the regulatory environment for financials and particularly large banks has gotten difficult to put it mildly. And so there’s a lot of regional banks and smaller cap banks that really don’t have those impediments. And so we do think that that’s something that’s beneficial when you’re investing within the mid cap section of the market. You kind of avoid those problem areas, but at the same time there are some larger mid cap banks that do fall over the SIFI threshold.

Courtney: They do, okay.

Derrick Deutsch: So there’s a few but not many.

Courtney: Alright, so it’s right on the cusp. How are you viewing financials in mid cap portfolios, Bryce?

Bryce Lee: Yeah. I mean I think you hit the nail on the head in terms of the Central Bank policy. We think that’s elongating the economic cycle. And typically when we’re evaluating managers, we want to see them through an entire cycle. We want to see kind of peak to peak or trough to trough to be able to see how they perform in different market environments. And what you’re getting is an environment where over the last three to five years, which might be a typical cycle; you’re seeing only one environment or one style in favor. They talk about lower quality or those types of attributes. And we want to make sure that we’re not firing managers for the wrong reason. So we need to take that into consideration. And to your point, if it’s going to make the cycle extend out even further, we have to be careful about how we evaluate those managers.

Courtney: Malcolm, I mean we talked about within financials, being on that cusp, between mid cap and large cap. Why do you think it is important to look at the market capitalization when evaluating an investment?

Malcolm E. Polley: We don’t necessarily look at the market capitalization other than to keep it within our sphere of influence, within that 1-10 billion dollar range. We do value companies and to
the extent that the valuation falls where we want it to. I mean market capitalization’s just one method of looking at that. And I ask my students when I teach periodically, how do you value any asset? It’s pretty simple; it’s the present value of all future cash flows. What causes those things to differ right now for instance interest rates have been fairly low which has helped values stay up fairly high. If interest rates rise, values have to drop. So to the extent we can help build a valuation case and figure out where that present value lies. You know, if it falls within our range, we think it’s undervalued, then we’ll buy it.

Courtney: And what about from your perspective, are you looking at style drift at all, for instance that good problem we talked about earlier when, you know, an original mid cap stock is now in the large cap, is that something you’ll look at when you’re evaluating the cap managers?

Bryce Lee: Absolutely. You want to understand why they own something. We use a lot of different tools, we can … something like MorningStar’s Ownership Zone helps plot the individual securities in your portfolio. And we can look at the spectrum of those; find out how you’re behaving in this type of environment. And especially we’ve married up two different managers that may do something very different, like each of these do. We want to make sure that they’re not overlapping at the same time, because then we’ve got unintended bets within the portfolio.

Courtney: Well, let’s talk about your valuation process?

Derrick Deutsch: Sure. So we look at valuation in a variety of ways. And so I think Malcolm talked a little bit about discounting cash flow analysis. And we always start there, but at the same time we want to also look at sort of other valuation metrics as well, because the inputs to a DCF framework, if you change it just in a small way you can have very large kind of differences in terms of the output. And so we recognize that. So we also look at things like cash on cash returns, that’s looking at a current point in time, how much cash flow is being generated relative to the enterprise value of the firm. We also look at free cash flow yield. We’ll look at traditional PE and EBITDA multiples. And it’ll change based on the type of business that we’re looking at. So more cyclical businesses, we might put more weight on price to book versus a PE or a free cash flow yield because there are just too much, you know, the earnings volatility is just too high for us to rely on any single point in time, what that earnings is going to be. And so we’re taking that into account.

Courtney: And with the growth of your focus, would you ever evaluate companies that may have a negative free cash flow at this point?

Derrick Deutsch: Yeah. So when we’re looking at earlier stage companies and certain sectors like biotechnology for instance, you often have companies that are in a stage in their lifecycle where they might not have commercialized product yet and they’re investing for future growth. And so we are willing to look at certain companies that might be free cash flow negative today, not to a very large degree, and they are quality oriented. So this doesn’t happen often, but from time to time, we will have the flexibility to look at companies that might be free cash flow negative today, for the promise of very nice free cash flows in the future if they’re successful. And so we need to use our judgment in terms of whether they will be successful, and to what degree and make sure we don’t overpay for that at today’s price.

William E. Polley: And even we will buy companies that on occasion have negative free cash flow. There may be a reason, perhaps they’ve a large CAPEX for plant equipment, they’re doing a major expansion that will cause free cash flow to be negative for a year or two. If we can understand when that cash flow will turn positive and we can present value that and buy it at a level that’s lower than the present value of the future cash flow streams. We’re willing to look at short term free cash flow negativity.

Courtney: How important is return on investment capital?

William E. Polley: Very important. I know a lot of people have got return on equity, and one of the first things they teach you in business school is that you can make ROE go up and down by doing one thing, adding and subtracting leverage to the balance sheet. We don’t like companies that use a lot of leverage. We will buy companies that have it in the business model. But by and large we want companies with management that make smart allocation decisions. And it doesn’t make sense for us to have management that invest in projects that have a return on invested capital below their cost of capital. I mean you’re destroying the value of the business. So we love companies that generate high returns on invested capital, that’s one of the things we look at.

Courtney: Yeah, that positive delta and profitability for management is always a good … I’m sure that’s a universal, right?

Bryce Lee: Remember, you’re in the mid cap space, it’s not been followed by as many street analysts, these companies are not as well researched; they’re not as well institutionally owned. So the work that they’re talking about doing on companies is extremely important.

Courtney: That’s a great point too, that you don’t have the sale side research competing with your own bottoms up research, I mean it’s an advantage, right, in some cases?

Derrick Deutsch: Yeah, absolutely. I mean if you look at sort of the degree of sale side coverage for mid cap companies relative to large cap for instance, it’s far lower. And so in our experience the quality of the analysis also tends to move down with the size of the company. And so, you know, I think that affords us an opportunity to find those companies that have great financial characteristics that are potentially being overlooked by the market. So things like the return on invested capital are critical to understand. And you know we see that is one of the most important metrics that we look at in evaluating companies. And if you look at our overall portfolio you’ll see our return on invest capital is probably twice that of the benchmark, if not higher.

Courtney: And mid caps are often described as being in the sweet spot of their business cycle. Tell us why that matters and how you apply that in your evaluation of the individual securities?

Derrick Deutsch: Yeah. So I think it matters because one, the investments have been derisked to a certain extent because they’ve really gotten past that startup phase, they’ve achieved a billion dollars in market cap at the low end and oftentimes a little bit higher than that when we enter a position. But at the same time they still have a lot of growth potential ahead of them. So they might be expanding into new markets. They might be adding new products and services to their clients. And they’re really at a point in their lifecycle where they’re going through very rapid growth. And they have market share opportunities to gain. They might have an innovation in terms of something that’s not being offered in the marketplace today, or something that’s superior to what’s being offered in the marketplace today. And they’re capitalizing on that. And so they’re growing rapidly and then they’re also at a point in time where they’re probably well financed and able to show increasing profitability as they grow their top line. And that has very powerful effects on the earnings growth of these businesses. And so we see it as really the sweet spot of a corporate lifecycle and really an area in the market where you can gain outsize returns.

William E. Polley: Yeah, very much so, you get past the small cap space where you’ve levered up to try and grow your … the company, grow the business and the company. In the mid cap space many of these companies are de-levering. And so cash flow initially is going to pay down debt which is a good thing for us. And become a company that is very focused which again leads back to M&A, it tends to be a very good bulk on acquisition for a larger company that wants to diversify its book away from a specific product or service.

Bryce Lee: That shows up in those risk adjusted returns that you talked about at the very beginning. So as Derrick mentioned earlier, over the long term they’ve had the best risk adjusted numbers, higher returns than large cap with lower volatility than small cap. And when you talk about your end client, small cap may be a volatile asset class for them and they may tend to make wrong, you know, bad mistakes in terms of investing, whereas in the mid cap space they can utilize an asset class that’s going to get a better return but not have as much volatility.

Courtney: And let’s talk about mid caps, we’re talking about their own business cycle, but what about in the broader economic cycle, where do mid caps fit in there and are there nuances between growth and value?

Derrick Deutsch: So I think when you have mid cap companies that are not entirely mature and really dependent on GDP growth per se, to grow their businesses because they have some unique business or product or service that they’re capitalizing on. Sometimes the economic cycle can be less important because they have a superior product or service that’s really gaining share. And where the GDP growth is 1, 2, 3 or 4, they’re still going to succeed in any case. So I think certainly there are more economically sensitive industries and companies than others and you need to be aware of where you are in the economic cycle and how that’s going to affect that individual business. But we feel that within the segment of the market, we can always find businesses that are able to grow, generate free cash flow, have higher returns on capital and in many cases allocate that in a very shareholder friendly way, whether through dividends or debt pay down, or buying back shares, so that we can find companies, we have 2,000 to choose from within the mid cap segment of the market, that can manage through even a tough economic cycle.

Malcolm E. Polley: Right. And because so many of these things are focused and they operate in subsectors within the broader economy, they’re growing fast as an economy just by definition, you’re getting a better growth rate. You’re also able to buy companies because of their financial position, because they’re larger than their small cap brethren, and because their balance sheets are relatively clean, can use the difficult environment of a down cycle in the economy to pick up assets from smaller companies that have gotten into trouble from a leverage perspective or even larger companies that are trying to divest and become more focused and goose their growth. So it’s really a benefit in many ways because of their size.

Courtney: So it’s a buying opportunity now for you, but maybe for the companies themselves.

Malcolm E. Polley: Most definitely. Most definitely.

Courtney: And we keep hearing about share buybacks across the board, how common was that in mid caps?

Derrick Deutsch: So it’s been a common phenomenon I think pretty much across the equity spectrum. And so, you know, we’ve been in a situation where companies have really high profit margins on average in total. And they’re generating a lot of free cash flow and leverage is not particularly high right now. And so there’s not a lot of debt pay down that needs to occur, if you’re taking a very broad look at things. And so what are their opportunities to do with, you know, what are they going to do with their cash flow? They can do M&A, so that’s an option. They can pay dividends and grow their dividends, that’s another option, or they can buy back stock. And so we have been in an environment where stock buybacks have been, you know, pretty robust. And that’s definitely helped earnings per share growth. But you know we want to make sure that companies are being smart about those decisions. And they should only be buying back their stock if it’s trading at a discount to the intrinsic value, otherwise they’re destroying value. And so we spend a lot of time with the management teams to make sure we understand how they’re making those decisions, whether it’s just proved problematic and they’ll buy back stock no matter what, regardless of the price, we don’t think that’s a smart way to manage the free cash flow. We want to make sure they’re thoughtful about really allocating the free cash flow to the most efficient use of it. And in some cases that might be dividends. In some cases it might be M&A. And sometimes it might be better just to sit on it. So it really kind of depends and we want to make sure that the management teams are thoughtful about making those decisions.

Malcolm E. Polley: Do you find the management teams more receptive to communication than maybe the large cap area or some other area of the market?

Bryce Lee: It really depends on the business. We’ve got a number of managements that are very receptive because in many ways, we’re their view to the marketplace, and so we can be in many cases the only company that’s following them. And so as they want to build a following and start talking to analysts, they will get some access that way. You know, some of them in certain businesses are very difficult. We’ve got one company in our portfolio that management will not talk to anybody. It’s just the way they are and it’s nothing personal, they don’t talk to anybody. You know, management happens on a large percentage of the outstanding stock of the company. So they’ve got skin in the game. So we think we’re at least on the same side of the table. But it makes it a little more difficult when you have to really dig into the financial statements. And that’s really the differentiator for us, is that we spend a lot of time digging into the Ks and Qs, digging into what the management are saying and the footnote switch. You know, a lot of people don’t want to take the time to do that and particularly in smaller companies, that’s where management is going to tell you what they’re doing and how they’re making their decisions.

Courtney: And when you mention M&A usually you’re thinking of the large caps being acquisitive and buying up mid caps. But are the mid caps actually being acquisitive and buying up small cap companies as well, is that happening?

Derrick Deutsch: Yeah. So we’ve seen M&A all up and down the market cap spectrum. So there’s certainly been a lot of cases where larger cap companies are buying small and mid cap companies. I mean that’s very common and maybe typical. But you also see a lot of mergers of equals if you will, within the mid cap segment of the market, and just larger mid caps buying smaller mid caps. And so given the environment we’ve been in where there’s a lot of cash on the balance sheets, the economic growth has been slow, so people are looking for ways to augment their growth, financing is very cheap, they’re generating a lot of free cash flow. You know, we’ve been in a boom in terms of an M&A cycle. And so, you know, we’re seeing lots of permutations of how transactions are being formed.

Bryce Lee: In the mid cap space if you get an industry that’s very highly fragmented, a mid cap company that’s got a clean balance sheet and good management can really use that balance sheet to roll up some of these smaller offerings and grow market share at a much higher rate than they can do organically.

Courtney: And with the free cash flow and all the cash on the balance sheets that we’ve seen, you mentioned dividends, talk to us about the dividend phenomenon in mid caps. It seems like they’re among the highest yielding of between small and mid.

William E. Polley: Yeah. We don’t specifically look for dividends as the chance would have it the dividend yield on our mid cap product is reasonably high. But that’s almost an accident of what we’re buying. Management only has a few options of what they can do with the cash that they’ve got on hand. And if they can’t find acquisitions then they really need to return that cash to shareholders. You can do it through buybacks certainly. But if you don’t want to go private and in some cases you have to buy back so much of the stock, you’ve got to go private. The end result then is to pay a dividend. And the payout ratios are very low in general. So you can pay a dividend, grow the dividend and still invest a lot of money back into capital. It’s a really interesting phenomena within the mid cap space.

Courtney: And earnings growth is such an important factor. Walk us through that.

Derrick Deutsch: Yeah. So clearly earnings growth is something that, you know, we focus on, both as just investors in general but certainly when we’re focused on growth investments we want
to see good earnings growth. And it’s a way for companies to really create value by growing their businesses and returning that cash, in some cases, to shareholders but also reinvesting in their business so that they can continue to generate good growth. And so you know, we’re seeing a market environment now where growth is a little bit challenged. But at the same time we’re seeing lots of companies that are able to demonstrate still very good earnings growth in this environment. And so it’s something that we focus on and we pay a lot of attention to. And we want to make sure that companies are just being smart in terms of how they manage their growth, that they don’t, you know, give up long term opportunity to maximize short term profit, because that’s not going to work in their favor in the long term.

Courtney: And, Malcolm, how is your portfolio currently positioned? Without getting into sectors, I want to get into that next.

Malcolm E. Polley: So we’re not really sector specific, sectors are really a byproduct of the investment process. There are certain businesses and business models that right now we think don’t lend themselves as much to an investment opportunity. So where we’re finding a lot more opportunity is in technology related businesses, both on the hardware and the software side. Businesses that are related to the cloud and the growth in the cloud and the growth in storage needs, a larger portion of our portfolio has historically been the case, which is again odd for a value manager is technology focused. We have had fairly large exposure to energy and materials in the past. And we’ve really pulled that down because the opportunities aren’t there, the valuations aren’t there, the cash flow isn’t there today.

Courtney: But with energy in particular, I mean do you think that with oil cratering, maybe we haven’t seen a bottom yet, but do you think that there will be a point of capitulation there and then…

Malcolm E. Polley: Eventually there will, but the big problem we have in energy right now is you’ve got two to three million barrel a day supply demand imbalance. And until that comes back into balance, I mean it’s purely economics. If supply exceeds demand, price has to drop until demand and supply come into equilibrium. And you’ve got a number of the players in that business that are playing a massive game of chicken, who’s going to get out of the business first?

Courtney: Saudi comes to mind, yeah.

Malcolm E. Polley: Yeah, exactly.

Derrick Deutsch: So what we try to do is find companies that are attractively valued within the energy sector, that are high quality, that have good balance sheets, that are generating free cash
flow despite oil being where it is today. And so that’s where we’re focused. We tend to have more of an orientation towards the service companies than E&P companies. The E&P companies are really having a difficult time with oil where it is. And you know they’re sort of in a catch 22 where they can just stop producing because they’re not really getting good economics at oil prices where they are today. Or they can continue to produce and have loss. And so they’re trying to battle for survival at this point, they have debt covenants that they’re running up against in many cases. And so it’s really a mess for most of those companies. But on the service side they can take their CAPEX down to a pretty low level, such that the capital intensity just is not there with most of the service companies. And that’s where we’ve…

Courtney: Like it would be in E&P?

Derrick Deutsch: Like it would be in E&P. And E&Ps over time tend to outspend their free cash flow generation through the cycle and are often issuing equity to cover that. And so we don’t think that that’s an attractive sort of attribute when you’re looking at investments. We tend to focus on the companies that can earn a good return on capital, generate free cash flow and live to fight another day.

Courtney: Sure.

Bryce Lee: And I mean in the mid cap world over the last several years it’s been one of the toughest benchmarks to beat, I think the statistic’s somewhere between 75 and 85% of managers have underperformed over the last couple of years. And energy is a part of that, remember, you’ve got an index in the case of Russell that reconstitutes every year. And because … just because we’re in the middle here sandwiched between small and large cap you’re going to get more rotating in and out of that index than you are in many other indexes. And so many managers have been a little bit overweight energy, once again not a bet on oil, but just thinking the free cash flow and the analysis they’ve done with the companies, and they’re not necessarily going to sell a company unless something’s deteriorating within their business model.

Courtney: And I know you both look at companies from the bottom up and sector biases and things may just emerge from that. What about healthcare, technology?

Malcolm E. Polley: Healthcare and technology and technology’s been a focus. Healthcare’s been a somewhat of a focus, but it’s been that because of a macro issue that we really see driving the whole thing. You’ve got a major generational shift going on, as the boomers get older, you know, I’m at the tail end of the baby boom generation; we tend to want to stay active. You know, unfortunately as you get older your body tends to break down a little bit and we’ll do anything to stay active. So the need we have for various medical products and drugs and so forth will certainly rise. We have been focused in areas that are focused on cost containment, particularly in the United States with the Affordable Care Act, ObamaCare if you prefer, has really put pressure on certain businesses. And there are certain businesses within the healthcare space we just don’t like because the economics aren’t good.

Courtney: Because of the Affordable Care Act?

Malcolm E. Polley: Because of the Affordable Care Act, hospitals for instance. When the Affordable Care Act was first … became law you saw a lot of hospital companies that saw a nice pop in their stock price, the thought process being a lot of the pro bono work they were doing for people that couldn’t afford it was all of a sudden going to get paid. But what people were forgetting is the other side of the equation; costs were going to rise pretty dramatically. And things that they were getting paid nicely on from those who were insured, it’s probably going to come down as reimbursements were going to come down. And we just didn’t see the real benefit there. So then we saw it was very difficult for us to find a good business case for investing in hospitals long term.

Courtney: What about, you mentioned the demographics with baby boomers, I mean that just seems like it would be a tailwind with so many people needing more services within healthcare.

Malcolm E. Polley: It can be, but there are certain sectors within there, for instance, nursing skill care. I would love to be able to invest in that business, there’s just no good way to do it. You can buy REITs but we don’t like the structure of a REIT.

Courtney: Like a senior housing REIT?

Malcolm E. Polley: A senior housing REIT, they’re highly levered, the only way you can expand your bed count is to lever up or delete your shareholders and neither is a particularly good option in our mind. So places that we would love to invest that are pure beneficiaries, the baby boomers, there’s just not a very good way to do it. And the pharmaceutical side, if you’ve got branded
pharma you’re facing a patent cliff as they have been facing for a number of years now, a lot of generic competition, a lot of pressure to push prices down. Generic’s a very interesting place to invest and we’ve really looked at it, at those very closely. Biotech is also an interesting place, and there are some biotechs that are earning nice cash flows from their business line even though they’ve got a very small product mix. There are also businesses that are blending the branded business and the store business to allow you to minimize to a certain extent the patent cliff that exists in pharmaceuticals.

Courtney: And when you mentioned the smaller nichier products, are these the orphan drugs?

Malcolm E Polley: Orphan drugs, or they are more focused drugs with an indication that’s been around a long time. That provides better efficacy relative to an indication that there’s been a non-biotech alternative available for.

Derrick Deutsch: So healthcare’s a sector that we actually like a lot. It’s been … it was a great sector last year as you probably know. And this year it’s been a little bit more challenging. And so, you know, there’s always a lot of cross currents in healthcare, it’s a regulated industry. So things like what the healthcare policy is in the United States is very important, you can see a presidential candidate post something on Twitter that gets everyone excited about drug pricing. And that could have a major impact on security prices believe it or not. So it’s something I think you need to, you know, tread carefully and find the companies that really have good durable businesses that are going to be able to do well even if the regulatory environment does shift in some
way, shape or form.

Courtney: But let me ask you too with that Tweet, which from a presidential candidate - Secretary of State, that’s what you’re referencing. Did you see that as a buying opportunity though, that people just sort of got, you know, scared and it was a Tweet?

Derrick Deutsch: So, you know, I think what gets drug investors and biotech investors very concerned is any form of potential price control, because this is an industry that has kind of been able to operate unfettered in terms of the ability to increase prices. I think the Affordable Care Act more or less institutionalized that because it doesn’t allow the federal government to negotiate prices directly with the companies. And so there’s a threat that, you know, there could be a change in the administration and that policy might change, I think there is some warranted caution and there is some sense in being nervous about that. But in our opinion it did create buying opportunities for sure. And so you mentioned orphan diseases, there are some companies that we own in that particular space. And the nice thing about that is that you have small patient populations but you do have high prices in order for these companies to earn a decent return for investing in the R&D to address those small patient populations, they need to be able to charge a fair amount in terms of the price of the drug, otherwise they wouldn’t make that investment and it wouldn’t make any sense. And I think that’s recognized by policymakers. And the last thing they want to do is shut off R&D such that these, you know, unmet medical needs are not being … going to be met in the future. And so it’s, you know, it’s a little bit of choppy waters that one needs to navigate in terms of all of these cross currents that are happening.
But I think if you focus on the innovative companies that really can address an unmet medical need they’re always going to be able to get value for their product. It’s the me-too type of companies that just generate a small incremental benefit that really doesn’t have a clinical significance. I think it’s less likely they’re going to be able to charge high prices for those types of products. And then there’s other areas of healthcare that are potentially are more interesting. So managed care is an area that we have at least one investment. And in the Medicaid side of the business that’s really growing and managed care solutions within the Medicaid population are more efficient. And so it’s part of the solution, not the problem. And so we don’t see that as being an area for regulators to target. So there are areas within healthcare that I think you can navigate and generate very nice returns, it’s just a matter of picking your spots.

Courtney: Yeah. I mean it’s so interesting because we do see a lot of this in the news, like the Attorney General of Massachusetts coming out and saying that a drug price was too high, it wasn’t offset by the need for innovation and R&D

Malcolm E. Polley: Well, you can either try and figure out which companies are going to have the best and most innovative drug or like it was in the gold rush, you can hunt for gold or you can sell the picks and shovels to the gold miners. And that’s where we have found more value, is in those people that sell the picks and shovels, that win regardless of which compounds make it to drug form and make it to market, they’re going to be providing research services to the pharmaceutical industry, to do that work. So from our perspective they’re a winner regardless.

Courtney: Alright. And before we leave the sectors, any last sectors that you just really are avoiding at this point?

Malcolm E. Pulley: Avoiding. We have tended to avoid consumer discretionary names, although we do have a few in our portfolio, retail in particular we’ve not liked a lot. But our general thesis is we’re overstored, not only within the United States but globally. And the economics have substantially changed for the worse. And there’s a lot of stores that don’t understand that and are really hurting because of it and Wall Street is making them pay. You get a large line retailer like Pennies for instance, you know, same store sales may be hurting, might not be because of the sales in a store, it may be because of their omnichannel, somebody buys a product, has it shipped to their home, it’s the wrong size, they deliver it to a local store and it comes out of that store’s comps. And that whole change in the makeup of the retail business has really changed the economics to the standpoint that online retailers and traditional retail simply isn’t going to be as successful as it has been in decades past.

Courtney: It seems too like baby boomers are not spending as much as they probably were at their peak earning period. And then we’re hearing that millennials are really valuing experiences over tangible goods.

Malcolm E. Polley: And it’s interesting, there is a lifecycle of earnings and spending. The boomers on average have hit the peak where earnings are starting to decline and spending is starting to decline. The average millennial is not yet 21 years old, think about that. So they haven’t gotten their first job, their first real job. And so their spending, while it’s increasing at a fairly rapid pace, is not enough to offset the spending decline that the boomers are facing. That we think is a big reason for why the economy can’t get out of its own way. You’ve got aggregate demand declining; growth just isn’t going to happen.

Courtney: Yeah.

Derrick Deutsch: Yeah. So as I mentioned earlier, we do tend to invest in a sector neutral way because, like I said, we do feel that if we’re either naked or massively overweight certain sectors, it does have a macro bias that’s embedded in the portfolio, which we try to avoid. That being said, there are definitely areas of the market that we are underweight. And we’re not finding a lot of good opportunities. So utilities for instance, not the best business model in the world, many of them don’t earn their cost to capital. But at the same time they’re very interest rate sensitive. And so if you don’t own any utilities at a time when interest rates are coming down, you’re going to pay for it, staples is another area where we think the stocks for the most part are very expensive. We’re not finding a lot of good opportunities within staples. But we own a few that we really like a lot. So we do have exposure there. I mentioned real estate investment trusts earlier. Again, a very interest rate sensitive sector, you know, we have some exposure there but we’re pretty underweight. And we’ve found opportunities in other areas of financials to kind of cover up for that. So there are definitely sectors that are less attractive than others.

Courtney: Tell me too about your portfolio management process, walk me through, you know, how concentrated you are.

Malcolm E. Polley: We’re fairly concentrated. We’ve been running focused portfolios since before it was cool, that’s kind of what I started doing when I got into the business in the mid 1980s. We’re in 30-50 names, because we don’t think that it make sense. And we think it’s much more difficult for a manager to keep their arms around the companies that they own and understand them to the depth that we understand them, if you own a lot of names. And then something interesting happens, as you get closer to a 100 names in your portfolio, your portfolio begins to look and act a lot like an index fund.

Courtney: Closet indexing.

Malcolm E. Pulley: Yeah. If that’s what you want that’s great. But Vanguard does it very inexpensively.

Courtney: Why pay for that?

Malcolm E. Pulley: Exactly. So if you’re going to be an active manager, have the strength of conviction in what you do and focus what you invest in. It’s never made sense to us to own things in bad businesses simply because they’re represented in an index. And utilities are a great example, they’re bad businesses. They’re not earning their cost of capital. They’re very interest rate sensitive. And so we don’t really see a lot attractive there and so we just choose not to own it. It’s not a macro bet, it’s not a call on where the economy is going. We just don’t like the businesses.

Derrick Deutsch: So we also run focused portfolios but not quite as focused as Malcolm’s portfolios. So our core product owns about 65 securities and that’s typically where we’ve been. And so, you know, if you look at our active share, which is a measure of overlap between us and the benchmark, it’s very high, meaning there’s lower overlap. So we have about 90+% active share in that portfolio. In our growth portfolio, it’s a little more concentrated, we own close to 50 securities in that portfolio, again very high active share in the 90s. So we feel that we’re very differentiated from our benchmark, yet we’re also diversified and able to control risk to a certain degree by being diversified.

Courtney: Bryce, how do you evaluate that?

Bryce Lee: I mean that’s the active share, the concentration, those are all important to us, definitely criteria that we look at when evaluating a manager. But we also want to evaluate the capacity of the manager too. We’re talking about mid cap here, it’s better than small cap in terms of being able to find enough names. But that’s another criteria that we’re going to look at is how large are you. You’ve got like I said, more room to run than small cap but you can’t get up to be, you know, many billions of assets under management because then you won’t be able to find as many of those good ideas, especially if they’re running focused or more concentrated portfolios, which we prefer.

Courtney: Yeah. I mean you bring that up, how hard is it to find good names? There’s more mid cap stocks than there are large cap, I mean there’s a big universe out there.

Malcolm E. Polley: It really depends because we’re valuation focused. There are times where it’s very difficult. I mean the first part of last year it was very difficult to find names. We found companies that we love their business model, we loved everything they do, we just didn’t like the price. You get the selloff in the fourth quarter of last year and the first part of this year, now all of a sudden price comes back down to make … where we’ve got a lot more names that we’re interested in. So it can be…

Courtney: Well, what are the other nuances when you’re evaluating mid caps? I know you evaluate a whole universe of funds out there, but what is it about mid caps that you particularly look at?

Bryce Lee: Yeah. I mean let’s talk about the universe real quick. There’s within each of these gentlemen’s universe there’s probably a 150 managers that we may look at and evaluate as a peer group that we’re comparing them to. Compare that to probably north of 500 on the large cap side. So you’ve got a smaller universe to evaluate those managers, you’re looking at all those issues we talked about, capacity constraints, their return profile, a lot of those different criteria. One thing that we’re finding a lot of, resonates with a lot of clients is we’ve utilized the SMID asset class which is of course small and mid cap. And that allows, if a manager, you know, if a client just says, “I can’t take 9 different managers with the MorningStar style boxes with all the diversification that portfolios either overseas or in the fixed income side.” It allows us not to abandon the asset class because we really do think mid cap is important, but it allows it to consolidate the manager, so that way they can let their winners run for a while. So that’s one potential solution if you’re running up against headwinds with clients that are saying, “I like the asset class but I can’t dedicate more assets to an additional manager.”

Courtney: And before I let you go, I’d love to get everybody’s take on your risk management process.

Malcolm E. Polley: We focus really on the price value relationship because we are very value focused, we won’t pay up for a company, the price value relationship is really the largest part of our risk management. And it shows up in the variability of our portfolio returns, our standard deviation is fairly low, relative to the market. You know, we don’t like to take risks. And when we do we want to make sure we get paid for it, hence the valuation requirement.

Derrick Deutsch: So I would say similarly, the most important thing that we do as portfolio managers is really make good investment decisions. And so that involves really getting to know our
businesses and derisking them, making sure that we understand how the company’s likely to perform in different scenarios, stress testing the model. We meet with each of the management teams to make sure we understand how they intend to manage the business and that we are aligned with them as stakeholders. So we will also seek out probably the most bearish analyst that we can find on each company that we invest in to make sure that we’ve gone through the [inaudible] adequately and we appreciate the downside risk. That being said, there are other sort of portfolio risk controls that we have as well. So you know, we have maximum position sizes, we won’t go over 5% at market in any individual position. We have sector constraints that I talked about. We run fairly close to sector neutral but, you know, we have some latitude 400 or 500 basis points within the sector weightings is where we like to be. And we do have tracking error constraints. We like to be within 4-6% of the benchmark. And so there are a number of things that we do, we use Northfield Information Services to provide outputs to make sure that the tradeoff between stock specific risk and factor risk is more heavily weighted towards stock specific risk. We look at the factor risks that we do have embedded in the portfolio; we make sure that we’re comfortable with them and they’re not unintended. And so there are a number of things that we’re doing from a risk control perspective.

Bryce Lee: In our manager evaluation framework it’s the exact same skill set that they’re using in evaluating companies, we’re using that to try to evaluate the manager. So we’re really trying to understand why they make their decisions and be able to evaluate that. We do use a proprietary risk optics model when we’re evaluating managers. And the way we define risk is not by just volatility but it’s really the potential loss of capital. So we’re looking at a lot of different factors that go into that, because at the end of the day, you know, all of us are trying to separate out luck from skill. It’s the same thing they’re doing with managers, at the end of the day we don’t want those me too businesses where they’re just riding the beta of the market. We really want to be able to identify a manager that can separate themselves and really be able to have a repeatable process. And so we’ll look at rolling period analysis, because a lot of times you’ll look at an end point and a starting point. But clients get in and out of strategies. We hire and fire managers at different times. So the more time periods we can look at, we’re really looking for that repeatable process.

Courtney: And lastly, Malcolm, any recent purchases or any good stories that you’d like to share with us?

Malcolm E. Polley: Lately we’ve tended to find companies that have a bit of a controversy. So for instance, GameStop we’ve owned for a long time, there’s a huge bear case against it. The
position being it’s another Blockbuster, you know, Blockbuster went under because of a lot of their business was being cannibalized by Redbox amongst other things. But what people don’t understand is the business model that GameStop uses. They don’t have the same long term lease issue that Blockbuster did. There’s no natural competitor to the secondary market that GameStop creates. They’ve done a great job of diversifying their business with the technology business that they’ve added on to it which is growing very rapidly. And management has been kind of holding off their shorts to a certain degree by buying back stock. They generate huge amounts of cash flow that they can’t adequately reinvest in their business. And so they’ve been giving it back to us as shareholders for buying back their stock. It’s a wonderfully run business, their capital returns are fantastic. And so we’ve done a good job of playing off the shorts if you will, comfortable with the risk, understanding the issues that people think are behind it. But we know that they’re wrong, because they’re not looking at it correctly.

Derrick Deutsch: So I’ll give you an example as well and it’s actually related to GameStop, it’s a company named NVIDIA, and they actually make graphic cards that go into the video games that people are renting at GameStop. And so what we like about NVIDIA, tremendous balance sheet, great returns on capital, they have a very nice market opportunity both in serving the video game market. And so they are the leader by far in that market. And there’s just a lot more video games being played that require more advanced graphics, and so they are serving that particular need. At the same time their one competitor is a company that’s under financial distress, AMD is the name. And they’re really able to capitalize on that. So they’re in a very nice competitive position. And then we see some very new growth opportunities emerging for the company, one is in virtual reality type of applications, which is becoming a hot topic in Silicon Valley and we think that there is a reasonable chance that that’s going to be a big market. And they’re also serving the auto market in terms of the newer technologies like self-driving vehicles and sensors and the ability to navigate without a driver at the wheel. And so they’re making the chips that go into these systems that enable these cars to be manufactured. And so that’s a new growth opportunity for them as well.

Courtney: And so all the cool parts of technology now, right, self-driving cars, artificial virtual reality. Wow! Alright, well great insights, before I let you go, I’d love to get everyone’s final takeaways. And let’s start with you Derrick.

Derrick Deutsch: So I think the biggest take away from my perspective is that you know, the viewer should really make sure that they understand the type of manager that they’re buying, and so from our perspective, high quality is really incredibly important when investing, not just in the mid cap space, but across the market. And I think the evidence that proves that these types of companies do better over time is very clear. We have, you know, a gap between high quality and low quality, roughly 700 basis points on an annual basis looking back historically all the way to 1965. We see no reason that that gap should not continue out into the future, especially after going through a period of time when high quality did not do well, a short period of time. So we feel very good that companies that have great balance sheets, high returns on capital, good free cash flow generation, management teams that allocate that capital effectively, are the ones that are going to win in the long term. And I think your viewers will be well served to focus on managers that identify and invest in these types of companies.

Courtney: Bryce, your final thoughts.

Bryce Lee: Yeah. So at the end of the day, we believe that mid cap has been an important area to be. And we think that will continue. We want investors to have that exposure. However, they need to get that exposure whether they have a manager that can dip down into that area or they utilize SMID or a dedicated mid cap manager, but at the end of the day it’s a growth area that we think is attractive. And so we want to make sure that people get access to that. At the end of the day though you can tell it takes a lot of research to identify those companies, so they do need to make sure that the managers have deep analyst and really understand those companies because they’re not as widely followed. So it’s an area that we think is attractive and we think that people should continue to look at it.

Courtney: Malcolm.

Malcolm E. Polley: We really think that investors need to think like business owners, because that’s what you’re buying when you’re buying a stock, is a fractional ownership interest in a business. And so from our perspective it’s always made sense that you think like a business owner when you’re buying a share of stocks. So as investors we really think you should be focusing on managers that think like business owners, high free cash flow, high return on invested capital, management that makes smart decisions with their money, and concentrates their bets so that they’re not investing in businesses that are bad businesses because they happen to be represented somewhere. We think that will serve investors very well going forward. Do your homework, just as we do.

Courtney: Alright, great insights, thanks so much gentlemen. And we want to continue this conversation about mid caps, follow us on our social media on Twitter, LinkedIn and Instagram. From our studios in New York, I’m Courtney Woodworth.