333. Why US mid-caps are poised for a turnaround

3 October 2024 (pre-recorded 25 September 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 (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. Following the first rate cut by the Fed in four years, we’re looking at US companies today, specifically mid-cap companies and their potential for future growth.

I’m Staci West, and today I’m joined by Bob Kaynor, manager of the Elite Rated Schroder US Mid Cap fund. Bob, thanks for joining me.

Bob Kaynor (BK): Thanks Staci, glad to be here.

[INTERVIEW]

SW: So I wanted to start briefly with valuations, because I was reading a few weeks ago that the US mid-cap companies are currently trading at near record valuation discounts which is incredibly interesting. But then in addition to that, the last time that the valuation discount was this large was back in the early 2000s, which afterwards this multiple year period of mid-cap stock outperformance followed. So I’m not trying to suggest that anyone listening tries to time the market but I just thought it would be an interesting place to start because it did catch my attention as something that’s probably potentially overlooked. So do you think that mid-caps are due for this turnaround in fortunes like we saw before?

BK: I do. I do, and I think you make a good point because starting points do matter and I think we’re starting from a very kind of extreme point from a lot of way lot of perspectives, relative valuations, relative positioning, concentration in the market. From a valuation perspective, historically the small and mid-cap space had been at a premium to the market because it had had higher growth earnings growth in the market. That narrative has changed recently.

It’s really been dominated by large cap and concentrated technology stocks. The past, you know, really since Covid, but historically there was always a premium paid for small-cap and mid-cap to access that higher earnings growth. We’re currently at almost a 15 to 20% discount relative to the S&P 500. The S&P 500 is trading at 23 times, I believe on next year’s numbers. And the small/mid-cap space is trading closer to 18 at a time when we should see earnings growth begin to accelerate.

And obviously there’s a Fed rate cutting cycle that just kicked off. That’s usually good for valuations. So I think the setup is very similar. History rhymes. It does not repeat. There’s a lot of similarities to what we saw in the late 90s. And to your point, the subsequent period coming out of it, I’ll say the internet bubble was a very good time to be invested in small and mid-cap equities.

SW: Well, you mentioned the Fed rate cutting cycle. So I wanna just touch on that as well. I mean, you are one, you’re the first US manager that we’ve had on since the news. So I want to get your perspective seeing as you’re actually based in the US but it’s also the first time that the Fed has cut interest rates in four years. So for those who haven’t seen the Fed cut interest rates by 50 basis points. And so I guess I wanna get your take on that for one for the US economy, but then also how does that really affect this area of mid-caps that we’re talking about?

BK: Yeah, so the Fed cut 50 basis points last week. I think it was a little bit of a surprise. If you listened to the Fed Jackson Hole meeting. So the Jackson Hole conference is held at the end of August. Jerome Powell is obviously the keynote speaker. At that conference, at the end of August, he was certainly signposting a 25 basis point cut. The message at the time was that inflation had been going the direction that everybody would hope and expect, and we had multiple data points confirming that inflation was slowing. The jobs market is the key variable in terms of determining the pace of the economics of the slowing economy. And the job data, we’d been in a bit of a Goldilocks period where inflation was coming down and the jobs data while weakening wasn’t accelerating to the downside.

So the message out of Jackson Hole for the market was pricing in 25 basis points. As we got closer to the meeting, the market began to price in 50 basis points. Candidly, there wasn’t necessarily more weakening jobs data that justified that move. So the 50 basis points was generally viewed as being a little bit proactive because the next Fed meeting isn’t until after the US presidential election. So we’re gonna have a lot of data, you know, in between that seven week time period between the meeting we had last week and when the next meeting. And the Fed clearly was trying to get ahead of that ahead of any potential weakening, further weakening in the jobs market.

I think it’s really interesting that for the first time since 2005, you had a Fed governor dissenting. I think it’s amazing that they’ve all been singing from the same hymn sheet, if you will, for the last 19 years in a very volatile type of environment that we’ve seen over that time period.

So the market is pricing in another 50 basis points in the November meeting. I think the direction of travel is clear. How the market behaves into that cutting cycle really comes down to whether or not the economic data weakens at an accelerating pace. Right now we’re in the sweet spot where jobs are slowing, but at a measured pace, inflation is coming down as expected. If the pace of economic decline accelerates or economic slowdown accelerates, the market will start to think the Fed is behind the curve and react differently. But for the moment we’re in this soft landing narrative, and that is very good for small and mid-cap equities that do tend to be a little bit riskier. There’s a little bit less liquidity, there’s a little bit more volatility. They’re very tied to the US economy. They don’t benefit from China making, taking aggressive monetary policy changes like they did yesterday.

So I think the backdrop right now is very good. If the pace of economic deceleration accelerates to the downside, I think it gets a little trickier. But again, to the first point you made, you’re starting this cycle from a point of really discounted valuations, which should protect you in the downside relative to what we’re seeing in in large cap valuations and what that market is pricing in.

SW: You’ve touched on the large cap and that market concentration twice now, if my mental tally is correct, so let’s just briefly, obviously this is a mid-cap fund as I have said, but the large concentration in the S&P 500, these Magnificent Seven companies, we can’t seem to get away from them. They’re everywhere and they take up so many headlines. But do you think that a slow down in these companies is kind of what’s needed to see that mid-cap end of the market come through stronger? Or will the mid-cap market kind of pick up itself and and power through with some of these other underlying fundamentals that you briefly already touched on?

BK: So I don’t think it’s as much about the Magnificent Seven starting to have deteriorating fundamentals as much as it is a broadening of fundamental improvement. I think one of the key things in term we can talk about valuation and the starting point and how that helps the risk reward of entering the asset class, but what is gonna be the spark that likes the fuse is really going to be relative earnings growth.

And so if we look at the relative earnings growth of small-cap versus large cap this quarter, the third quarter 2024 should be the first time in two years where we’ve seen a higher rate of earnings growth in the small-cap market than we’re gonna see in the large cap market. You have to go back to 2022 was the third quarter of 2022 was the last time small-cap earnings growth outperformed large cap.

So I think that is what matters. I think the Fed rate cuts help. They help risk appetite and potential reallocation across portfolios away from the seven to everything else. But what will keep it going is the earnings growth acceleration in the small and mid-cap market. And I think that investors and allocators are recognising how one sided they’ve been on a quarter to date basis, small, mid, S&P equal weight, all of those indices are up 10%, almost 10%, and the S&P is only up 3.5 to 4%. I think it’s a recognition that the tides could be turning and when they turn the cycle tends to last a long time. It’s not just for a quarter or for a month.

If you go back to the early 2000 periods that you were referencing, when that tide turned, there was a period of six plus years of outperformance of small and mid-cap equities relative to large. So it’s not necessarily about catching the first moment in time when the market starts to price in a rotation. I think there is time to continue to change allocations across portfolios especially with the tailwind of relative earnings growth.

SW: And these mid-cap companies are kind of referred to as this sweet spot if you like. They have kind of the best features of the large and small companies. But last time you spoke, you also told me how they were the heartbeat of the US economy these companies, which I love – it’s ingrained in my mind forever – so I have to ask, how’s true is that still today of these companies that you have in your portfolio?

BK: Yeah, we’ve always said large cap is the headline, but small and mid-cap is the heartbeat. 80% of the revenues of these companies, or 84% to be precise is generated in the US. So they are very much domestically focused companies. I think one of the appealing aspects at this point in this cycle is that we have lots of fiscal stimulus that is working its way down the funnel. Many of these laws were approved a couple of years ago, but they didn’t go through the rules making process in the US which is the unfortunate period of time I’ll say, where politicians get to put their fingerprints on these until really just a year ago, and it was really a year ago at this time, that the companies we speak to started to talk about orders and bookings and revenues associated with specific fiscal stimulus plans like the IRA, like the Infrastructure Investment Act, and to us that’s a catalyst. So I would say very much we still feel like our companies are the heartbeat. They’re where real employment is in the US and their revenues are heavily, heavily concentrated towards what’s happening in the US.

SW: You and this fund have a focus on stop picking, which I want to come to in a minute, but it would be remiss of me if I didn’t ask about the elections. We are a few months out, so let’s just rip the bandaid. US elections, does a Trump or Harris victory have any implications for certain sectors in the US? And I guess, do you view the elections as a risk to investors or is it more of it’s political noise and you have to just invest through the long term, even through it? What’s your message and view with the elections?

BK: I certainly think that policy can influence fundamental outcomes for companies, especially domestic, small and mid-cap companies. If you go back to 2016 when Trump was elected, which was a surprise to everybody, the reaction in the market was a big rally in small-cap stocks because it was reshoring domestic manufacturing tariffs. It was a rally in banks around deregulation. It was a big rally in biotechnology around eliminating the prospects or potential of price controls, which was something that Hillary Clinton was talking about. And that momentum continued until really the end of February of 2017 when the Congress shot down Obamacare reform and reforming Obamacare was a big part of the Trump campaign in 2016, but he couldn’t get it through Congress even when he had a Republican House of Representatives and Republican Senate. So I think it speaks to the lack of ability for a presidential candidate that becomes president, getting everything through and along those lines, I think this time around the Senate is probably a greater focus than what happens on the presidential ticket.

I think the market, the working assumption and the market today is that Harris will win the presidency and the Republicans will take the Senate. The Democrats in the Senate have a number of seats up for, that they have to defend this year that are up for election in hotly contested geographies. The Republicans have a smaller number of seats up in the Senate, and they tend to be in very red leaning states. So right now the Senate split 50/50 with the vice president being the deciding vote, which means it’s a democratic senate. And if Harris becomes president and the Senate goes Republican, I think it’s a very, I’ll say, safe prospect for risk assets.

If the Democrats take the Senate and Harris takes the White House, I think that becomes a less favourable backdrop given some of the narrative around increasing corporate tax rates, wealth tax, et cetera, billionaires tax. If Trump does get the White House, I think that they’re, irrespective of what happens in the Senate, I think he could make things a little bit more challenging for the some of the IRA subsidies that are out there, including electric vehicles, I think that would be a real focus of his.

So it does matter, but it matters across specific industries and specific kind of sub-sectors as opposed to broad markets. But I do think a Harris White House with a Democratic Senate would would change the outlook, could potentially change the outlook. I think you always have to be aware because policy does matter. A lot of our favourable view on the US is a function of the fiscal policy that’s come through over the last four or five years, even in the Trump administration. The infrastructure bill was a big focus for him as well. So it does matter. And it does change the way that it could change the way we think about the outlook, but our foundation is about generating risk adjusted returns. We always think about mitigating downside. So I think we’re in a pretty good position to outperform relatively in either scenario.

SW: Well, I will make an note to come back and ask you your outlook after the election then and we’ll see if it’s right. But just for the end of this podcast, I wanna get into some of the stock picking and companies in this fund, because this fund is a wonderful collection of companies that most people will have never heard of. And I think that’s great. So in the top 10 alone, you have insurance, you have aerospace, marine time transport companies and that is just from the top 10 that I could see that I was like, I have no idea what these are. So how do you go and narrow down everything that’s available in this universe to find these companies for the portfolio? What are you looking for? What’s the process behind it?

BK: So the process is very much anchored in quality first. So we think about the quality characteristics of a company. The way we measure that it can be margins, return on capital, return on assets. So it’s not just looking at earnings growth, it’s how much capital is required to generate that earnings growth. We think about things like cash flow and free cash flow yield. Those are the metrics that matter to us. So it is quality first and then it is what type of growth can we access and how much do we have to pay for that growth, or what is the valuation embedded in a company and what is that valuation discounting as it relates to the growth rate, and is it overdone? So we lead with quality and then it’s the interplay between valuation and growth.

So when we find companies that fit for us, they tend to be I would say a little bit more stable top line, very good balance sheets, strong cash flow generation. Sometimes they can be cyclical, sometimes they are what we call steady eddies. And the top line growth is not overly dependent on the direction of the economy, or GDP.

Insurance is an area that we’ve had success in recently. Insurance is certainly cyclical, but it’s not necessarily tied to the economic cycle. So we can find insurance companies that are tied to auto insurance, life insurance, or property and casualty insurance, and they can all be on very different cycles. One of our top holdings in the portfolio is a company called Assurance, which is transitioning their business from a traditional insurance company to more of a warranty business. They have warranties for your cell phone, your cell phone, if you have insurance, it’s either Asurion or Assurance. They do aftermarket auto insurance. But the appeal is they’re transitioning their business from what has been a balance sheet heavy business in the insurance space to a cashflow generating business, consistent cashflow generating in kind of a more steady type of warranty business.

The market has completely missed this transition that’s occurring. The stock trades at about 12 times earnings, importantly to us. They generate lots of cash and they’re using that cash to reduce their shares outstanding. If there’s one model I could put forward in terms of building a portfolio, it would be finding those companies that can grow their top line mid to high single digits with a shrinking share count because they compound incredibly well for investors. So it’s one of our favourite names in the portfolio.

You mentioned Marine Transport. We own a company called Kirby. Kirby does inland barges. It’s an industry that’s massively consolidated capacity came out during Covid, and it’s a contract business, and they’re contracting at much higher rates for their barges than they have historically. That industry has a huge moat around it because there’s something called the Jones Act in the United States that requires ships, transporting between, moving in between ports in the US must be built in the US so you can’t really bring capacity in from the outside.

Their earnings growth is gonna compound at over 30% for the next three years. Pre-covid, they used to earn $3 in earnings. We have them doing north of $750 in two years. And the stock trades at 16 times earnings. So yes, it’s a very diverse market in small and mid-cap. One of the reasons I think we love the asset classes. There’s nothing we have to own. There’s nothing in the benchmark that represents a large percentage. If I’m a large cap manager and I don’t own Apple, I’m short Apple, we don’t have that risk in the small and mid-cap space, which allows us to go access growth and opportunity across a wide variety of industries and sectors.

SW: Well, that brings me on, I think, kind of nicely to my last question then, is when you are assessing the universe available, it sounds like it’s mostly on a company by company basis, but do you see spikes in opportunity in certain sub-sectors? For instance you mentioned insurance briefly, or are you really looking at each company on its own merit and not going into these sub-sectors when you’re building the portfolio?

BK: Yeah, so it always starts bottom up trying to find the companies. And then if we have a number of companies that are fitting within the same industry or theme, we’ll step back and have a top down view of, is there a reason that we’re finding companies many different companies that kind of fit within the same space. So insurance was that over the past few years, I tell you that as we look forward, one of the areas that we found a lot of interesting individual ideas, and we’ve had to build a mosaic around kind of the top line industry trends, is on communication equipment.

So these are companies that are connecting the data centre to the telecom network if you’ll, and there’s a lot of talk around AI and all the investment that’s been made, but a lot of that investment’s made what we would describe as the back of the data centre. It’s not really being deployed into the network for enterprise applications. That is the next step. And so we’re finding a number of companies in the communication equipment space that are gonna be the beneficiaries as we move from the back of the data to the front of the data centre. So we own companies that do optical components and switching and switches and routers in network, in the telecom network. In that scenario, I would say we haven’t seen it pay dividends yet, but when we look at over the next couple of years, that’s an area that we think we’re gonna be generating very good returns from.

SW: Well, Bob, I think you and I could probably talk for another hour, but I’m not sure the listeners signed up for that with the podcast. So I will leave it there. Bob, thank you for joining me and talking through quite a lot of different areas today from the US economy to valuations and of course your portfolio. So thank you again.

BK: Staci, thank you for having me.

SW: In a market as difficult to beat as the US, we like that good stock picking, as opposed to sector allocation, has formed the foundation of this fund’s success. Schroder US Mid Cap is set up quite cautiously, with a three-bucket approach, and consequently tends to hold up well in tough markets. To learn more about the Schroder US Mid Cap fund please visit fundcalibre.com