Q: What is the history and scope of the fund?

Mid-cap companies, to my mind, capture the sweet spot of the U.S. stock market, based on their historical performance over the past nearly thirty eight years, which is as long as we have mid cap index data.

Back on October 31, 2006, we started the Scout Mid Cap Fund, with John Indellicate and Derek Smashey initially hired to help launch the product. They co-manage the portfolio with me, as does Jason Votruba along with analysts Craig West and Eric Chenoweth, who cover healthcare, and energy and utilities respectively. The team has expanded as the fund has grown. 

The fund’s benchmark is the Russell Midcap Index, which is our targeted universe along with companies in the same market capitalization range as the benchmark. The current market capitalization range of the benchmark ranges from a low of $1.5 billion to a high of $32 billion, and the benchmark is re-constituted annually by Russell. 

Our portfolio turnover has been 100% to 200% in recent years, but has dropped as we’ve become more diversified.

Q: What core beliefs drive your investment philosophy?

For us, quality matters. We believe that an active quality strategy not only outperforms over the long term but also generates better risk-adjusted returns.  We take a balance sheet and cash flow approach to investing, which helps us to control risk and spot opportunities.

Mid caps are a really interesting space to invest in for a number of reasons. They tend to have more sophisticated management techniques and better executives and board of directors than smaller companies. They grow faster than large caps and lack the degree of risk and volatility of small caps, and the fact that they tend to be acquired more often than large caps creates upside potential. 

Also, mid caps often boast a strong financial position, are better established companies, and can afford to spend more on R&D than a smaller company, to develop new products for not just the U.S. but also export markets.

Q: Would you describe your research process?

We incorporate top-down macroeconomic and company-specific analyses to enhance shareholder returns. Working top-down, we track more than 150 economic and sentiment indicators weekly to determine which way the U.S. and global economies are moving, and which sectors may or may not be doing well. 

From there we screen out the companies we like best and conduct bottom-up fundamental research, which incorporates a 10-point checklist that includes analysis of the company’s financial strength, valuation, fundamentals, and other risk factors.

So, to further break down our checklist in more detail, the first thing we do is cash flow analysis. We prefer companies that feature strong cash flow, ideally higher than the reported net income, and eliminate from consideration those with persistent negative cash flow or no history of generating positive cash flow. 

Although we do own some biotech companies, they are companies where we expect cash flow to improve in the future and they must demonstrate some cash flow generation ability and possess a product on the market that sells. We want to assure ourselves that the earnings generated are real and the accounting is suitably conservative.

Next we screen the balance sheet. For most industries we require that net debt be less than five times the normalized cash flow from operations, although we make some exceptions for REITS—real estate investment trusts—and regulated utilities because of their unique characteristics that can allow a higher debt load to be carried with relative safety. In the case of REITS the asset value of the real estate and the cash flow supports the debt load, while in the case of regulated utilities, the nature of the business is usually stable due to regulation and steady customer demand, and capital intensity requires some leverage on the balance sheet.

So our cash flow and balance sheet screens filter out the worst balance sheets or negative-cash-flow companies and help us to avoid companies with bad accounting, poor business models, and ones that tend to disappear in bear markets. We want to own the higher quality portion of the benchmark.

Next, the income statement analysis reveals revenue growth, the profitability history, and which way margins and tax rates are headed in order to help determine the company’s future earnings power. We plug those earnings estimates into our forward-looking valuation model, projecting the future earnings potential and discount that back to the present value, because the goal is to buy at a discount to the present value of the earnings potential.  Warren Buffett fans will recognize this valuation technique.   And being a core manager, we own both the growth and the value sides of the market.

Then we look at historical valuation ratios, like price to tangible book value (P/B), enterprise value (EV) to EBITDA (earnings before interest, tax, depreciation and amortization), enterprise value to sales, and P/E, price to earnings. These types of ratios are good cross-checks to our overarching valuation model. More importantly, they help us measure the downside risk of the stock price.

Next, we look for any catalyst—a new product cycle, executive team, or CEO, for example, or a change in the competitive dynamics, perhaps a consolidating industry, or a company that innovates a product with little or no competition. At that point, we check the accounting quality, reading through the company’s accounting policies in the Form 10-K filings, because we eschew companies with aggressive accounting. 

We also gauge the quality of a company’s management. For instance, reading their conference call transcripts reveals what the CEO says about their strategy and we can see how effective they are at deciding on that strategy and managing the business.

Another screen I would mention is to check risk factors, such as serious losses disclosed in the 10-K and the potential for litigation or bankruptcy, which helps us to control downside risk.

The final step of the process is to look at how the chart is doing and other technical factors, whether it confirms the fundamentals or reveals a major gap. We want to examine the bear case, especially when there is a high short interest.

We pay attention to insider buys and sells if we think they are significant, such as when a chief executive, chairman of the board or chief financial officer buys or sells in the open market, or certain directors or officers. It doesn’t always signify something, but occasionally we see one that signals to us if we interpret it correctly in the context of other fundamental information.

Q: Is meeting management a critical part of your research?

We do see a lot of management teams either in our offices or at conferences, and sometimes visit their headquarters, but meeting with them is not a requirement before we invest. It’s too restrictive and takes too much time.

That said, we want savvy CEOs who manage well. The more confidence we have in management, the greater our conviction is to own, or own more of, the stock. That and how cheap the valuation is, and how powerful the business fundamentals are, determine how large our position size will be while also staying diversified and running our weekly portfolio risk checks based on statistical data. 

Q: Can you provide an example of your research process?

Our largest holding is DXC Technology Co., which we bought back when it was Computer Sciences Corporation, prior to its recent merger with Hewlett Packard Enterprise Services. Historically, it had had accounting issues and was criticized by street analysts for lack of free cash-flow generation. The catalyst was new CEO Mike Lawrie, who managed the company much more efficiently. He fixed the accounting, cut costs and focused marketing in areas where they grow revenue with better profit margins. 

The stock has been amazing; first they spun off their government services business into CSRA in 2015, which we received as shares and still own, and paid a $10.50 per share special dividend. Next they announced the merger with Hewlett Packard Enterprise Services, and we think that was another huge development for the company. That deal closed earlier in 2017. 

We continue to hold it because the company is being run more efficiently and effectively by their CEO. Most if not every corporation in the world needs help managing their IT systems—complex software and hardware, layering in security, databases, cloud computing—and DXC provides all this for corporations. It’s a huge market, with competitors like IBM. 

DXC is currently more of a margin expansion execution story than one of top-line growth, a good example of how a great CEO can improve a business and make accretive deals. Margin expansion, cheap valuation and a great CEO story—that’s why we own it.

Q: Can you cite another example, one in a different industry?

Abiomed, Inc., which we’ve owned for a while now and is the second largest holding in the fund. It makes tiny pumps for heart procedures, with several FDA approved designs, and currently holds a monopoly, with no real competition yet, because other companies, although having tried, have failed to get approvals.  We believe the Impella products are taking market share from intra-aortic balloon pumps in certain cardiac surgeries. 

We view the world’s aging demographics as a potential secular tailwind for Abiomed, one that will create a likely demand for such cardiac devices. And Abiomed’s growth is not limited to the U.S. One of their devices has been approved for use in Japan and they’ve improved their position in both Germany and France. It’s a classic mid cap with a great product, where their R&D efforts target not just the U.S. but foreign markets, and they’re expanding.

Their cash flow is also improving, the price-to-earnings multiple is high, it’s growing fast, the latest quarter EPS, or earnings per share, grew 58%, and top-line revenue grew 28.6% year over year. We believe that the long-term growth potential should be steady for many years, and that the company can protect their margins unless effective competition comes into the market.  

Q: What drives your portfolio construction process, and what role does diversification play in it?

The goal is to own companies whose fundamentals and valuation are attractive, and the better they are, the larger the position we’re willing to consider taking. To start with, we track every company in the benchmark daily and actively watch 10 to 15 companies in addition to the more than 140 that we own. If there is a positive fundamental development in one of the stocks we already own, we consider increasing that position. 

We set target prices by calculating intrinsic value, favoring companies that trade at a discount to that target price. We don’t hesitate to sell or trim a stock if we think valuation is an issue or if there is negative fundamental development. 

We stay diversified and target a tracking ex-ante error score of 2.0 to 8.0, which right now is at about 2.5, indicating that we differ enough from the benchmark to generate active alpha if our investment positioning is correct versus the benchmark. 

Q: How do you define and control risk?

We view our primary risk factors as risk versus the benchmark and risk of a large loss of capital. Controlling position size offsets the latter risk, as does our quality approach and diversification.

The former is the risk of underperforming the benchmark. As I mentioned, we track the benchmark daily, and have outperformed over the long term, even significantly outperforming during the bear market of 2008–2009. Our process works in many different types of markets, reinforcing our conviction that active management adds value over time when it is properly executed, with a quality repeatable process. 

We measure our tracking error every week to score how our portfolio is likely to vary versus the benchmark over the next year, and use diversification, position size control, control over the industry and sector weights to further control risk. 

Owning companies with quality management teams, strong balance sheets, and cash generation plays a role as well in reducing risk. Moreover, measuring the downside potential of each company prepares us for negative developments, such as a bear market.

In summary, we run our process with the goal of generating attractive risk-adjusted returns for clients.