Are We in the Final Innings of a Bull Market?

Are we in the final innings of a long bull market? Steve Scruggs, CFA, Portfolio Manager of the Queens Road Small Value fund discusses the firm, his investment process, current market valuations, Fed action, and what he is buying in today’s market.

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  • 10 mins 32 secs
Gillian: Welcome to Asset TV. I am Gillian Kemmerer. I’m here at the Schwab Impact Conference in San Diego with Steve Scruggs; he’s a Portfolio Manager for the Queens Road Small Cap Value Fund. Steve, thanks so much for joining us.

Steve Scruggs: It’s nice to be here, thanks for having me.

Gillian: Absolutely. So let’s start out with the basics. Tell me a little bit more about the Queens Road Funds.

Steve Scruggs: Well, we’re based in Charlotte, North Carolina. And we are managed by Bragg Financial Advisors which is a family business, started 15 years ago. We have about $1.2 billion under management primarily for institutions and high net worth individuals. And we started the funds 50 years ago. And I have been the portfolio manager since inception.

Gillian: Great. So a long story history. Tell me a little bit about your investment team.

Steve Scruggs: Well, as I said, I am the portfolio manager, I am supported by two analysts, Benton Bragg, who is the President of our firm and also the Chair of our Investment Committee. And also Matt DeVries, who is CFA, he’s on the Investment Committee. They support me but ultimately the buy and sell decisions of the portfolio are made by me.

Gillian: And what’s your investment process?

Steve Scruggs: Well, we’re in small cap values, a very straightforward Graham & Dodd based approach. We like to say it’s a four step process. The first couple of steps are more quantitative in nature. We’re looking for companies that have strong balance sheets, serviceable levels of debt. So if they have a strong balance sheet, the next thing we look at is valuation and we usually use a discounted free cash flow model to come up with an estimate of intrinsic value to make sure that we’re getting these companies at good prices. So if the balance sheet is strong, we’ve got a good valuation. The next two things that we look at are more qualitative in nature. The first is management, so we like to see managements that can lay out a strategy and execute to that strategy. We like open and honest communication. We like to see managements take calculated risks. And if they don’t work out we want them to be open and communicate honestly about them, even if they don’t work out. And then the last thing is the industry and sector analysis we do. We want to make sure that all the companies we’re investing in are competing in industries that have favorable economics. And by that we mean industries that are growing, that aren’t overly competitive, ones where the competitors can earn rates of return on their invested capital greater than their cost of capital. And we think that that really prevents us from falling into some value traps, which is a problem a lot of value managers can fall into.

Gillian: Tell us a little bit about some of the things you’re seeing in the markets today.

Steve Scruggs: Well, it’s been kind of a crazy year. If you remember back in January, markets were pretty much at freefall, it’s the worst January we’ve had in many years, based on the Federal Reserve raising rates in December, kind of started that, and then the worries in China, and what oil prices were doing. But you know, a month later things kind of turned on a dime and we’ve been racing up ever since in the markets, except for the period in June with the Brexit vote. It’s been a very upward market.

Gillian: What’s driving some of the low volatility in markets today?

Steve Scruggs: Well, we think it’s primarily central bank policy around the world, and in particular the Federal Reserve. The old saying of don’t fight The Fed has never been more true. We see when they raise rates what happens, when they back away from their commitment to raise rates, what happens, markets tend to do really well. So we think that’s what’s kind of driving the markets right now.

Gillian: And in light of this low volatility and this continuous Fed support, how have the small cap funds performed?

Steve Scruggs: They’ve done well. As I said, in the first couple of months when markets were falling, we held up much better than our competition. Since then as markets have raced ahead we’ve trailed a little, but we expect to do that with the nature of our portfolio. We’re focused on having a margin of safety, downside protection. So typically we’re going to lag in markets like we’ve had over the last six months. Through the end of the third quarter, the Russell 2000 Value was up about a little over 15%. And we were up about 9%.

Gillian: Now, you’ve touched on this a bit, but you have a history of strong downside protection in your funds, how do you accomplish that?

Steve Scruggs: Well, we think it’s a byproduct of the process, the kind of companies that we end up investing in are really high quality, stable businesses, that hold up well in down markets. Since inception in 2002, the Russell 2000 Value has had 17 periods with negative returns. And in 15 of those we’ve outperformed. So we think it’s … we can’t guarantee anything in the future, but it’s something that we consistently see.

Gillian: And what’s your performance profile in up markets?

Steve Scruggs: Well, that’s the cost of that downside protection is that when markets get momentum based and run up like they have, as I said, over the last six months, we’re going to trail and we fully expect to. Our process, it leads us to a lot of really boring companies. If you look through the portfolio there’s some boring companies in there. And these are companies that when things get frothy, they get left behind, people don’t rush out to buy these kind of companies. But the upside of that is when things get real nervous and a lot of worry comes into the market, these aren’t the companies that get indiscriminately dumped.

Gillian: Sure. And what do you think about market valuations today overall?

Steve Scruggs: Well, we think generally speaking markets are fairly valued to expensive. Back in 2008/2009 you could find excellent companies that were very reasonably priced. Today if you find a company that we would consider a very high quality company, it’s going to be in the fair valued to overvalued range. There’s really not a lot of value broadly speaking. We are finding some areas where there has been a company specific or an industry specific event that has caused a stock to sell off a lot. And we’re seeing some opportunities there … here and there. But the key there is to make sure that the selloff is something related to a onetime event and not a structural problem, either with the company or with the industry that they’re competing in.

Gillian: As you’ve trimmed some positions, do you find that you’re holding more cash lately?

Steve Scruggs: We have, we’re over 20% in cash right now, and that’s a lot historically for us. But it’s not a call on the market, it’s really more of an outcome of this process of finding good companies at reasonable valuation. And when we can’t find those, we’ll let cash build.

Gillian: Well, let’s talk about some of the opportunities that you’ve recently added to the portfolio, tell me about Harman Kardon.

Steve Scruggs: Harman International, best known for their Harman Kardon speakers, JBL speakers, is how most people would probably know the company. But their biggest market is in the Touchscreen Infotainment systems in cars. They are a leader in that area. And there’s a lot of … you’ve probably heard about the whole connected car trend of making these devices, much more feature rich. They’re a leader in the mid to high tier. But there’s a legislation has been created, a rule that’s … by 2018 all vehicles, light vehicles in the United States are going to have to have a backup camera on them. And we think it’s going to be really favorable for them because that means every single car is going to have to have one of those screens, a touchscreen, which is going to create some good opportunities for them to increase their penetration.

Gillian: Excellent. And what about Synaptics?

Steve Scruggs: Synaptics, that’s a very interesting company. They make the touchscreen controller in smartphones, for touchscreens anywhere, tablets, PCs, they’re the leader in their markets. They’re currently in the iPhone. There’s a lot of worries, the stock has sold off a good bit. I’m worried that they’re not going to be in the iPhone 8, which, you know, we can’t predict that, no one can. But even when you back out for that and you look at some of the other things they’re doing and the winds they’re having in some of their other placements. We think that the selloff has been really overdone and there’s a lot of value there.

Gillian: So shifting away a bit from electronics, tell me about your thesis on Sanderson Farms.

Steve Scruggs: Sanderson Farms, it’s the third largest poultry producer in the United States, a very cyclical business, this family has been running this company for decades. It’s remarkably well managed, well run, the highest return on invested capital in the industry, has a solid balance sheet. We know that the chicken markets are cyclical, but the way they manage through that cycle, historically gives us confidence in the long term prospects of the company.

Gillian: Great. Well, this has been really interesting. Do you have any closing thoughts that you want to share with us before we close out?

Steve Scruggs: Well, thank you for having me and as I said earlier, we’ve been managing the fund for 14 years, I’ve been the Portfolio Manager. We have a philosophy that works over long periods, and our management of our firm, our board of trustees of the fund is fully committed to the process, which can give investors comfort that it’s not going to change. And we think that’s very valuable, it’s a philosophy that has proven to work over long periods of time and we expect it will continue to.

Gillian: Well, thanks so much for taking the time to share your process and some of your most recent portfolio ideas with us.

Steve Scruggs: Thanks a lot.

Gillian: Absolutely. From the Schwab Impact Conference in San Diego, I am Gillian Kemmerer for Asset TV, thanks for watching.