Q: What is the investment philosophy of Thrivent Mid Cap Stock Fund?
We’ve put together growth and value strategies to create this core mid-cap product. John Hintz and I have overall responsibility for the portfolio as a team, but we have divided it along the growth and value lines. When we get to individual industry levels, it makes a lot more sense to focus on specific areas, so I focus on growth areas and John focuses on value areas. On top of that comes the layer of risk control to make sure that we stay within the core universe and that we don’t take too much risk relative to the expected return.
Q: Why should investors consider the mid-cap universe? Why do you think that mid-cap core investing is a better way to balance a portfolio?
I believe that there are two big benefits to mid-cap investing. The small and mid-cap stocks have higher growth profiles than large caps because they're smaller companies that can grow faster. At the same time, mid-cap stocks provide the risk protection that is more characteristic of the large-cap universe, while small-caps usually don’t have established management teams, customer base, or distribution channels. So with a mid-cap fund, you’re getting the best of both worlds – higher growth than large caps with less risk than small-cap stocks. Regarding the core strategy, there are many benefits of combining growth and value. That approach enables us to take advantage where we see opportunities. When there are more opportunities on the value side, we can tilt the portfolio that way. If there are more opportunities on the growth side, we can tilt it that way. Also, with the expertise that we both bring to the table, we can provide insight to the other one in a particular aspect. For example, energy historically has been a value industry before it became more of a growth industry, so we can apply some of the growth aspects to that value industry.
Q: Do you hold any macro views or you strictly follow a bottom-up approach?
The fund has a very bottom-up focus, so most of our overweight and underweight positions come from individual stock selection and analysis. However, there are particular times when we see many opportunities from a bottom-up perspective, like in energy in 2004 and 2005. Then we start to analyze that trend, which leads us to some top-down view. In industries like energy and semiconductors you need to have a macro view and we pay attention to that. However, the goal is not to make huge industry bets or swings; it’s the individual stock selection that provides value to the shareholders and that's where the alpha comes from.
Q: Generally, the peaks and the valleys along market-cap lines are not as extreme as in the past. Has that been your experience?
Yes, there isn’t a huge valuation discrepancy between the different market caps. When we got out of 2000 there was big valuation discrepancy, maybe in 2003 as well, but that’s been narrowed. We don’t see a huge valuation argument to take advantage of a certain opportunity from a top-down view, which leads us even more to the bottom-up stock selection process. But the great thing about the mid-cap arena is that you have large-cap companies that have stumbled and have become mid-cap companies. You also have smallcap companies with a strong growth profile that have grown to the mid-cap range. So our approach of having two managers, one with value and one with growth perspective, works pretty well. We have a lot of fallen angels form the large-cap world that are value play and a lot of small-cap companies that are still growth stories, so we bring a fresh approach in evaluating most companies.
Q: Could you describe your investment process?
The process that we go through consists of idea generation, fundamental research, portfolio construction, risk management, and review. We get out ideas in a lot of different ways. The universe consists of about 3,500 stocks and we both screen it on a weekly basis. Each of us uses specific screens, including growth screens, such as estimate revisions, earnings momentum, incremental margin improvement, and insider analysis. We also run screens on valuation metrics like P/E, price/book, EV/EBITDA, returns on capital versus the cost of capital, free cash flow as a percentage of EV, and insider analysis. We have 12 analysts that cover various sectors and we get a lot of ideas from our internal research staff as well. Once we get our ideas, we do fundamental research on the names that passed the screens. Our research team meets the companies, goes through competitive analysis and through fundamental research. In analyzing the companies, return on capital is a big focus. We like to see improving return on capital, whether through increased sales, margins, or preferably both. Essentially, we’re looking for companies with improving positive fundamentals relative to what the market expects. Our analysts are divided by industries, not by products or market caps, so we have an energy analyst, a materials analyst, etc. We do a lot of research on each individual company before we decide to put it in our portfolio. In terms of valuation, we use various metrics because we don't believe that one valuation metric fits all; the various sectors of the market and industries require different valuation techniques. For example, for banks the common metric being used is price/book whereas for an industrial company the P/E would be the most common metric. For a lodging company that would be EV/ EBITDA. So we don't have one strict valuation approach but we’re looking for the appropriate valuation metric for the particular industry. After we go through the research process, we lay the risk management aspects on top, and then we review this process on a weekly and on a daily basis.
Q: What are the most important elements of portfolio construction?
First, we stay fully invested. We’re not trying to time the market by holding cash because we believe that it is the financial planner who should devise the portfolio allocation for the individual investor. We want to make sure that we’re not messing up the portfolio allocation for that investor by cash of funds that he has allocated for mid-cap core assets. We have a custom-built mid-cap benchmark that’s based on Lipper's peer group. We also look at the S&P 400 Mid- Cap index, so we use those two benchmarks for diversification guidelines and for a gauge to being overweight or underweight. In terms of the number of securities in the portfolio, we’re in the 125 to 200 range, with the sweet spot being around 150 stocks. We believe that this number gives us the appropriate balance between diversification and the ability to use our stock selection process to add value. Probably the most unique aspect of the portfolio is that we break it down by growth and value. For example, Brian is responsible for healthcare, technology, telecom, and financials, while I’m responsible for the consumer area, energy, industrials, materials, and utilities. As we both come from the analyst side, we’ve covered all these sectors. Often our competitors would cover one or two sectors and do a good job, but they don't have the pure analytical experience in each specific sector which Brian and I bring to the table. We know the inner workings and the critical aspects that we should be focusing on.
Q: Could you give us some specific examples of investments that have worked out and some that haven't?
Since we started managing the fund about two years ago, our largest overweight has been the energy sector. That’s where we saw a lot of positive fundamentals both at the sector and the company level. We saw strong energy demand and supply wrestling to keep up with demand; we saw excess capacity being eroded and inventories falling over the last couple of years. Yet, the companies were very cheaply valued and there was a lot of insider buying in early 2004. From the bottom-up perspective, the free cash flow and the return on capital were increasing. We also saw positive earnings revisions and that led us to a substantial overweight in energy for the last two years. Recently, that trend reversed as the stocks had tremendous run over the last couple of years. Now the demand is starting to taper off, supply is starting to grow at the margin, inventories are increasing instead of decreasing, and excess capacity is also starting to increase. The valuations have become quite full, so we’ve been reducing our overweight to the point of being underweight in energy. That’s an example of a combination of our bottom-up process with a top-down overlay.
Q: Which industries are you currently overweighting?
One area that we’ve increased our exposure to is technology as we're seeing spending trends that are fitting many of our criteria. Specifically, the area that we focus on is semi-conductors. Typically, when unit growth gets to the level that we are, that would be a signal for us to sell. However, during this cycle we're seeing much more capital spending discipline by the semi-conductor companies and on top of that, the inventory levels are still low. Valuations are at more reasonable levels than the last time that we’ve been at that part of the cycle. So we dug a little deeper and it appears that the companies have more focus on return on invested capital and much more capital discipline. And while we may see a short downturn during the first quarter with consumer spending pulling back, we think that the downturn will be much shallower than expected.
Q: What are the key aspects of risk control? What is your buy and sell discipline?
Each portfolio has risk constraints that we must stay within. The quant team constantly runs our portfolio against those constraints to make sure that we’re within the guidelines. So when we construct the portfolio we can’t put it all into technology or all into energy. Typically, we aren’t more than 1.5 or 2 times the benchmark weight. We aren’t less than 0.5 the benchmark weight, so if we are completely wrong in our analysis, we won’t get blindsided and end up in the 90th percentile. We also keep maximum individual position limits of 2% in any particular name, but we'd get to the 2% position only when we have all the stars aligned between our fundamental research, insider analysis, and valuations. We have in-house investment tools, including quantitative research tools and riskcontrol measures that help us evaluate how much risk an individual security is contributing to our portfolio. From a bottomup, stock-specific perspective, we need to see that we are valuing the security appropriately, while from a top-down perspective, we check the diversification and the risk-reward profile of the overall portfolio. We value each company before we buy it, so we have an estimate for its intrinsic value. We also incorporate a downside protection to better evaluate the risk-reward for each individual stock. We monitor price movements that may trigger revisiting the company to check if everything is on target, if the valuation has become full, if new information could mean further upside and increasing our price target. If the stock has fallen, we check if there is anything we’re missing. We'd sell a growth name when we see deteriorating fundamentals relative to expectations and we'd sell value names if the valuation exceeds our target and we can’t justify the ratio. We reverse our buy screens to see if there is anything in the portfolio that should be sold. For example, if for a growth name the estimate revisions are decreasing, insiders are selling into price weakness, that will definitely show up on our screens and we would typically sell that stock.
