QPD Podcast – Defining Quality in Smaller Cap Stocks

KEY TAKEAWAYS:

• The core of QPD – quality must be demonstrable in their financial performance.  Margins, free cash flow, ROIC and leverage are all important to validate a good qualitative story
• Two camps of stocks have led the markets recently – Reopening play stocks and expensive, high-quality stocks.
• Growth is an input in the calculation of value.  Being a bit more open-minded about the growth vs. value debate can lead to a more opportunistic view of the market.
• Until liquidity is drained from the market, aggressive valuations will not likely change.

TRANSCRIPT

Portfolio Manager:

We’ve got a research team comprised of a lot of different backgrounds, whether that’s on the education front, professionally, or even in terms of ethnicity. And there’s a real advantage in that diversity of perspectives. With both of our backgrounds in both professional money management and going all the way back to team sports, there’s a real importance to having a unifying goal across the team to drive performance both internally and most critically on behalf of our clients. It’s really most troubling to lose money for avoidable reasons, either a bad company or a silly price paid. And so, orienting our process around seeking the exceptional intuitively made sense to all of us when managing other people’s money.

Host:

Hello and welcome to the QPD podcast, a limited series where we take a deeper dive into the Cambiar investment philosophy of Quality, Price, and Discipline, or QPD. These gentlemen have over 20 years of investment experience and have been at Cambiar for well over a decade. Together, they manage the Cambiar SMID and Small Cap Value portfolios and have been a driving force in the creation and implementation of QPD.

Gentlemen, welcome to the show.

Colin Dunn:

Good to be here. Thanks.

Portfolio Manager:

Thanks.

Host:

First let’s begin with a quick overview of Quality Price Discipline. Can you briefly describe what QPD is for our listeners?

Portfolio Manager:

Colin and I both feel like there are many ways to win in the equity market. From our perspective, I think we’re most comfortable with those where we have time on our side. And so, we’re seeking durable businesses where evaluation at attachment really de-risks the possibility of long-term capital loss. And there are certain characteristics like high return on invested capital, consistent free cash flow that speak quantitatively to a sustained competitive advantage that leads to excess returns over time. And this is the quality that we’re seeking and having the discipline to pay a fair price for that quality.

Colin Dunn:

So I want to highlight something that was said there. We’re specifically interested in the quality being demonstrable in the financial performance. So margins, free cash flow, returns on invested capital, leverage are all important to us to validate a good qualitative story. So all stocks have narratives of why they’re supposed to perform better over time. And for us, it’s very important that those narratives are matched with strong financials.

Host:

I’m curious as to how you’re applying QPD to mid and small cap stocks. I’m assuming it’d be even more important as you go down cap.

Portfolio Manager:

Well, if you look at the indices down cap, whether it’s the Russell 2500 or the Russell 2000, what you’ll notice is a high percentage of companies that simply aren’t profitable, and that number borders on plus or minus 40% typically in both those indices. And so it really is important to pay attention to where you’re actively exposed and really dig through to find where you’re putting your clients further less at risk, just in terms of the durability, the profitability, and cash flow generation of the underlying businesses that we hold.

Host:

Maybe the best way to talk about QPD at this stage would be to give an example of a stock that you think best fits the investment philosophy. Colin?

Colin Dunn:

There is a name we own in our SMID portfolio called IPG Photonics. It is the pioneer in fiber laser technology. Fiber lasers are a laser that uses fiber optics to convey the power from a light source—in this case, being a semiconductor diode. The technology is new. It’s been commercialized over the last 20 plus years and it replaces legacy technology that was more expensive, less durable, less specific in terms of its ability to deliver the solutions to customers, less mobile around a manufacturing facility, larger, clunkier, just not as good. And so, over the last 10 or 12 years, the company has really ramped up its penetration of its solution, fiber laser solution into the industrial base. Specifically, the first place they went after was the cutting market. One of the things that we liked about this company was they had an internally generated piece of intellectual property that they converted into strong margins on the order of 30 plus percent operating margins. Strong returns on invested capital, again around 30%.

And it has an ongoing growth opportunity. They have penetrated a significant share of the cutting market, but there remain new applications in welding as well as a new technologies in solar and EV battery production. The stock had oftentimes traded well above evaluation range that we thought we could earn a skewed return opportunity relative to the level of risk. But as 2018 time period rolled in and they had just experienced super normal sales and you have the trade war come about, people were a little more skeptical on the next few years for the company and the valuation plummeted precipitously from record levels on multiple ratios, price to sales, EV sales, and obviously price to earnings and free cash flow.

And to us, that was an opportunity to be able to engage with a good business we had admired over many years at a time when people were incrementally had a little more anxiety about their potential. And so we did engage with the stock or purchase the stock on behalf of clients, as it represented our kind of quality attributes that we pursue, but finally came to a price where we felt like there was a lot of upside relative to the level of downside.

Portfolio Manager:

Yeah, another company we’ve held for a number of years in the SMID portfolio is Expeditors. This is a company based in the Pacific Northwest. That’s involved in the global logistics, customs brokerage, and freight forwarding industries. As you might imagine, business right now is outstanding, but over the years, they’ve really been a strong executer across each of those disciplines. And what’s traditionally been interesting to us is this is a company that continues to put up great numbers in terms of high returns, high margins, and growing profits with, in fact, the net cash balance sheet. And they do it with very little fanfare. They don’t spend a lot of time with Wall Street catering to sell-side analysts or even buy-side analysts, for that matter. But what they do do is focus internally on their operations and generate outstanding financial results.

Host:

Many managers talk about buying quality companies. In my opinion, it can often be one of the more overused phrases in the investment management industry. So in that light, what differentiates Cambiar, and our philosophy and how can we quantify what quality means to us and potentially our clients?

Colin Dunn:

Yeah, we would agree that the word quality is thrown around a lot in investment management. And we have made efforts here to specifically define what quality is to us. From a qualitative perspective, we would say that we’re looking for our companies to have an advantaged market position via some unique know-how or capability or product that they have, and/or have a durable position in the market. Importantly, though, whatever subjective or qualitative narrative we use to describe those attributes must be backed up by the financials. And so to the extent they have a special product, we should see that in margins that are above normal, mid to high teens margins and above should be evidenced in the financials consistently over time. I think consistency is another important attribute across the financial statements that we’re looking for. And we think good companies should be able to deliver in thick and thin.

A return on invested capital is also a way to validate the strength of their market position. If it was so easy to replicate a company’s know-how or intellectual property, it would have been done. And so, you’d see those return on invested capital erode over time. And to the extent the return on invested capital again is superior and consistent over time, it suggests to us that the qualitative work we have done on a company’s market position is in fact there and durable.

Finally, we also think it’s important that a company have robust and consistent free cash flow. It is true economic profits that support the business in both good times and bad. We also think it’s important that companies have clean balance sheets. We’re not particularly interested in businesses that have added a lot of debt onto the balance sheet. We think this can erode the company’s ability to invest in their good products or good market position over time, and also turn a good company into a bad stock by introducing volatility to the financial statements.

Portfolio Manager:

Yeah, I think in terms of quality, as Colin suggested, it’s really in the eye of the beholder in many ways in an investment context, because you do hear that word thrown around a lot. And I think from our perspective, what we’re really focused on is having really three metrics show up consistently across the portfolio in aggregate, where we would screen higher on those variables, certainly relative to any kind of benchmark. And those would be profitability, return on invested capital, and leverage. And where businesses are able to deliver those metrics with low leverage to us really speaks to some form of truly identifiable competitive advantage that’s both quantitatively and qualitatively stated.

Host:

Up to this point, we’ve talked a lot about company specific fundamentals, which is natural for a bottom-up manager, such as Cambiar, but I’m interested in talking a little bit about risk management and portfolio construction and how we’re incorporating that into our investment process.

Colin Dunn:

We define risk as the potential to lose money on a given investment. And we have a number of steps in place in an effort to protect client’s capital. It starts at the stock level with our bottom-up research analysis. Our analyst followed these sectors over a long period of time and know their sectors and their underlying companies very well.

We think our investment philosophy is also a source of protection for client capital. If you’re buying strong companies, they tend to do better in times of stress. And when things go wrong, there tends to be less downside risk. Similarly, the price side of things, we’re buying stocks, where there is a skewed risk-return. We think there’s three times as much upside as downside. So when something goes wrong, we think there’s much less risk of permanent capital loss. From a portfolio construction perspective, we also take a number of steps to protect overall client investment.

We look to have many drivers of return across the portfolio, lots of ways to win. We get a lot of insights from our analysts, but we try to spread our bets around lots of different insights. So to the extent anything goes wrong, again, we’re not too beholden to one insight. We also have position limit sizes where we enter each position at 2.5% in our SMID portfolio, 2% in our Small Cap portfolio. That has two effects. One is to simplify the go or no-go decision on a stock, but also is a form of risk mitigation, in that we will only commit so much capital to a specific stock. We also use third-party data sources to help validate that we are doing what we say we do. We referenced earlier that we are specifically focused on highly profitable companies with low leverage. And we have tools like Barra and FactSet that help us determine if in fact, across our portfolio, we are investing that way. So our profitability factor in Barra should be elevated versus the index, our leverage factor should be below that of the index.

Host:

It’s a good segue into my next question, talking about transparency in portfolios is important to investors. So what should investors and potential clients or current clients expect from a Cambiar portfolio? 

Portfolio Manager:

Well, I think they should expect a lot of the things we focused on so far in this conversation, which are really for us to deliver an aggregate portfolio that reflects a high degree of relative profitability, that reflects a high aggregate return on invested capital, and also reflects minimal balance sheet risk in aggregate across the portfolio. And that’s built up on a company by company basis. And if those criteria are ultimately evident to our client, from our perspective, we really have time on our side. And ultimately, the probability of long-term capital loss is mitigated by the evidence of durability of the underlying franchises. While there may be near even medium-term volatility around the specific stocks themselves, the long-term value accrual to be seen in those businesses based on their historic and likely forward financial performance is likely to offset any timing misfire.

Colin Dunn:

Yeah, it’s also worth noting that we invest the way we do, because we believe it’s the best way to deliver superior risk-adjusted returns to clients. If we are buying good companies at a good price, we are buying these good companies because we believe they should be delivering superior financial performance over time. Specifically, bottom-line earnings should compound at a rate that is above average. And if you bought them at a valuation that has a skewed upside relative to the downside risk, again, you should be able to deliver superior returns relative to those superior financial performance at the stock level.

Finally, good companies at good prices also tend to be a little less volatile from a portfolio perspective. We do think low downside capture is a critical deliverable from active managers, and we believe this structuring, this portfolio structure in terms of the kinds of companies we’re buying, the prices we’re buying them at. And as well, the way we’re structuring the portfolio with diversity in terms of drivers of returns collectively should work together to deliver a portfolio that’s a little less volatile than a lot of what we see out there.

Portfolio Manager:

Yeah and I think one thing that should be clear to any investor who might be looking at the Cambiar Small or SMID Value portfolio is that we are at heart value investors. From our perspective, we take a little bit more of a holistic view in terms of defining value. And what I mean by that is that we’re very focused on the collection of attributes that we’re getting. So ultimately, what is the value we’re getting for the price we’re paying in any equity rather than being focused on any historic asset-based metric to ascertain value?

Host:

That’s a good segue into my next question. We’re getting more into the current environment. And since the lows of the pandemic in 2020, market backdrop has been really interesting with low quality and deep value rallying strongly. Can you discuss how this has impacted your portfolio and your thought process, given maybe this type of environment working against a lot of what we have talked about today?

Portfolio Manager:

Sure. Yeah. If we go back to the origins of the coronavirus pandemic in the early part of 2020, one of the things we’re really pleased with in terms of the way the portfolio acted was the amount of downside capture we were able to provide in the early stages of the market reaction to the pandemic. And alternatively, as markets did recover with the amount of liquidity and other government support that was thrown at the problem, we were also quite pleased to see our ability to keep up as that rally started to gather steam. What we’ve been less successful at is keeping up with the market really since the vaccine approvals in the latter part of 2020, which triggered a lot of the low-quality stocks that you referenced to outperform in a meaningful way a lot of their more stable peers.

And so from our perspective, while it’s always disappointing to lag, I think we’re quite comfortable that there’s been no real degradation in any of the criteria we’re using to either identify what we’re holding or we’re looking to potentially hold for our clients. And suspect that over the longer run, our clients will be pleased with how we’ve maintained positioning throughout the last couple of years.

Colin Dunn:

Yes, it has been an interesting period for going on a year now, where there have really been two camps of stock that have traded market leadership. Both of those camps are outside of our purview of our Quality Price Discipline approach. Specifically, you have a camp of stocks that are supreme beneficiaries of two things currently going on in the economy. That is the reopening. So airlines, restaurants, to some extent, hotels and other beneficiaries of the reopening trade, people spending more money like crazy with the stimulus they have in their pockets and maybe a new lease on life. Those businesses don’t often fit our quality criteria. These are not businesses with high barriers to entry and therefore tend to have lower returns and lower margins. Again, they often don’t fit in our profile.

Then that group as well, you would have materials companies that have benefited from the level of inflation we’ve seen recently. Again, these companies often don’t have an intellectual property advantage, just a matter of having the capital to put steel in the ground and produce more of XYZ material. In the short term, there’s not enough of that, but in our view, most of that can be fixed over the medium term. On the other end of the spectrum are companies that might have a terrific quality story about them over the medium to long term. They are solving real problems for customers, both business customers and consumer customers, but the price folks have been willing to pay for those stories is way elevated versus what we think is appropriate and where we feel comfortable investing on behalf of clients.

And so with the market oscillating almost from a leadership perspective between these really attractive long-term stories at a price we would view to be unreasonable from a risk-reward perspective. And these other companies where there might be a valuation story, but the quality, we’re having trouble reconciling, if the quality is good enough to deliver durable financial performance over rolling three and five-year periods. And so in the middle are a bunch of businesses that we think satisfy our criteria of being good, medium to long-term companies, strong margins, strong returns, good free cash flow, plenty with good leverage situations that feel left out of one narrative or the other.

Host:

Colin, you touched on the stimulus, which is really unprecedented in this cycle, both on the government and then the fed side. Many investors are concerned with inflation, that’s been extremely topical. We’re seeing that result in moves in interest rates that have been volatile as well. Does that expectation with respect to inflation, has that changed your mindset? How do you feel about equity’s valuation, especially in the small cap realm with respect to that environment?

Portfolio Manager:

Yeah, the unprecedented levels of liquidity are not just an equity problem, to be clear. If you look at really asset at this point, the valuations are at or above in some cases, by leaps and bounds, previous historical highs. And those would be things like housing, pick a commodity, you look at the fixed income markets. So really liquidity’s hit just about all assets with equities certainly being a beneficiary of that as well. And so the dynamic that we’re most focused on is really the pricing power evident in our companies because that’s ultimately how companies who are going to navigate this well are going to do in fact do that is by being able to price it at an elevated level above cost escalation that they’re seeing. And so the good news from our perspective is that we think a good many of the businesses where we’re exposed have and will continue to evidence the type of pricing power reflective of their advantage franchise position. But it is a real concern.

Host:

After a long drought value has shown signs of being able to outperform growth over extended period of time, this is a discussion that has been ongoing as growth stocks, especially over this cycle, have outperformed value substantially. And many investors obviously are allocating capital both to growth and value and waiting for the value cycle to really gain momentum. What’s your view about where we are in the value cycle today?

Colin Dunn:

Yeah. As value investors, we think financial gravity is a real concept. There is a price at which you pay too much for an asset, regardless of how good the underlying story is. And we think it’s really tough to call the timing on when people will ultimately care about valuation. We talked about inflation just a minute ago, and that is something that could drive interest rates higher and force people to consider near-term profitability a little above long-term potential at some point soon.

But again, we don’t really put ourselves out there in terms of being able to call when trends will change. Really just trying to align our clients with good companies at good prices and kind of wait for the returns to come. That said, there are lots of markers out there in the financial markets that suggest risk-taking and valuation is very elevated versus history. And so we are a heck of a lot closer to whatever turning point is out there than we were a year ago. And we continue to go further beyond reasonable levels than we would have expected.

Portfolio Manager:

I think we have been and continue to be a little bemused by how starkly the dichotomy between value and growth is portrayed. From our perspective, we in fact, look at it as growth being an input to the calculation of value or the price that you might pay for an asset. And so while historically in a Graham & Dodd context, price to book has really been the primary determinant of how one might categorize a value stock, we think that being a little more open-minded about a series of valuation measures helps be a little bit more opportunistic and ultimately holistic in terms of how we’re approaching investment opportunity than just purely categorizing something as growth or value.

Host:

I expect our listeners will appreciate your take on where we are today. Equities remain near all-time highs. Obviously, we’ve discussed a number of risks and uncertainties over the context of this discussion. What are some of your greatest concerns moving forward that you could communicate to the listeners today?

Portfolio Manager:

Well, I think from our perspective, until you really see liquidity start to drain out of the system, we’re not really anticipating the dynamic of aggressive valuation to meaningfully change, but as soon as you do, there are any number of dynamics that could prove a pretty deleterious to any number of businesses. Specifically those who may be levered, those who may be trading at a multiple not supported by the long-term financial characteristics of those businesses. And so, we’re focused on is making sure that we don’t make those mistakes in terms of how we’re allocating incremental capital right now, not making the quote-unquote unforced error and really just focusing on businesses that do have an interesting long-term trajectory in a generally growing end market that possess the type of characteristics we’ve previously discussed, an advantage market position that’s reflected in above-average margins, returns on invested capital, and as well, the ability to conduct that business without a reliance on the capital markets and most specifically a higher level of debt, that makes sense against the cashflow support of that business.

Colin Dunn:

Yeah. The third pillar of our investment philosophy is discipline. In a time like now, there’s all kinds of people trying to get you to shed your discipline and chase these attractive stories. And the price you pay for shedding that discipline won’t be paid tomorrow or next week or next month. It’ll be paid into the future. And so the decisions we make today will pave the road for over the return stream and the kind of return stream we generate in the future. So we plan on exercising discipline and sticking to the quality and price situations that we’re looking for.

Host:

Well, that about wraps it up for the first episode of the Cambiar QPD podcast. Gentlemen, thank you for taking time out of your schedule to chat with me today. For all of our listeners, we thank you for tuning into the show. Be on the lookout for the next few episodes where we focus on QPD from a large cap perspective, as well as how the philosophy applies internationally. Until next time, take care.