MASTERCLASS: Fixed Income - January 2020
December 19, 2019
Remy Blaire: Welcome to Asset TV, this is your Mid-Caps Masterclass. Mid-Caps are useful for diversifying portfolios and for providing stability and growth. A Mid Cap falls smack dab in the middle of the small and large-caps. Today I'm joined by Malcolm Polley, President and CIO at Stewart Capital Advisors, and Nathan Brown, Senior Vice President and Portfolio Manager at Ivy Investments. Gentlemen, thank you so much for joining me today.
Malcolm Polley: Thank you for having us.
Nathan Brown: Yes, thank you very much.
Remy Blaire: Well first and foremost, I want to take a look at the current market environment. Now we know there is uncertainty over policy, whether we're talking about trade policy, or monetary policy. In terms of the U.S. economy, we continue to keep an eye on the economic data that's coming out, as well as commentary from the Fed. First and foremost, Malcolm, could you give me your perspective on interest rates, and how this is affecting valuation as well as the way you look at equities?
Malcolm Polley: Certainly. So, business valuation is really nothing more than discounting cash flows from the future to the present value, using a discount rate. So as is the case with fixed income investments, the lower the discount rate the higher the valuation. We had expected more stable rates than what we've been seeing, and really no one predicted the tenure to dip this low. So, the fact that we've got lower rates on the tenure and potentially lower rates from the Fed in the not too distant future, then valuations are actually lifting.
Remy Blaire: Nathan, moving on to you, you do meet with company management teams on a regular basis. So, what are you hearing from executives, as well as company leaders right now?
Nathan Brown: Management's love certainty, to the extent they can have certainty either on the good or on the bad, they can plan their businesses. So, when you go into recession, sometimes it's difficult because managements are going, "Are we in a recession, are we not in a recession? Should I cut cost or not?" In the environment that we're in today, certainty is tough to find. I mean just imagine trying to plan your supply chain for the next 10 years when you don't know where you can ... What country you can go to and what's going to be tariffed, what's not going to be tariffed. So, I would say from a very consistent basis, managements are trying to get out of China, because they realize whether or not we get a trade deal or not a trade deal, China's and U.S negotiations and relations are probably going to be in the strain for a decent period of time going forward.
Nathan Brown: So that's been difficult for managements to try to figure out how to redo your supply chain. On the opposite side, managements are still fairly optimistic about the economy, the underlying economy. Confidence levels are very high with consumers and with small businesses, and a lot of the customers that many management teams go in and sell goods and services to. So, to the extent we can get beyond some of this uncertainty, if the managements are ready to spend, they just tax reform in 2018, provided some confidence to start spending again and now trade has taken that confidence out of their plans.
Malcolm Polley: I agree, and we've seen that from businesses that we deal with. The difficulty is particularly even the small or middle-sized business, a lot of what you get, a lot of the parts and pieces come from overseas. When you don't know what your costs from your costs of goods sold is going to be, at least on the product side, it makes it difficult to figure out what your pricing is, and indeed what your margins are going to be.
Remy Blaire: I think that's a very important point when it comes to the Mid Cap companies, especially given the current uncertainties in the market place. I do want to take a deeper dive and look at Mid-Caps, starting out with the very, very basics. Now, sometimes Mid-Caps may be considered the overlooked middle child in the world of market capitalization. So, Nathan, what market cap size do you define as Mid Cap?
Nathan Brown: The way we look at it, it's we use, we allowed the people who set benchmarks to determine what Mid Cap is. So, for us, our benchmark market cap range is anywhere between two to 35 billion. Now that is a wide range. Quite honestly for the most part, we do most of our fishing toward the middle to lower end of that range. That's where we find most opportunities and it allows us to, when we make a good decision, to continue to keep that stock and equity in our portfolio for a long, long period of time as it matures.
Malcolm Polley: That's the interesting thing about Mid Cap, right? These definitions change depending on who you're talking to, and we have always defined Mid Cap as one to $10 billion. That doesn't mean that I'm right and Nathan's wrong, or Nathan's right and I'm wrong. It's just how our definitions work. It gives the asset class the ability to have really a wide moat deficient.
Nathan Brown: Yeah. One of the struggles, we used to have that hard definition on very similar numbers of one to 10, and we're judged versus relative to our benchmark. What we found when we had that constraint on our portfolio, it meant that we couldn't invest in more than 50% of the names that sat in the benchmark that we were being evaluated against. So, during that period of time, we decided to get a little bit more flexible with those hard constraints, because when you're being judged against something, then it's nice to be able to participate in all names in that judgment measure.
Remy Blaire: I think it's helpful to know your individual definition of Mid Cap, since there is a wide range especially in the billion-dollar mark. So, when it comes to the Mid Cap space, it's often referred to as the sweet spot of the economy. Do you agree, and if you do, why?
Nathan Brown: 100% I agree. So, we had some people at our firm do a deep dive analysis on Mid-Caps make up about a quarter of market cap in the market. Clients typically have half of that in allocations. That allocation makes no sense at all, because if you look at Mid-Caps over a long period of time, medium and long-term rolling returns, it outperforms every other asset class, large, small. You do a risk adjusted basis, then it outperforms by an even greater extent. The rationale for that is, well Mid-Caps have better growth than large caps because they're typically smaller companies, so they haven't reached their terminal growth rate that will find, and their business models have been de-risked versus small caps.
Nathan Brown: So they have better capital structures, and not as reliant on external sources of capital. They can use some of their own internal. So, you've got a de-risk business model that has more growth. So, we, myself and my partner, Kim Scott, the Portfolio Manager on our products, we are so happy and confident and it's just such a great blessing to be able to invest in where we think the best returns in the markets are.
Malcolm Polley: I agree, and it's interesting because in the Mid Cap space we've got a decent note to play. If you're looking at a large-cap manager for instance, and trying to find and you're given that mandate, how does a large-cap manager outperform a large-cap manager while they go down market cap. They pickup return and they don't really give up more risk, and how long as this small cap manager do you reduce the risk in your portfolio? You go up market cap in what you do to reduce the risk and again, don't give up on return. Mid Cap picks up both ends of that. So, you get really good returns from substantial companies that have a lot of the risks that would be associated with smaller companies taken out of them.
Remy Blaire: Well, I think it's very helpful to get two different perspectives on this topic, but I know you highlighted this before, and you talked about how Mid Cap stocks might be difficult to define. What's your definition when you're talking to people?
Malcolm Polley: We tell people that we invest in companies that are one to 10 billion in size. Our sweet spot tends to be at the lower end of that, and we will tend to ride those names until we just don’t make sense to own them anymore. When you buy a company at $1 billion in size and you ride it to 60 billion, it's difficult to justify buying it in a new client's account. That's when you'll tend to exit those names and recycle the dollars into lower valued assets. We also tell people that while these businesses that we're owning are substantial businesses, they're not necessarily household names, which means that you have a little bit less coverage on Wall Street. So, you get a little bit more value in actually doing the work to understand what's driving the business, and how the business generates its capital returns, and how the business generates its cash flows.
Nathan Brown: That's a very important thing. It's the divergence of returns go up as you go down cap, and the whole idea behind that is that's where active management matters, when you can get the divergence and that divergence exists, because you have a different view than what the market has, and you can understand a company and the growth algorithm better than someone else who's not as focused on these undiscovered assets.
Remy Blaire: I think you brought up a very important point that some of these names may not be household names. So, when it comes to education, what's your advice?
Malcolm Polley: Well, our advice has always been to learn what it is that you own. I've talked to so many people that have no clue what it is that they're buying, and it doesn't matter the degree of their supposed sophistication. People buy something because their neighbor did it, that's usually a recipe for disaster. So, we always tell our clients, look we take the time to understand what the business is, to understand what the business does. It doesn't always make sense relative to what you think it does, and understand how they generate cash flows because in the end, it's the cash flow the business generates that the business owners have, and can make decisions on that makes a difference and determines whether or not it makes sense to own the name.
Remy Blaire: I think that does indeed highlight why active management is so important in this space.
Malcolm Polley: Correct.
Remy Blaire: I do want to move on to tailwinds in this market cap. So, Nathan, could you tell me about some of the tailwinds that you think are impacting Mid-Caps right now?
Nathan Brown: Well, it's an interesting time in the market environment because it's rare. Large-caps had a nice run here over a very short time perspective. Partly that's because you've had these five, six giant companies. The largest companies in the market that are also some of the fastest growing companies in the market, which that typically doesn't happen. Usually as I said, you got to go down cap to find that type of growth. Now it seems like a couple of them might be reaching a point where growth is becoming more difficult, and as that happens then all of a sudden, you're left to go, "Well wait a second, do I have to go back down cap to find that growth". We feel like over the next handful of years, there's definitely that potential.
Nathan Brown: Beyond that, you've got just a tremendous amount of change in innovation that's going on across multiple industries. So, you have these giant platform companies that sit in large-cap, and then you've got all these domain expertise platform businesses that exist in Mid Cap that are benefiting from all those same trends, cloud computing, software as a service, med devices. All this stuff that's going on that really provides a great tailwind for mid-size companies. Then on the other side, relative to small-cap companies, because they're less reliant on the capital markets which at this point as you said, interest rates are so low that just about anyone can get a loan. At some point that's no longer going to be the case, and when that happens, you don't want to have your business model dependent on being able to source capital out there in the market.
Malcolm Polley: Plus you don't have the antitrust issues that those big platform companies are dealing with. So, you don't have that regulatory risk as much in the Mid Cap space.
Remy Blaire: Going forward, when investing in the Mid Cap market for advisors who may be watching, how should they be addressing the changing climate? Do you think it'll be more difficult to invest in them going forward?
Nathan Brown: Well, when we invest, we always think about a three to five-year time horizon. If you look at our turnover numbers, it represents a three to five-year time horizon. That's one thing that I would suggest when people, three to five years is a very common answer when people think about time horizons. Sometimes the portfolio turnover really tells you what the true time horizon of other managers are. So, when we do that, that allows us to really look through a cycle and understand, and really focus on the business models. How they make their cash flows, how they grow. So, as we do that, we're less focused on the news of the day.
Nathan Brown: At the end of the day, if we can find what we think are good quality assets that have growth ahead of them, at valuations that we think are overly discounting the growth rate fate factor. Said differently, we think these companies have the ability to continue to grow at their current pace for much longer than is embedded in the valuation. I feel like that's a good place to invest in regardless of the cycle, regardless of the headwinds and tailwinds that exist in the market.
Malcolm Polley: As you get companies, another nice sideline in Mid-Caps is that for us anyway, one of the biggest reasons we lose a name out of our portfolios is Mid Cap is prime hunting ground for M&A. So, we lose a lot of names out of our portfolio because it gets acquired by a larger company as a bolt on acquisition that makes sense. So, you get a lot of unintended turnover for good reasons.
Remy Blaire: That's an important point. So, I want to dive deeper into the investment process when it comes to some of these Mid-Caps. So, when making investment decisions, there are obviously so many moving parts for advisors, as well as people who want to invest in these companies. So, Nathan, starting out with you, could you tell me about your investment strategy. Tell me whether it's top down, or fundamental, or bottom up?
Nathan Brown: The vast majority of what it is that I, my partner Kim Scott, and our equity analysts team that support us do on a day to day basis is bottom up fundamental research. Trying to understand, as Malcolm said, what the company does, how they make their money, how they're going to grow, and then figure out okay, what valuation would we be attracted to own this growing asset. So, the vast majority of the time, we're looking at five things, which is we want to own a strong profitable business models. So, high margin and bottom line profitability. We want it to be supported by a sound capital structure, so low use of leverage. If they don't use leverage at all, we're fine with that as well across the growth spectrum. So, we're willing to invest in some of the fastest growing companies in the market.
Nathan Brown: We're willing to invest in stable growth companies, we're willing to invest in companies that something has happened, because a bad decision that the management made, or a product cycle issue, or an example of Chipotle, which we own. They made people sick for a period of time. Well, we didn't own it when they make people sick, but we thought, "Okay, you can have a reemergence of growth here." So, across that growth spectrum, as I said earlier, we're looking for companies to own at valuations that are overly discounting that growth rate fade factor over our time horizon, which is three to five years. So that's what we spend about, 95% of the time, that's the lens we're looking through. About 5% of the time, and we've got a morning meeting where all of our investment professionals come together, fixed income, economist, our equity analyst, are all in a room and we use that to try to figure out when we should deploy this other 5%.
Nathan Brown: This other 5% is when you go into a period of time of earnings contraction, or when you're coming out of recession, we feel like that's a period of time in which you might want to more force a top down look, stay very true to the type of companies that you would invest in. If from a bottom up perspective you're going into recession, but there's in the non-cyclicals may be your weights would be a little bit lower, but if you're going into a recession, you'd want to force those weights higher. Then coming out of recession more force of weights higher in some of the more cyclical industries. So, don't use it always asking ourselves whether we should use that top down or not, and the vast majority of the time we don't, but there are some periods of time like '08 and '09 when the only thing that mattered was your allocation, not necessarily the names that you were invested in.
Malcolm Polley: We start with a broad macro overview, so it's not necessarily macro from what's the economy going to new next year, but what are the big major trends that are affecting the global economy, so that we can use that as a filter to get into industries that take advantage of those trends. Sometimes the economic environment allows you to jump in big, as it did in 08, '09 when you could've bought the entire fertilizer industry for two times earnings. Forefront of a huge economic trend, we went from zero exposure materials to 30 plus exposure to materials almost overnight, or it allows you to look at places that potentially won't give you the investment returns that you seek. So, we're concentrated investors, and we make our asset allocations really determined by security selection.
Malcolm Polley: So for instance, in utilities and in REITs today, we just don't see return perspectives that we care for. So, we don't own any, and our discipline gives us the ability to do that as we focus on companies that meet our long-term return expectations over the three to five-year time horizon in businesses that are at the forefront of major trends. Then from that perspective, we are pure bottoms up stock pickers, because we want cash flow. We want growth of cash flow so that we as business owners can make decisions on where to deploy that cash.
Remy Blaire: Well, I think it's always helpful to know what you're thinking, especially for the viewing audience to get this perspective. Malcolm, why do you think traditionally Mid Cap stocks have offered a better risk reward that small-caps or large-caps?
Malcolm Polley: Because you could have, overlaps both of them. So, you get the best of small-cap which is return, and the best of large-cap which is risk mitigation, because they're real substantial companies that can generally finance themselves internally. So, you eliminate a lot of the noise risks that comes about from having to source your financing from areas outside of your control.
Remy Blaire: I do want to take a closer look at this category. Now, some portfolios invest in stocks of all sizes, and that might lead to the Mid Cap profile, versus just talking about the market cap. So, Nathan, can you tell me more about the Ivy Mid Cap growth fund? I know that you describe it as quality focus, so give us an overview as well as insight into this fund.
Nathan Brown: I said earlier, maybe one of the most overused phrase is three to five-year time horizon. It's one of the most overused, because probably the most overused is quality. If you go and look at various fund perspectives out there, you will see that word a lot. There are some services out there that attempt to define what quality is, we don't feel like they do a particularly good job of defining what quality is. So, I'll give you what our definition when we're thinking about investing in quality. So, the first thing we do is we want, as I said, strong profitable business models, which that is we want companies that have high gross margins and are profitable. We want companies that have low amounts of leverage and if they don't use leverage at all, that's fine. Well, why do we want that?
Nathan Brown: Well, inevitably something bad is going to happen to these companies. Either the economy, a bad product cycle, whatever it is. If you are a low margin, highly levered non-earner, there is a great chance that you're not going to make it out of whatever problem exists. So, there's some, one of the metrics is that a lot of the services use are ROE. ROEs are always a really good metric, but you want to know what's a better metric is ROA. ROA in terms of quality tells you how much you're getting your return on the assets that you have before you throw on the leverage, because you can juice ROE by adding a whole bunch of leverage. That to us, that's not quality. That's pulling more out of the company than maybe the model can really produce. So, to us quality is high margin, profitable with sound capital structures.
Remy Blaire: Nathan, before I move away from Ivy Mid Cap growth fund, I want to get your take on opportunities you're finding. You highlighted technology as well as some of those cloud companies out there, but what are you seeing in terms of healthcare in addition to tech?
Nathan Brown: As I said, so we are very much bottom up stock pickers. So, we don't go and say, "Okay, we want to go find a SAS software name to own." It's very much the opportunities that we just as we're scouring the universe, both Kim, myself and our analyst, we're just looking for stuff. So, you're right, healthcare and technology are two areas that there's a massive amount of innovation going on. Particularly in large-cap land, you got to deal with the reimbursement pressure, the Medicare for all debate. You got the pharmaceutical pricing. As you go down cap, what you find is these incredibly innovative companies. Names like Dexcom which make continuous glucose monitoring patches. When we talk with parents of these kids, it's the first time that they have ever had a good night's sleep because they have their phone on their bedside, and to the extent that their blood sugar falls, they get an alert and get woken up. So, they can let their kids spend the night over at a friend's house.
Nathan Brown: We own Abiomed, which makes heart pumps. So, when people come into the emergency room with the cardiac event, they can put in a heart pump into the heart to help relieve some of the pressure off of the muscle so it can heal itself. We own Glaukos, which is a Glaucoma Med device companies. So, there is a tremendous amount of these industry domain expertise companies that exists within Mid Cap, which is partly why Mid Cap area is just so broadly attractive.
Remy Blaire: I think you highlighted a lot of the interesting innovations that are happening within healthcare as well as technology. I think it's also interesting because we're seeing a lot of regulations surrounding these two sectors, as we had entered the second half of this year. Indeed, as you both mentioned, we're seeing every day from the large-caps into the Mid Cap space. So, Nathan, before I move on, what is the typical investment time horizon when you're talking about the space?
Nathan Brown: When we're initially buying a stock, we're thinking, "Okay, what's the growth rate for the next three to five years?" Then what's the follow-on growth rate for the next three to five years, because at that point that's what the stock is going to be valued at. It's not what you did for me yesterday. It's what are you going to do for me in the future. That being said, we've got a name in our portfolio that's been in there since 2001. Fastenal, it's a company that it's just progressively becoming a larger and larger company every single year that goes by, and it's just a really nice compounder. To the extent we have those, we're more than comfortable to own those for long, long periods of time. So just because we reach the graduation point of four years, our kids can stay in the school as long as they want.
Malcolm Polley: Yeah. We've got names in our portfolio that we've owned for years and years and years, except for a small period of time in '08/'09. We've owned Polaris and I've owned Polaris industries in my portfolio since the late '90s and previous Polaris into now. So, I've owned it 20 plus years. We've got names that started in our Mid Cap product, went to our large-cap product. We still own it because it's a fantastic company. So, we have the ability to own names, and we don't have to graduate them just because they hit a specific size.
Remy Blaire: Taking a closer look at the indexes in terms of performance as we move forward, what do you think is driving the results, Malcolm, in the index? We know that many people, when they're looking for Mid Cap indexes, they might look at the S&P 400, or the Wilshire, or the Russell. What are you seeing right now?
Malcolm Polley: We bench to the S&P Mid Cap 400, we've always used it. I mean there have been people that wanted us to bench to the Russel mid value. We tell people we're benchmark agnostic. We really don't care because we don't spend a lot of time looking at our benchmark. It's there because people want to compare us to something, but that's our universe that we utilize from our comparison purposes.
Remy Blaire: Nathan, what about growth beyond Mid-Caps? Now do you have a hard sell once a security grows beyond your mark for Mid-Caps?
Nathan Brown: We feel like Mid-Caps is the best place to invest and we take our investment mandate very seriously, because at the end of the day, we think it's the best place to invest. So, if people want you to hang at the cool party, well guess what? I want to hang out at the cool party. So that being said, when we make a good decision, our clients shouldn't be penalized because a company graduates above whatever the hard floor is. So, we have the flexibility to be able to own names as they graduate out of Mid Cap. We have right now, I think three names that have graduated out, and one that will graduate out just given the performance of that stock. So, Zoetis Intuitive Surgical, electronic arts and service now are all kind of on that cusp of large-cap.
Nathan Brown: Over time, you should expect us to take our weight down in those, and redeploy it as we find other Mid Cap opportunities, but to the extent we still think that there are appreciation opportunities, we are not forced to sell it, which it would be such a disservice to our clients if we had that hard sell. If they've given you the money and you've made the right decision, those clients should be rewarded for them giving you the money and you making that right decision.
Remy Blaire: Speaking of graduation, I do want to graduate our conversation and talk about the risks and benefits when it comes to management. Now Nathan, how would you recommend managing risk in a portfolio?
Nathan Brown: I think it starts at the very top of, risk management in something that has come to the industry over the last two decades as another way to look at portfolios. Our process and philosophy that we have been deploying has been very consistent, and very much focuses not only on return but risk. As I said, if you're buying the high margin, profitable, low leverage companies, there's an error there of taking down the underlying risks that sits in the portfolio. That being said, we do have a risk team at the firm who looks at our portfolio through a risk management lens, and to make sure that at the end of the day, we don't have any unintended factor tilts in the portfolio. I can tell you we don't, and the vast, vast majority of our "risk" has always been stock specific risks, not industry and not factor. It's nice to have their view of your portfolio just to make sure, okay are we doing anything that we intend to do because of what's going on in the underlying market?
Malcolm Polley: Yeah, we really deal with risk in a similar vein, although I've learned over 30 years in the business that you can mitigate a lot of your risk by avoiding stupid things. So, we avoid companies that can't give us a return that we want. We avoid companies that needless to use leverage, so looking at companies that generate high degrees of cash that don't have to use external financing to fund themselves, that have a good business model, that have strong management. Back when I started on the sell side, it was a sales trainer. I mean Zig Ziglar used to say something that I've taught my people, and it was you can't do a good deal with a bad guy. So, good people in management make a lot of sense. We think that if you look at a balance sheet, cash flow statement and the quality of management, you take a lot of the unforeseen risks out of the portfolios.
Remy Blaire: Those points may be very obvious, but I do believe they're often overlooked. So, I'm glad that you brought that up. Now Malcolm, before we move away from you, are some of the investment themes easier to exploit would you say in Mid Cap versus the other market capitalization?
Malcolm Polley: Mid Cap allows you to get pure play. So, in food for example, if you're looking down in agriculture, there's really very few pure plays and very few ways to get a pure play investment in agriculture. So, if you're looking at farm equipment, you've only got a handful of companies. You've got John Deere, you've got AGCO, which is a pure play, and you've got Caterpillar. Well, both John Deere and Caterpillar have other stuff in their balance sheet and their income statement. The seed businesses, you've got very few pure plays. You used to have DuPont, you've got Syngenta, and you've got a couple of others and it's a very difficult to find a pure play, and difficult to invest a lot of money in those businesses.
Malcolm Polley: In Mid Cap space, for instance, in the fertilizer business, I had mentioned it once before, there are a lot of names in that space. Mid Cap companies are focused. So, they tend, which was one reason why they tend to pop up in M&A space so often is their focus business is on one or two businesses that are able to fund themselves internally. So, it really allows you as a manager, or you as an investor to focus in on a specific thing that you're looking for and make a better investment alternative.
Nathan Brown: That provides one domain expertise, so you can be the expert and it provides barriers to entry because when you become part of workflow, we know company Guidewire, that are basically the front end for insurance. So, they're doing what service now does and what Salesforce.com do, but they're doing it for a specific vertical. So, they can develop that expertise and they know how to solve that industry's problems much better than what the larger companies can do. So, absolutely.
Malcolm Polley: Exactly.
Remy Blaire: I think you've both highlighted a lot of insights that may not be commonly associated with Mid-Caps. So, I do want to move on to some of the trends that we're seeing in the market. Nathan starting out with you, we may be in late in the cycle, and growth companies have done well, but how has growth outperformed value year today and the last two calendar years?
Nathan Brown: Yeah, so this cycle has definitely been interesting, and it has continually been faced with this wall of worry from investors. I don't know if that wall of worry is there because of the depth and pain that people felt in '08 and '09. I'm sure that that's part of it, or if we just had this unrelenting things to increasingly worry about. So, because of that, what you've seen is a definite preference for the secular growers, versus a cyclical growers. We've definitely seen that valuation dispersion take place. That's not that odd at this point in the cycle. Typically, as you move late in the cycle, growth becomes more difficult for more and more companies. So, you have these what you thought were angels, they just fall off so those who can produce the growth get ever and ever-increasing valuations.
Nathan Brown: You saw that with the tech bubble, you saw that with materials and energy, and industrials into '06, '07 periods. So those were, it's not what's going on with growth beating value. It's not that odd for where we are in the cycle. The tough part about value and I'll just, at this point pretty much value is a bet on financials at this point. They make up such a large portion of the value relative to growth, and so financials really start to perform better than the market, then value can have a nice run. The issue with financials is their income statement is driven by three things. Loan growth, NIM and credit. Loan growth is dependent on economic growth. It feels like if we're not late in the cycle, we're definitely, we're past the middle point probably.
Nathan Brown: NIM, I don't know where interest rates are going, but interest rates have been compressing and so that becomes a struggle. Obviously, the shape of the curve matters as well, but that's been depressing. The interesting one and I feel with a great deal of certainty on credit, is credit cannot get better from where it is. That's not to say that it's going to be terrible going forward. It can't get better, because basically every single loan that has been written over the last five years has been good. If you look at mortgage delinquencies, they're at 20, 30, 40 year lows. Well, that means that it can either stay this good, which is I mean that means that the stock can work, or it can get worse from here. If it gets worse from here, then you're going to have an earnings issue. If you haven't earnings issue, then what you thought was cheap can continue to get cheaper and cheaper.
Nathan Brown: I don't want to make it sound like growth is going to win every single year going forward, but given where we are on the economic cycle and given what makes up the value index as we said today, it still feels like growth has a better short-term outlook than what value would have.
Malcolm Polley: That's interesting. We talked a little bit before we came in the room and from our perspective we're value managers, but as I was telling Nathan beforehand, value and growth are really quantitative constructs. So, if you look at how the consultants, how the index people define it, it's purely quantitatively driven. So, if you have a high dividend yield, low PE ratio, your value stock. If you have a high PE ratio and a low dividend or no dividend yield, your growth stock. The reality is we do business valuation. We don't care if a company pays a dividend or not. Yes, a lot of my value brother and have a lot of financials, we were underweight financials for a long time. I've gotten to a point where we're getting close to "an equal" weight in financials, but almost no banks.
Malcolm Polley: So there are businesses in financial services that are, I want to say money printing machines, but if you get an insurance company that is able to make money on their underwriting, whose cost of funding is negative, that's close to a money printing machine as you can get. That's where our financial exposures come from.
Nathan Brown: That example of the financials with credit, I mean I don't remember the year, but home builders in I think it was call it '05 general, they were like four times earnings. They were some of the best returning stocks for the following year because it was, well house building can't get any better than it is right now, and it extended for a year. So those ended up being really, really good returns knocks now. Eventually, things normalize but there's periods of time in which stuff can get so cheap that just as the continuation of the current trend can provide appreciation.
Remy Blaire: I'm glad we're talking about different times in the past where we've noticed significant changes. I think when you're talking about market trends, it's always important to gauge the audience's age as well, because if you've lived through the tech bubble or the financial crisis, you obviously have a different perspective versus if you're a millennial, and you've never actually experienced those conditions. It is a very different environment right now, and very unprecedented as well. Now Malcolm, do you have any additional insights into the current trends that we're seeing, especially as it relates to the Mid Cap space?
Malcolm Polley: Yeah, so the biggest thing driving the economy in the markets today is demographic. So, we were in this massive demographic trend. If you think of it in fixed income terms, you've got the barbell curve, or you've got long dated bonds and short dated bonds. Well, demographically in United States, we're in a barbell. So, you've got the two largest demographics in history at opposite ends of the curve, right? So, you've got, we baby boomers and I'm at the tail end of that group. The average baby boomer is now 65 years old and retiring. The youngest millennials are not quite into the workforce yet, and their earnings are ramping up dramatically. So, people are wondering why in the world we're having an inflation. It's back what we learned in basic economics, supply and demand, right?
Malcolm Polley: So demand is leveling off because as you get older, your spending declines. The millennials increase in wages is not off, and their demand for stuff has not been enough to offset that. So, if you can understand those things, you can understand where to place your research to find companies that take advantage of both of those. Unfortunately, from my perspective, finding ways to take advantage of the millennial spending is difficult, because most of those companies are pre-public and we don't invest in venture capital. You can still do that in derivative manner. So that really has been driving a lot of what we do as we look for things to invest in Mid Cap space.
Remy Blaire: Nathan, before we move away from market trends, I do you want to get your insights regarding your strategies. So, what type of market environment would you describe as the sweet spot for your strategy?
Nathan Brown: As I said, most of our returns over time have been driven very much by stock selection, and not the overall environment and not sector weights. That being said, there were two markets in which we struggle. The first one happened in earnest in 2013 through 2015. During that period of time, you had significant quantitative easing that was going on, right? That was when interest rates were really pushing lower. As that was happening, companies that have high, high amounts of leverage in our benchmark, were just beating the snot out of the companies that have a more conservative balance sheet. Like I said earlier, we invest in the ones that have the conservative balance sheet, and it's not that the market did anything wrong there. No, the companies that had the most amount of leverage, they benefited the most because one, you had the greater likelihood of continuing on from a bankruptcy risk perspective because interest rates weren't going up, and the financial markets were wide open. So, you could refile that debt at much lower rates.
Nathan Brown: As that happened, what happens? Well, your earnings go up because your interest rate's going down. So, the market was rewarding those companies, because they were being able to show earnings growth from, not organic growth, but they financially engineered earnings growth, but it was earnings growth nonetheless. The market has been so desperate for earnings growth at different points of the cycle anyway. So that's an environment to the extent that the highly levered companies are rewarded. That's an environment that we will struggle. On the opposite side when those companies get punished from interest rates either going up, or when we enter the next recession and we actually have to worry about those companies going out of business, that's a market environment that we should do particularly well.
Nathan Brown: The other environment, Malcolm said earlier about valuation. If you have valuation in your process and philosophy, which we do, there's periods in time in which the market just doesn't care about valuation. Really those growth at any price rallies, those are periods in which when we had valuation discipline, when the stock is 35 times we were comfortable with it because of growth algorithm. Now it's 65 times, we're not so comfortable with it because we just don't think that we can get much more upside. So, we'll sell, and then it ends up going from 65 times to 85 times, which those markets exist when you have valuation discipline. Those markets are two markets that you should expect us to struggle.
Remy Blaire: It's interesting because hindsight is always 2020, and it's always easier to have these types of conversations after they have happened. When you look back in history, especially financial history, you tend to associate different monetary policy environments with who was in office as Fed chairwoman or Fed chairman. There are lots of myths and misconceptions when it comes to Mid-Caps, so why do you think we have so many of these misconceptions, and why do you think they tend to be overlooked?
Malcolm Polley: Mid Cap as an asset class really hasn't existed that long. It grew out of the mixture of both large and small cap, and exist between them. So, it really hasn't existed as an asset class all that long. I believe it first came out in S&P in the late 1980s as a specific asset class. Still a lot of consultants don't really view it as an asset class, and so it's hard to get people to understand it as a Mid Cap, what in the world is that? Compound that with the fact that definitions vary from manager to manager. It makes it difficult to understand what in the world it is that we do from an investment standpoint. From our perspective, it's decent sized companies with better returns and lower risk profile than you can get at opposite ends of the risk and return spectrum.
Nathan Brown: I had Malcolm touched on this earlier, but I had a conversation with an advisor on this very topic. What he said was why would I be interested in Mid Cap because I've got my large cap manager reaches down cap and picks up Mid Cap from there, and small capital will continue to own as things graduate out of small cap, and so I have Mid Cap there. So, I get my Mid Cap exposure by owning large and small. It was a funny answer because what that person told you is your large-cap and small-cap manager are looking to generate their different returns by investing in the Mid Cap space. If that's true, don't have a large and small-cap manager. You should in a broad asset allocation theory, but if they're different because they own Mid Cap, then have just the Mid Cap because if everyone recognizes that's the best place to be, then be there with your portfolio. Don't leave it to small and large-cap managers to get you the exposure.
Remy Blaire: I'm sure there are a lot of investment professionals that are watching this segment. So, if there could be better education regarding Mid-Caps, what do you think should be instilled?
Nathan Brown: I would say the risk adjusted return in the space, I mean we are all, the industry is judged on performance and fees, but at the end of the day, those who have garnered the most assets over time are those that have generated the best performance in the market. This is an area within the market that that has not happened yet. Over time, why is it going to be any different than the way that active management has gone with the best performers getting the lion share of the assets. I feel like at the end of the day, if Mid-Caps were representing 25% of the market, they should be in the client's portfolio up to that 25% of their assets.
Malcolm Polley: Your starting to see more and more being written on the Mid Cap space, which is encouraging. It's nice being the unknown commodity, because it gives you a lot of places to play, but it's nice to see more being written about us because then people will learn to understand that while it's not necessarily a free lunch, you can certainly get better returns with a better risk profile than other areas of the market offer.
Remy Blaire: Gentlemen, last but not least before we wrap it up for this Mid-Caps Masterclass, I do want to ask about the future. Now as we head into the second half of this year, we'll continue to watch trends that are happening in different sectors. Now you mentioned technology as well as healthcare, some of the innovation that's happening in both of those sectors. What are you watching elsewhere? Are there any specific sectors or trends that you're keeping your eyes on?
Nathan Brown: I've got three. So, the two macro obviously trade that is to the extent we get trade deals, and this gets behind. Although still believe that U.S./China negotiations and relations are going to be strained going forward, but to the extent we get trade, that would be good and companies can at least start to get comfortable about when they should take inventory, and when they shouldn't take inventory. Interest rates somewhat in conjunction with what's going on with trade, and I think that those are two good areas. The other area, and it's somewhat related to the tariffs, but a lot of companies have been met with a lot of inflation in their P&L. This call it over the last two, three years, whether it be commodity or transportation and even good companies. Sometimes it takes, there's a lag between when they can push through pricing.
Nathan Brown: As we get into the back half of this year, most of the companies that we've talked with, they feel like they've pushed enough pricing to be able to offset. So, margins have the ability to begin to increase. Absent tariffs taking all that away, and us having to push through more. Polaris is a great example of that one. They've been pushing hard on getting price, and they've just been in this cross hairs of everything that they do. The trade negotiations have been impacting their commodity, their raw materials, but there's a bunch of companies. We own RPM, they make dAP caulks and Rust-Oleum paint. They'd been chasing commodity inflation for a while now. Well we're getting to the point where they've been able to, that commodity inflation has rolled over.
Nathan Brown: Trucking transportation rates are down. Spot rates are down something like 24% this year. Year over year, I mean that's, in General Mills I think in the first quarter of 2018, they had negative earnings announcement because transportation was eating away too much of their margins. So, you're finally to the point where we should be able to see margins start to improve, unless tariffs take it all away again. That's one thing that we're definitely keeping a close eye on, to see if these companies were able to push through enough pricing to offset it.
Malcolm Polley: From a trend, from our perspective, we've really been following the employment situation. You've been in a situation for a year now, more than a year now where there are more jobs in the marketplace, and they're unemployed people to fill them. So, to the extent you've got the ability to replace low skilled labor with machines or with automation, and I know that's not popular politically, but from a business perspective it makes sense. If you can replace somebody that you're going to have to take from $8 to $15 an hour in New York for instance, you're going to replace the low skilled people at the front end with automation, then let people do it themselves. We've seen that in McDonald's and a lot of fast food locations, in convenient stores where you no longer visit the person at the cash register until you're ready to pay or pick up your product, because you made your order on a kiosk.
Malcolm Polley: Where you've got the ability to change business models from a subscription base to as a service base. Street doesn't like that because cash flow, which they can understand on a subscription basis, on a renewal basis now drops down dramatically as they switch to a subscription base. What they don't understand is that subscription based process is so much more profitable, and so much more understandable that it's really a good decision. So, we like businesses that have done that.
Remy Blaire: Well, gentlemen, thank you so much for joining me today for this Mid Cap Masterclass. Thanks for all of your insight and analysis today.
Malcolm Polley: Thank you very much.
Nathan Brown: Thank you very much.
Remy Blaire:Thank you for watching. This has been your Mid-Caps Masterclass. I was joined by Malcolm Polley, President and CIO at Stewart Capital Advisors, and Nathan Brown, as VP and Portfolio Manager at Ivy Investments. From our studios in New York City, I'm Remy Blaire for Asset TV.