A Q&A with KAR and NFJ

John Mowrey, CIO of NFJ Investment Group, and Craig Stone, portfolio manager at Kayne Anderson Rudnick (KAR), take a closer look at the mid-and small-mid (“SMID”) cap equity segments – why they are often overlooked by investors, their diversifying roles in an equity portfolio, and the growth opportunity that quality mid- and SMID-cap stocks represent in the current market environment. Recorded May 16, 2023.

Transcript

Q: John, what is the mid-cap equity space, why are mid-caps considered an “overlooked" opportunity, and why consider adding mid caps to a portfolio?

John Mowrey: So, to think about the mid-cap space, if you take the top 1000 stocks in the U.S. and you lop off that top 200 and you focus on kind of the bottom 800, if you will, of the top 1000, that is the mid-cap space, and it starts at around two billion in market capitalization and it goes all the way up to 50 billion in market capitalization.

We believe this group of stocks is systematically neglected by the investment community because everyone focuses on the large-cap space and then the small-cap space. The perception is that you're getting mid-cap exposure via the mix between your large cap and your small cap, and I can tell you as a portfolio manager that you're not.

So, we think this is an area that is ripe for investors, and there's two things I'll point out. You know, one of the things that we like to tell investors is that mid-caps actually have faster earnings growth than their large-cap counterparts, but they typically have lower levels of volatility than their small-cap counterparts. So, you get this sweet spot for better risk-adjusted returns, as well as just better absolute returns in the mid-cap space over market cycles.

Q: Craig, what is the potential benefit of owning both small- and mid-cap equities (“SMID” caps) in a portfolio?

Craig Stone: As John mentioned, in mid-cap, most people think of the [Russell] 1000, and you lop off the top 200 [stocks]. In Small/SMID, the Russell 2500, which we benchmark ourselves against in this portfolio, we're talking about roughly 2500 stocks, a really big basket of opportunities out there, but like most people, that's too many stocks to go through by themselves. And so we think there's a lot of inefficiencies in the marketplace, a lot of stocks that are overlooked simply because of a smaller market cap size.

We can take advantage of that and by owning these companies earlier on, still very high-quality businesses, but we can own them early on, and then just own them for the long term and let the market cap appreciation move into the higher market cap space and continue to own them for a very long time. So, we think there's a lot of opportunities there. A lot of stocks that are overlooked simply because of market cap. We can dip down into the one to two billion market cap area and then hold that up to the 20-plus billion dollar market cap area and ride that market cap up over long periods of time.

Q: John, why are mid-cap stocks considered to be an “overlooked” opportunity? 

John Mowrey: I think it exists because the investment community typically doesn't allocate to mid-caps. I won't name the consultant name, but there's a prestigious consultant that has the periodic table of investment returns kind of color-coded, and mid-caps are not on that list. If they were on that list, they would be one of the better performing asset classes over time. So, I think that there's just been a perception that you're getting that exposure, and that's created a kind of arbitrage. It's amazing when you talk to investors, how few people have exposure to mid-caps.

And to kind of showcase that in an analytical sense, the mid-caps, as I mentioned, make up 800 of the top 1000 by name count, if you will, but they make up less than 25% of the total market capitalization. So, they're just under-represented from a market cap standpoint but have a very high representation from a name count perspective.

The other thing I would say about mid-caps is these companies have the training wheels off. They're not in the small-cap arena, so they’ve got their business models down. They’re growing. These are meaty companies that are very tied into the infrastructure and the fabric of the American economy. They're typically pure plays, unlike the large caps, which have much more of a conglomerate feel. And I think that allows for a premium in the marketplace. You see a lot of companies spinning off parts of their business or hiding off parts of their companies to realize a greater value in the marketplace. The mid-caps have that already in their DNA by virtue of their business model.

And then you have very seasoned management teams. These teams have been around a long time, so you have good stewards of capital. I think all of those things allow for a premium to be placed on the mid-cap space, and it allows for those higher returns relative to some of the larger-cap areas in the market, even though everyone loves to buy the S&P.

Q: Craig, how does KAR define a quality company, and what advantages do small-cap stocks offer when added to a mid-cap portfolio?

Craig Stone: No one on the equity side, at least, says they're junk equity investors, but everyone defines quality maybe a little bit differently or have a different emphasis or focus. For us, quality is a qualitative aspect with ability for these companies to have some sort of competitive protection, business models that are like network effect or scale cost advantages, high customer switching costs. We're trying to find companies that have been very successful in generating very high returns on capital but trying to understand the source of those returns and how durable those returns are because inevitably, when you have a successful business, competitors want to come in and take a piece of that.

And if you don't have a durable competitive advantage to keep the competitors at bay, returns start to degrade and that's never good for the stock. So, we're really focused on the qualitative aspects of these businesses and what has led them to generate the high returns of capital. But more importantly, what competitive advantage they have and how durable that is long into the future.

So, we think of ourselves as more business analysts rather than just financial analysts. And so, the financial returns and the balance sheets and the cash flows are all very important to us, but we spend the bulk of our time and the most of our time trying to understand the qualitative aspects of these business models.

And then for the small-cap aspect, I think a lot of times what we think is that a lot of these small-cap companies that we look at have all the characteristics of a blue chip business, but they're just on a smaller market cap format. So, we think of ourselves as trying to find really the next-generation blue chips. And so a lot of times we can tap into, like I said earlier, the inefficiency of the marketplace where you just have too many stocks.

I mean, in the Russell 2500, you have 2500 names out there. For most people, that's too many stocks for them to go through individually on a qualitative and fundamental basis. And so, shortcuts are taken and a lot of times you miss things. And so, we're able to do that because we have been in this, looking at small-cap stocks for nearly over 30 years. We have built a huge database of companies, and quality doesn't come around often and doesn't happen overnight. We kind of know these kind of businesses that are there. We have a deep, experienced team and so we're able to look at these businesses and own a collection of very high-quality businesses in the small-cap area and take advantage of that efficiency.

Q: Craig, portfolios with fewer stocks can be seen as higher risk. How do you address that concern in the concentrated portfolios that KAR manages? 

Craig Stone: We run about, our portfolios are about 25 to 35 names. So, let's say 30 stocks on average. Most people will ascribe that small caps are higher risk, have higher risks, and that's true. But because we stay in quality, if you look at the results and if you look at things like risk measurements, like standard deviation, and you look at the up and down capture ratio, you look at the beta of our portfolios, they're all more akin to a S&P 500 type portfolio than a small-cap Russell 2000, Russell 2500 characteristics. And again, that's because of the quality aspects. Our companies, because they are the next generation of blue chips, really have the ability to give our clients the returns of a smaller asset class, but along the way, taking the risk more akin to an S&P 500 type of holding.

Q: John, what characteristics does NFJ look for in a quality company? What differentiates NFJ’s investment approach from traditional value managers? 

John Mowrey: We take a little bit different spin than maybe the traditional value manager. The traditional value manager is, I would say, focused on low P/E, strong balance sheet, and a catalyst. I'm guessing everyone listening to this has probably heard some variant of that value manager pitch.

We have a slightly different focus, and I'll mention the custom benchmarking in a moment. But, while we do focus on the balance sheet, we have an intense focus on the income statement as well, cash flow included, but over time, you should expect cash flow and income statements to converge, and I think that the income statement really can be a thermometer for the company's health. And there are a lot of value traps that have good balance sheets but very unhealthy income statements, and they're never able to fix that part of their business. So, that is an emphasis that we have and that kind of bleeds into our definition of quality.

So, we define quality in two ways, qualitatively and quantitatively. Qualitatively, we define quality focusing on companies that tend to have higher ROEs, higher ROAs, pricing power, bigger margins. That way when they need to fund working capital, they have multiple levers to pull. They don't have to do it a dilutive share issuance or tap the debt markets at an unfavorable time. So, we want to make sure these companies have the bandwidth and the ability to be nimble regardless of the environment because we want to find businesses that can do well in multiple environments and don't just need one macro environment to thrive. So, we define quality in those ways. And, if you look at our portfolio, we typically boast higher ROEs, higher ROAs, as well as companies that are growing faster than the benchmark.

Quantitatively, we define quality in two ways. We have two models. One is price momentum, the other is short interest. Price momentum is an interesting model because there's two things that value managers do badly -- they buy too early and they sell too early. This model helps correct for those inefficiencies that the value manager tends to have. So, when we're looking at a stock, if it has very bad momentum but it appears to be attractive and the balance sheet looks stable and the income statement looks stable, we'll just wait. We don't want to step in front of a train, try to catch the falling knife. I can't tell you how many times we thought a stock was cheap, it was bottoming, and it had much farther to fall. So, I think price momentum is kind of crowdsourcing, if you will, the collective market wisdom to help us avoid those value traps, and it helps us bias toward higher quality businesses.

On the short interest side, you might hear people say, hey, I love when shorts are in the stock because when they're wrong, I'll be right and they have to turn into buyers of the stock. We would take the opposite point of view. We would say, yeah, we would rather not be betting against the hedge funds. You're already betting against someone implicitly when you buy shares and they're selling them to you. When there's very high short interest, that's another risk layer. And the hedge fund community has paid a lot to get those idiosyncratic risk events correct. And those can be quarterly events that can really be exogenous in nature, and we want to be very cognizant of that.

So, similar to momentum where we crowdsource the market participants, we crowdsource the hedge fund community, and we look at short interest by industry to get a feel for what companies have the most stink on them, if you will. And those companies that have high short interest, again, we typically skip over those. We do dig in to see what's going on. Maybe it's a [convertible], maybe someone's buying the equity, shorting or excuse me, buying the convert, shorting the equity. So, there could be reasons to have higher short interests that are not indicative of poor fundamentals. But nonetheless, in general, those two models help correct for errors that we think we can make as analysts and as humans.

With regard to the customization, I think this is a real differentiator for NFJ because one of the things that we do is create our own custom peer groups. And if I was to ask everyone in the audience, if you live in a house, are all the houses on your block comps? When you go to sell your house, the realtor prints out a comp sheet and they give you those comps of the best houses to price yours off of. And we would argue that a similar thing is occurring in the stock market. Everyone relies on GICS to tell them what the industries should be. But the reality is there's a lot of dispersion within these industries and you have some very low-quality names that are in industries with very high-quality names and they can skew a manager's perception of what's expensive or what's not. And I'll give an example of this in a minute when we discuss stocks. But I think that customization appears, helps us in two very powerful ways. A, we get the valuation right, and B, we have a better feel for risk management in the portfolio.

Q: John, can you give an example of a mid-cap stock that NFJ’s custom benchmarking process has identified that other managers might overlook?

John Mowrey: I'll start with a hairy area. So, everyone loves to hate office REITs. I'm sitting in an office, and I think a few other people might be as well, but nonetheless, office REITs are quite hated and understandably so. There's been a structural shift in the demand to be in offices, coupled with very high interest rates. That's not a very good recipe for the office REITs.

But there's one office REIT in particular called Alexandria Realty that looks very attractive. It's a top holding in our Mid-Cap Fund. This particular company actually, if you were to look at just a simple price-to-FFO screen, it’s actually the most expensive office REIT. So, if you're a traditional value manager, you might get to the office REITs and say, I don't want to even mess with office REITs and I'm definitely not buying this one because it's the most expensive.

And that would be a mistake because Alexandria Realty actually does not trade with traditional office REITs because its tenants are life science companies, pharmaceutical companies. They have strategic locations near universities, these pharmaceutical companies, and they simply can't up and move. And in fact, even during the pandemic and through COVID, the collection rates were very high. And so what's happened with Alexandria Realty is you have a dislocation in the fundamental, or excuse me, a dislocation in the valuation, but not a dislocation in the fundamentals. That's the exact scenario we're looking for. We want a dislocation in valuation but not a dislocation in fundamentals and ARE fits the bill for that.

And it actually trades with many of those life science tenants, which I'm guessing if you were to ask most REIT analysts, do you think about valuing that stock relative to its tenants, they would say no, I value it to that GICS peer group. It also trades with some of the higher quality REITs such as industrial REITs, tower REITs. So, we've created kind of a customized basket, and we use big data to achieve this and it allows for a pure analysis of companies that look attractive. 

Q: Craig, what’s an example of a stock in a KAR SMID-cap portfolio that exhibits the quality characteristics KAR is looking for?

Craig Stone: I think one of the ones that we've owned for a very long time now and it's very interesting is Jack Henry. We think of this business as a very, very high switching cost, and the proof of that comes in the form where, if you go back and look at 2008 and 2009, the Global Financial Crisis, the heart of the issue was financials, the banks themselves getting into trouble with credit losses and so forth.

But if you look at the banks that Jack Henry serves, they’re small banks and credit unions, a lot of them were in distress, were not doing well, but because Jack Henry provides these banks with a core processing software, it's very, very unlikely for any bank to switch away from them even during those times of high distress in the industry. And so what you see is that Jack Henry's retention rate is very, very much 99%-plus. The only time they really lose a customer is if the bank goes out of business or a larger competitor buys them and they have a different internal system or something else.

So, the ultimate proof of the high switching costs for Jack Henry comes in the form that if you go back again and look at 2008/2009, there was very few businesses out there, unless a company that serves a financial end customer, that came through without seeing a decline in revenues or earnings. But yet Jack Henry's results during that time was that revenues were flat, earnings per share were flat, which speaks to that high switching cost model.

And so we want to find these kind of businesses that have the protection during times of distress, that they have the protection of the business so they don't have that revenue and margin pressure, and then also be able to participate when times are good, when banks are doing well and they have a lot of money to spend on IT upgrades, or they have new things to worry about like money laundering or digital conversions that we've seen in the last decade. Jack Henry participates in those, but really have that protection as well because that business model allows them to even do well when times are really, really tough in the industry.

So, those are kind of businesses that we want to own, that we can own for a very long time, and let that high business return -- John talked about the high returns on equity and capital earlier -- we want these high returns on capital businesses to turn into the highest shareholder returns over time and own these businesses longer term and just let that business, on the wonderful characteristics, and the wonderful returns, and the wonderful business model, turn into the high investment results for our clients.

Q: John, is there another example you’d like to give that illustrates NFJ’s process in the mid-cap value space?

John Mowrey: Another example that I'll give is TransUnion. So, people think about credit rating agencies, they might think about financials. They might think about credit risk. They probably don't think about industrials. This actually maps to the industrial subindustry of research groups and it's buried in there. So, you've got Cummins, Caterpillar, you've got a whole smorgasbord of industrials that fall into this.... [Also,] Stanley Black and Decker. But TransUnion is kind of its own animal within that industrial segment and it's trading very attractively. And what's fascinating about TransUnion is even though housing stocks have rebounded tremendously, TransUnion is not participating because mortgage applications are down still. And it is not participating at all with kind of that rebound you're seeing in the home builder-related group.

And we’ve identified that TransUnion does trade to some degree with home builders, which are a sub segment of consumer discretionary. It also has relationships with some of the financials, and it also has a relationship with some very high-quality industrials that tend to have a much stickier recurring revenue, and less cyclicality than many of the other industrials. So, this is one that our process will kind of bubble up to the top as a high-quality business. To steal one of Craig's terms, typically higher switching costs for folks. There’s really only three companies that do this, Equifax, FICO, and TransUnion. So there's not a lot of companies out there.

And you're getting TransUnion at the lowest multiple that we've seen going back even pre-pandemic. So, it's a forgotten stock. It was loved when it first IPO’d, but you're getting this stock actually today -- I'm just pulling it up -- you're getting it below March of ‘20 and you're getting it below the fourth quarter of 2018. If we could get in a time capsule and go back to the fourth quarter of ’18, wouldn't that be a great time to buy stocks? We could also take that time capsule to March of ’20. Wouldn't that be a great time to buy stocks? Well, you can buy stocks that are trading at those multiples. And that's part of the reason that myself and Craig are so bullish on active management because there's real opportunities below the surface. And you simply have to go through and have an efficient process to ferret those out.

Q: Craig, given the challenging market environment, what is your outlook for small- and mid-cap stocks going into the second half of 2023?

Craig Stone: We tend to focus on fundamentals, but it seems to us that a lot of the pundits out there or a lot of the investors out there have already built in some sort of recessionary environment. A lot of the earnings estimates, particularly on the smaller-cap side, it seems like historically, yes, small-cap earnings get hit harder during recessionary environments. And so, I think some of that's already been built into some of the smaller-cap company estimates and looking forward.

The other thing we're, we're looking at, too, is that if you look at small-cap valuation, a company’s valuation relative to large cap, it seems to us the relative valuation has never been as attractive as we've seen it today. You have to go back almost 20 years to look at where there's during the Global Financial Crisis to see those kind of better valuations relative to small cap to large caps. So, we think that there's a clear valuation opportunity for smaller-cap assets and already, like I said, the investors have already built in some of the expectations for the most anticipated recession that we've had in a while. And so some of that has already been built in, particularly on the small-cap side, so that excites us about going forward and, and looking at the opportunity set that we’ve got.

Q: John, same question: What is the opportunity for small- and mid-cap stocks in the current market environment?

John Mowrey: Well, I could not agree more. The small/mid-cap area is deeply discounted to its larger-cap peers. And that is partly due to the recession fears, to completely agree with Craig, but it's also due to what's going on with the Fed, interest rate hiking, and the bank failures. This is something that is a little bit unique more to the value side of the equation. If you look at the Russell Midcap Value, it’s got 16.5% in financials, it's got 10.5% in REITs, and then another 10% in consumer discretionary. So, it's like, wow, that's over 30% of the opportunity set that's in consumer discretionary, financials, REITs. I can tell you that those areas are hated today. REITs are hated. Financials are hated, particularly banks, and many of the consumer names are hated as well.

This is providing a real interesting opportunity. And if you go back in history, it's very hard to get market rallies without financials participating. The perception today is that financials won't be participating going forward. And it reminds me of similar things in years past. Oil is going to zero a few years ago. The tech wreck – tech was going to zero not that long ago. China was going to zero – the second largest economy in the world. So, we can keep going on with these shocks to the system, but the shocks create opportunity, and particularly if you're a skilled active manager, you should be able to go through and identify really interesting opportunities.

You know, Warren Buffett came out today and took a position in Capital One. That's a name we actually added earlier this year to our portfolio. We also see value there. That's tied to consumer. It's tied to banking. So, all those areas of reciprocality. And Warren Buffett has said many times that he's not going to sit there and try to predict the next recession. He's going to focus on the bottom-up fundamentals. So, we're doing the exact same thing.

But I will share one other data point, which I think is fascinating, and I think there's some recency bias going on. If you look at the yield curve version today, I think a lot of people use that as a reason to stay away from equities, and the three previous yield curve inversions were all times to sell. So, the yield curve inverted in ’19, right before the pandemic -- maybe that was luck or maybe the market knew something -- but nonetheless, it inverted. It also inverted back in 2007. That was right before the Great Financial Crisis and then it inverted in 2000. All those times with the twos and the tens inverting, and all of those times, the market was at all-time high, and everyone gave excuses why this inversion wouldn't lead to a downturn in equities.

But the inversion today is much more akin to what we saw in the 80’s. And that was coupled with higher levels of inflation, rate increases. And if you look at what happened in the early 80’s, when they were raising rates, coming out of that inversion, you had massive returns in the equity markets as that cycle kind of unwound. So, we think that that's the more applicable time to look at versus the others because you already had a market down 25% peak to trough last year.

So, for all those reasons, the market was not at all-time highs this time. It definitely wasn't back in October, and particularly those small- and mid-caps are big time on sale because of the banking crisis, recession fears. And it can be scary, I admit it. It's not like I'm a robot or Craig's a robot. We look at this and there's always concerning things, but over time, the valuations and fundamentals always weigh in heavier than the fear trade.

Conclusion

  • Mid-cap stocks represent an overlooked investment opportunity, accounting for nearly 25% of the equity market but only 10% to 11% of the average investor’s portfolio.
  • Over the long term, mid-cap stocks (and small-mid cap stocks combined) have provided strong returns and a risk profile more akin to the large-cap space.
  • For more information about NFJ’s mid- and KAR’s mid- (and small-mid) cap strategies, please visit Virtus.com/our-products or call 800-243-4361.

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