SMID Sailing: Celebrating 10 Years of the Cambiar SMID Fund
A decade after the launch of a SMID Fund at Cambiar Investors, Co-Portfolio Managers Andrew Baumbusch and Colin Dunn sat down to discuss the asset class and what makes their approach unique.
Can you talk about the SMID style at Cambiar? What are the parameters for investments and where could SMID fit into an individual investor’s asset allocation?
Colin: We target companies in the market cap range between $2 billion and low double digits, so $12-$15 billion. We typically buy 40 stocks in the SMID Fund and run an equal-weighted strategy, with all new purchases entering at a 2.5% position. We think a SMID allocation could fit alongside a small-cap allocation for many clients.
Our research shows that there is an equal alpha opportunity to be generated versus what many people observe in the small-cap asset class. However, we think this alpha opportunity is paired with a higher quality company set. SMID businesses tend to be more mature, possess a better margin profile, and higher returns on invested capital, and these companies also can gain better access to the capital markets. The relatively lower market capitalization (relative to large caps) is often a function of a more focused business niche. In aggregate, our observations have been that SMID companies tend to have increased durability and less volatility than small-cap companies, yet offer similar alpha potential.
Over the last 10 years, the Cambiar SMID Fund has outperformed its benchmark over longer time frames (3 years and beyond). To what do you attribute the performance?
Andy: The ability to preserve capital in downturns is a critical component to compounding returns over a long arc. We are conscious of not just capturing alpha in up markets, but also giving up less on the downside. One of the things we are especially proud of is that our down capture stats line up quite favorably relative to the Russell 2500 Value Index.
We have also consistently invested in the research effort at Cambiar. It is a core asset of the firm and as such, we are continually looking to upgrade with both new hires and, for those who have been around a while, continuing to challenge our own underwriting approach, looking to explore each sector with dynamism – not resting on our laurels.
How has the approach evolved since the launch of the fund back in 2010?
Andy: The major tenets of the SMID Fund have not changed meaningfully. At the margin, we have made tweaks in terms of the number of holdings; at one point we were 30-35 names vs. the current range of 35-40 positions. But in terms of the underlying approach to stock selection and portfolio construction, we continue to try and just get better at it. By that, I mean continue to make sure that the portfolio delivers balance and has exposure to a variety of factors that can deliver excess return. That is something we have continued to iterate as we have more observations and data-based tools to evaluate performance in a historical context and try to incorporate in a real-time context.
Price is what you pay, value is what you get and we’re really focused on what we get.
Still, 40 positions is a fairly concentrated Fund…
Andy: We are looking for high performing businesses that, over time, demonstrate better financial and operating metrics in the form of their margin and cash flow profiles. These attributes reflect either an internal innovation engine and/or franchise position that has supported the durability of such metrics over long periods of time.
It is not as though there are hundreds of opportunities consistently available across the market, so we tend to end up with a narrower set of names. That said, we believe a portfolio of around 40 names can provide the high active share that is relevant to an investor who is seeking to potentially meaningfully outperform an index. Secondly, within those 40 stocks, we look to provide a varying degree of return sources, whether that is across sectors or by the nature of a particular business and where it fits within its own industry.
Colin: That’s right. Active share is a very specific intent on our part. We think, as an active manager earning the fees we do to deliver alpha, you need to focus your bets accordingly.
What factors do you think contributed to growth’s outperformance for the last decade or so and do you think that value will eventually have its day in the sun again?
Andy: To us, that is one of the interesting things less discussed around the growth and value dichotomy: we believe that value benchmarks are simply not appropriately capturing companies that, over the last few decades, have been able to do more with less. Traditional book value measures for companies 40 or 50 years ago reflected high levels of infrastructure, metal, machines, etc… to generate output. Yet the world has evolved in areas like healthcare and technology, where asset-light business models are part of the reality. Many of these businesses possess a lot of the attributes we are seeking, in terms of high margins and free cash flow.
It is almost definitional to some degree that asset-light businesses do not often require a lot of capex, so a lot of the growth from investment ends up flowing through the P&L, vs. accumulating on the balance sheet. It does not mean that they are more expensive, per se, it just means they are structured differently.
Colin: First and foremost, the whole growth vs. value concept— investors shouldn’t have to choose. Unfortunately, value investors have been painted with this low-price brush. Which is one factor, whereas the characteristics you get for that price is really the value you are getting.
There’s an age-old saying, “price is what you pay, value is what you get,” and we’re really focused on what we get. Our investment team is charged with uncovering companies that possess a structurally advantaged position which can translate into good returns and free cash flow—and then determining a fair price to pay for these attributes.
One should always be price-sensitive; decades of market history suggests that valuation matters. But value investors should ultimately care about where value is being created in the economy and focus on getting clients exposed to those specific areas.
Sectors where historically you might focus on price-to-book—financials and real estate are two examples – dominate the value index. Those are capital intensive sectors that are bounded to some degree in their ability to grow by GDP and they tend to have a lot of leverage. Whereas technology and healthcare, two sectors that dominate the growth index, are very IP oriented – not a lot of book value required to get the business up and running, and very often are creating profit from scratch or taking profit from elsewhere.
These conditions allow them to grow at an above-average rate. They also tend to have, given the lack of capital intensity, the sort of business models we like. They’re delivering terrific value for the customers, which manifests itself in a nice margin. And the capital lightness of the business can yield good returns on capital. Sometimes you pay more for that, but are you paying a reasonable price for what are superior characteristics?
Andy: As price-sensitive investors, we are constantly thinking about valuation. We are not looking to overpay for the characteristics we seek, but at the same time do not want to sacrifice quality to achieve low statutory valuations within the portfolio. We are looking to be patient and time the entry when price against attractive fundamentals makes sense.
Talk about the sectors where you have the strongest conviction this year?
Andy: The climb in stock prices near market wide in 2021 has created some opportunity to source capital from several longer term outperforming names in the SMID strategy where the relationship between valuation and fundamentals moved past a more normative risk reward relationship. We continue to recirculate capital into other great businesses where the price to value relationship has afforded attractive attachment, across several different sectors year to date.
We recently purchased an industrial software business (Information Technology sector) where valuation may be overly discounted based on fears of a forward revenue hole as the company anniversaries a strong customer spending cycle. We see a potentially more resilient top-line path with more recurring spend in combination with other growth angles set to continue to offer strong and consistent free cash flow and further capital re-investment opportunity where the company has a strong record of execution.
We further bought into an attractively valued casino business (Consumer Discretionary sector) with ongoing travel recovery spend exposure along with dynamic growth potential in its multi-state online product rollout. We also bought into an electric arc furnace business (Industrials sector) with both share gain potential as blast furnace capacity stalls over the medium term on environmental considerations, and further overall pricing power leverage as the broader end market supply/demand dynamics may be set to remain tighter than seen in quite some time.
Our pipeline at current features names in Financials, Industrials and Materials as we patiently await to see where and if attractive entry prices present themselves, with a little cash on hand to execute.
And where are we now in that scenario?
Andy: Critically we believe portfolio balance and low downside capture are among the more effective ways to both preserve and compound long term returns for our clients. We also believe our ability to forecast market direction over the short to medium term is less a core competency, made further opaque over the last decade plus with previously unseen levels of central bank and general government intervention in the global capital markets. As such, we are more focused on continually assessing the durability and financial wherewithal of each business we invest in on behalf our clients, and whether the forward return potential measured in years not quarters offers appropriate value for the price. It would seem inarguable that there is some current froth in aggregate to be eventually unwound in multiple assets classes – perhaps residential real estate, baseball cards, fixed income, commodities and certain concept stocks to name just a few – making price sensitivity that much more critical, a discipline we feel much better equipped to execute day to day, and that is where we remain focused.
How do the two of you work together?
Colin: It starts with a shared set of principles about how to invest capital to deliver superior returns to clients. With this mutually agreed upon shared vision as a filter, we constantly discuss incremental ideas, brainstorm on areas of opportunity and review current holdings that may be nearing price targets or are not working out as planned. We also regularly discuss if the portfolios are performing to our expectations. Finally, we both recognize there is room for different points of view and thus try to bring humility to the table when evaluating alternative opinions.
What makes this a Cambiar strategy?
Andy: One consistency across the firm is the goal to outperform over a three- to five-year investment cycle. We are a high active share manager, which from time to time is going to leave us at loggerheads with what the particular benchmarks might be doing, but the idea is if we can get invested on behalf of our clients in businesses that can generate very high returns themselves, we can almost allow the companies to do the work for us as much as we do the work in terms of picking specific stocks.
To the extent we can identify great businesses and buy them at appropriate attachment points, the financial histories and competitive positions of those businesses suggest that they should continue to outperform their industry peers and competitors.
Such industry-leading returns should then be accompanied by outperforming stock prices that may not be evident over shorter periods of time but tend to be clear over longer arcs. Again, that is largely what all products at Cambiar seek to deliver and what we will keep aiming for over the next 10 years with the SMID Fund.
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