318. Uncovering the secrets to consistent market outperformance

20 June 2024 (pre-recorded 11 June 2024)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]

Staci West: Welcome back to the Investing on the go podcast brought to you by FundCalibre. In this episode, we’ll dive into the secrets behind the impressive performance of the T. Rowe Price US Smaller Companies Equity fund and also discuss the opportunities in small-caps today.

I’m Staci West from FundCalibre and today I’m joined by Michele Ward, Portfolio Specialist on the T. Rowe Price US Smaller Companies Equity fund. Michele, thanks for joining me today.

Michele Ward (MW): Thanks for having me.

[INTERVIEW]

SW: Now, this fund has outperformed for 1, 3, 5, and 10 years, which is quite the accomplishment when I was looking to organise some questions. So maybe let’s just start with what’s the secret to the success?

MW: Well, it is a combination of things actually, Staci. One is that the fund is very broadly diversified. We typically have about 175 stocks in the portfolio and for a lot of investors outside the United States, that sounds like an enormous number, but it’s against an opportunity set of about 3,000 companies so it’s actually fairly concentrated. And the benchmark, which is the Russell 2500, has an average weight for the typical or average stock of only four basis points. So when we own 50 basis points / 75 basis points of a name, that’s a big high conviction position, but it’s spread across every sector and all the important industries.

And that’s supported by a team of about 50 analysts who are out there combing the 3,000 opportunities for the really best ideas. And that diversification – hedging out a lot of the macro risk, making sure we’re not absent anything that’s really important, has led to a very consistent pattern.

We also look for high quality companies, and I think we’re going to be talking about some of the things that define quality for us in this conversation. But by focusing on the best companies in a particular industry and sticking with them for the long term, that has led to a pattern of performance that allows us to capture most of the upside, but not participate so much when things get challenging in the market.

SW: You touched on a few things there. One, the fund is looking at the Russell 2500 – which is the small and mid-cap market in the US – but also that the fund has a chance to run its winners. So maybe talk us through that: how does that work in the portfolio? And also if you have an example that you can share of where you’ve been able to run your winners and see that success come through.

MW: Sure. This is a philosophy of small-cap investing that actually dates back to Thomas Rowe Price. He was one of our early portfolio managers in the small-cap space. He was the first portfolio manager of our New Horizons fund, which focuses on small-cap growth stocks. And that was launched back in 1960, so decades ago. But one of the things he learned is, it’s really hard to find great companies. And you don’t want to sell them arbitrarily because they hit a particular size, as long as the fund itself stays true to its mission. And we’ve approached the investing in US smaller/mid-cap stocks with the same view.

The general philosophy allows us to buy anything below the top end of the Russell 2500. That’s about $18 billion in terms of market cap, but we can allow stocks to run past $18 billion; that’s the letting your winners run idea. And so typically what we find is that we have a handful of names that do extremely well for us and they grow larger. If you just think about that full mid-cap spectrum in the United States, that goes up to about $50 billion. So we have one or two names that are in that sort of $30-$50 billion range, and we’re typically harvesting profits in those names.

So an example would be Arthur J. Gallagher, which is one of our largest in terms of market cap positions today. It’s not one of our largest holdings in the portfolio, but it has been an important contributor over the years we’ve owned it – that dates back to 2017 – and it’s a company that is a very high quality in its area. It’s an insurance brokerage firm; it’s benefited from a strong insurance pricing cycle; the company’s extremely well managed. They grow through acquisitions as well as organically. They pretty much do everything right. And so, we are looking to find opportunities that are smaller in the insurance space, but it’s hard to find one that’s as good a quality as Gallagher. So we sell some most every quarter. Sometimes it doesn’t look like we sold a share because they have done so well in that period of time. This is a very high class problem, but it’s really the opportunity set that drives us to sell faster or slower.

Contrast that with Devon Energy. It was a name that we bought in the depths of Covid when it was only $4.5 billion in market cap. That was back in the day when nobody was flying or driving and gas prices were low and so were oil prices. And, as a result, so too were energy stocks. We have seen a resurgence in the economy and oil prices have gone up and people are flying and driving again. And Devon Energy went from $4.5 billion to over $30 billion. Now, in the energy space, we found a lot of good small cap ideas so we were able to sell that idea very quickly and redeploy the capital back into a handful of smaller small-cap energy stocks. So it’s a little bit dependent on where our analysts are finding new ideas, how quickly we sell those long-term holdings, the winners that we love to let run.

SW: When you’re trimming back the winners, are you looking to stay within that particular sector? For example, if you’re trimming your energy holding, are you looking for the smaller company energy or are you maybe looking to go into a different sector because that looks more promising or more opportunities than previous?

MW: It’s actually a little bit of both. All of our sector weights are determined from bottom up stock selection, so sometimes the best ideas are indeed in the same sector. Other times, they’re somewhere else. It really is a matter of looking every day at where the best risk-adjusted returns are, looking out three to five years. So that often means taking some money out of a part of the market that’s very overvalued or expensive – maybe it’s not overvalued, but it’s just plain old expensive – and putting it into an area of the market that is currently expressing some controversy and, as a result, is sort of cheap. So that being a little contrarian is important and that can sometimes, as I said, lead us back into the same sector; other times it’s taking money out of one sector and putting it somewhere else.

SW: And the fund does look to try and balance between growth and value within the portfolio. So maybe just briefly, what is that split at the moment? Are you seeing more opportunities for one versus the other? Or is it evenly split?

MW: Well, we always have stocks that are growth and value, but I’d start out by saying that growth and value are not inherent to a company. They are phases in the market. I think it’s worth noting for listeners that it wasn’t that long ago, at least in my career age terms, that Microsoft was a value stock. And now we think about it as one of these Magnificent Seven large cap, growth stocks. So companies can go through growth and value stages of their lives or phases in the marketplace so we don’t arbitrarily think about growth and value. I can’t tell you what the balance is today because we just don’t think about the world that way. What we look for is quality in everything we look for.

Now, there are some parts of the market that maybe people would consider more value and some that would be considered more growth. But in virtually every sector there’s growth and value. And some of our best ideas have been ones that start out, say as a small-cap value stock and become a mid-cap growth stock. That’s a great outcome for us.

Like we had in a company called Molina Healthcare. Molina’s a Medicare/ Medicaid-focused HMO (health maintenance organisation) or insurer. And when we bought them, it was definitely a value stock. It was a turnaround situation and a new management team came in, ones that we had known from their prior experience at two other insurance companies, and we knew how well they had done in those experiences. So we were willing to put money into the situation. At the time they came in, they turned the company around – improved its margins, improved its underwriting, put it on the path to growth, and now it’s a mid-cap growth stock. That’s a great success for us because the company has improved its operating earnings and become more expensively valued in the market itself.

SW: You mentioned Microsoft, Magnificent Seven, hard to talk about the US without talking about some of these names nowadays it seems like. And the US stock market itself accounts for over 60% of the global market and small-caps have been left behind by some of these big names. But not just in the US, kind of globally small-caps have been left behind I should say. So, what is your view? Do you think that small-caps can do a turnaround, can these names continue to grow at the expense that they’re growing or will we see this performance come through to the small-cap sector?

MW: So if you look back over the long term, say to the last century, small-caps and large-caps have essentially traded off leadership in about 10-year cycles so we’re kind of overdue. That alone won’t change things. You need something to happen. One of those possibilities would be that small-cap earnings start to outpace large-cap stocks. Tough to get a really accurate read on that, but if you look at the general consensus of outlooks, it would seem that later this year, early next year, that might well materialise and that would be favourable for small-cap stocks.

It could be that this group of large-cap leaders who are great companies having really good returns, generating legitimate returns and perhaps not overly valued, they rely on continuing to outpace the market’s expectations to maintain that multiple. That’s happened before where we’ve had great companies that have done the same kind of thing, led the market, the tail end of the Nifty 50 era in the early 1970s is one that seems a lot like the market today. And those companies that led back in the day, they didn’t all of a sudden become bad companies, but they failed to continue to exceed the market expectation. Disappointment is not something the market handles particularly well. And that ushered in an extended period of small-cap out performance. The seventies were a period when small-caps led and it was a period characterised by high inflation, higher energy prices, war in the Middle East, Watergate and political disruptions back in the United States – all of the things that are in the headlines today, and yet small-cap stocks massively outperformed their larger counterparts for the next decade. So, from my lips to God’s ears, we’ll see if that happens again.

It’s hard to use valuation alone as a catalyst for this to happen, but small-cap stocks are cheap and usually, when you look out 10 years, that valuation will be a harbinger of good things to come. It’s just hard to know exactly when the catalyst will materialise, but it’s always better for investors to have the cheaply-valued assets in their portfolio when the market starts to turn.

SW: So it’s a good entry point is, is what you’re saying? [MW: Absolutely.] Well, one thing with smaller cap companies is that they do tend to hold proportionally less cash and rely more on bank lending, meaning that they’re typically more sensitive to interest rate changes than their larger counterparts. Has this held true for the companies in the portfolio?

MW: Well, not exactly and to be fair that perception is maybe over generalised. A lot of the debt in the portfolio – in any portfolio – of small-cap companies resides in a relatively smaller part of the portfolio than every company for example. Real estate companies, for example, carry a lot of the debt in small-cap land; companies like in the materials industry, materials, industrials, consumer, tech sectors typically have very little debt. And if you look even at the smaller part of the market, just the Russell 2000, one out of five companies doesn’t carry debt.

It’s also important to look at the companies as individual companies and really do the analysis yourself because some of the time what you find when you look deep down – do the digging the way our analysts do –  is that what might look like floating rate debt on the surface, meaning the company is vulnerable to interest rates moving one way or the other. Or maybe if the Fed doesn’t cut, they might have a concern over the future of their balance sheet. They might have done some financial engineering that effectively fixes that floating rate debt. We have a couple of portfolio holdings that have chosen that kind of approach. There are some very sophisticated treasury offices in some of these small companies, who are able to think about the ‘what if’ scenarios and make sure their companies are protected regardless of what the Fed chooses to do, what the economy chooses to do.

And we’ve also noticed in our portfolio over the course of the last few years, that our companies have meaningfully less debt relative to their market capitalisation than the market as a whole. And that’s partly because we choose to avoid certain companies that have a high level of debt, but it’s also something that the companies have chosen to do. Some of them have done it because they’re concerned about rising interest expense. Others have done it because they’d like to have a very clean balance sheet which provides them with dry powder if a great acquisition should come their way. And we often rely on these companies to grow through acquisitions. So, if they’re a thoughtful management team with a good business strategy, we don’t mind them taking on some incremental debt if that means they have a great business opportunity, one that will fuel growth for the coming 5, 10, 20 years.

SW: And I just want to finish with an example in the portfolio. You’ve given us a few already, which is great, but one of the things that I love about smaller companies funds is that there’s often so many companies that are doing really interesting and diverse things that most general public would never know about or hear about unless they had a reason to use these companies. So let’s just finish with some of these wonderfully diverse companies that you have maybe something interesting or different just give us a little bit of flavour of what’s in this portfolio.

MW: Well, you’re right, and small-cap investing is a process of looking through these thousands of companies and finding these interesting opportunities and sometimes they’re really innovative and different. So let me give you two different alternatives.

One is Manhattan Associates, it’s a software company and they started out just creating software to manage warehouses. Well, in the omni-channel world of today, warehouse means not just the big building with lots of inventory in it, it also means the stores that a retailer might have. And if you’re thinking about the complexity of managing all of that, knowing how many shirts of a particular size or colour or type that company has available to sell, tracking it all is really complicated. And so Manhattan Associates products have expanded so it now doesn’t manage just warehouses, but the entirety of the supply chain for these companies and helps companies in that space know whether a customer has bought an item online and then has returned it to a store, and is that available to be sold again and how and where and and so forth. That company has continued to provide us great returns because they’re outpacing their larger competitors, their products are really just a better mousetrap. And so it outsells the large-cap alternatives.

But at the other end, I’ll give you another example of a company that sounds way more prosaic but isn’t actually been a great holding for us. It’s a company called Vontier and most investors in the United States have never heard of it, so investors outside are probably even less likely to.

It was a spinoff from a company called Fortive back in 2020 and they provide gas stations with the pumping equipment and point of sale equipment to sell gas. Now, if the world is just going to EVs, you kind of wonder are gas stations a thing of the past? But in reality, at least in the United States, EVs are gaining traction, but hybrids are probably more attractive for most US drivers because we drive a long way.

And so, gas stations are probably not going the way of the buggy whip anytime soon. However, Fortive was under a lot of pressure or Vontier was under a lot of pressure because, a couple years ago, there was a huge upgrade cycle and a lot of the convenience store or gas station chains upgraded their systems because of a regulatory change, leaving a period of fallow orders. And that put a lot of pressure on this stock.

And our analysts really dug in and thought that all of the worst had been discounted in this stock and found that the opportunities going forward were greater than the market was giving credit for. And so we were willing to step in, classic value name under a lot of pressure, controversy and so forth. And the company has proved itself to be far more resilient. There’s more demand out there, there’s more need for ongoing reinvestment, more upgrades that haven’t yet been done, greater parts and service revenue to come. So, we love to find these companies that the market has just tossed out and look for the hidden gem in that situation. And that’s what our analysts are paid to do day in and day out.

SW: But that’s really interesting and that is the beauty of smaller companies funds. We have covered a wide range of companies and sectors today, all within the one portfolio, which to your opening credit just tells you how diversified this fund truly is. So Michele, thank you so much. That was a excellent overview and glimpse into the portfolio and very much appreciated. Thank you for joining us.

MW: Thank you for having me. It’s been a pleasure.

SW: As highlighted in this interview, the T. Rowe Price US Smaller Companies Equity fund has a flexible approach. The manager looks to build a diverse portfolio of best ideas. The fund’s ability to run their winners means the portfolio is likely to have more of a mid-cap bias than its peers. To learn more about the T. Rowe Price US Smaller Companies fund please visit fundcalibre.com