Q: What is the background of the fund?

I have been with Segall Bryant & Hamill since April 2007, after beginning my career in investment in 1996. We started the Small Cap Value strategy in 2008 with a separately managed account product. Later on, in July 2013, we launched the mutual fund based on the same investment strategy. 

Presently, the small cap strategy has about $500 million in assets under management, of which $27 million are in the mutual fund. We generally look for opportunities in our benchmark, the Russell 2000 Value Index, in the market cap segment between $100 million and $4 billion. 

Q: How is investing in the small-cap market different?

To begin with, the small-cap segment of the market has nearly 3,000 companies, so the universe is quite large. In addition, this segment of the market is neglected and few investors pay closer attention to day-to-day market development. Even though the small-cap company news is publicly available, and things are starting to shift positively or negatively, many times you are able to exploit the lack of market reaction and earn healthy risk-adjusted returns.

One of the main advantages in the small-cap sector is that investors have greater access to management—something that allows us to understand the culture of the company. That is a critical differentiation of small-cap investing from other asset groups. 

While looking at all the companies in the Russell 2000 Index, we are also taking into consideration the broader universe of small caps. Since there are a lot of small-cap companies that do not make money just as there are a lot of management teams that are poor allocators of capital, it is our job to ferret those out and not invest in them. 

We look for companies that are able to improve their returns on capital and be more productive with their assets. We utilize technology in order to sift through these names from a valuation sensitive standpoint and eliminate companies that are expensive versus their peer groups. The value-add comes in analyzing all of the data, aggregating it, and having it in one source. This information gathering is extremely valuable to us because it enables us to evaluate the relative investment merits of each company. 

Q: What is your investment philosophy?

We look for opportunities that the market has not started to price into the stock price, and one of the key evaluation metrics is return on invested capital. We are basically assessing whether the management is good or bad based on their ability to allocate capital. 

We want to invest with management teams that understand where the cost of capital is and know how to improve returns that are substantially higher than the cost. Essentially, we are not just looking for companies that have high return on capital but companies that have a business model to sustain that in the long term. We are prepared to buy companies that do not look that attractive with regard to their return on capital. Even if these companies are showing losses today, there may be a new management team that is ready to make different capital allocation decisions and is prepared to sell businesses that are subpar in the company’s business model. 

Many of our peers invest in companies that are already generating high return on capital, but those companies are already recognized too. To outperform the market, you have to find the companies that are still unrecognized as high return companies today, but are likely to become higher return generators tomorrow. 

The core belief that guides our embracing of return on capital as a key metric is that we look at it from the standpoint that our client’s money is of the utmost importance. Not only do we want our investment back in the process, but we also want an appropriate risk adjusted return on that investment.

Q: How do you transform this philosophy into an investment process?

First of all, we start with screening for companies that are attractive to their peers. The primary reason for that is to limit or eliminate the risk of overpaying. In other words, we are looking for companies that are attractive on relative valuation. 

We also look for companies that have underperformed the market, based on the market of peers, not the stock market. The companies that are lagging to peers are likely to have low investor expectations, which in turn limits additional downside. These companies will deliver returns that we seek only if they have the right attributes thereafter. At this point, we take into account the capital return rate to understand what catalysts are in place or are likely to emerge for the market to begin realizing the potential value and any potential positive changes.

If the current management have been poor capital allocators, it will often require a new management team. This will explain why they have underperformed and why they are relatively attractive but nobody has been paying attention to them. If a new management team starts creating discipline and transforms a negative culture into an entity focused on returns, as good stewards of capital, then we can capture a lot of that positive change before it occurs. More importantly, we want to do this before the development is recognized by the market through a higher stock price.

At the balance sheet level, we start seeing subtle changes as confirmation of what our expected catalysts happen to be as they begin to unfold. Typically, an improvement in working capital is one of the best leading indicators of a positive change at a particular company. 

Q: How do you avoid value traps?

When you are dealing with value, you are also dealing with a possible situation where the change may never happen. This potential positive change may never create the hoped value, and a cheap stock may trade sideways or become even cheaper. We will not stay long in a name that does not meet our improving return catalyst approach.

In this process, the cultural focus is one of the most unique aspects. Not only do we need to understand what the executives are concentrated on, and what their plans are, but we have to understand the middle and lower level management employee thinking and their focus too. Even the best laid-out plans of executives will fail if the broader employee base is not energized enough to implement the change. In the world of small-cap investing, we have access to company management at all levels to evaluate this. 

Q: What is your research process? Could you use an example?

We prefer to have frequent contact with management and we like to have face-to-face contacts when possible. As long as they are available, we are happy to do manufacturing and facility tours in order to understand what is going on behind the scenes.

One of the names we invested in was Chiquita Brands International Inc., a company that had been underperforming for a while in a competitive industry. Although they had screened reasonably well for a long time, we could not find capital return improvement catalysts that we could hold on to.

Then, new management came in and we liked what they were doing and talking about, but we could still not see a pathway to get their returns to above cost of capital. We kept revisiting quarter-after-quarter until we could find what we needed.

Chiquita announced its merger plan with Fyffes, an Ireland-based company operating in the same business segment of selling fresh produce like banana and salads. What Fyffes brought to the table was a materially higher capital return profile. Once we understood the pathway to above cost of capital, we bought the company. Even though the acquisition never closed, the combination did make other competitors take a look at Chiquita to understand and value its brand and opportunity set from a diversification standpoint. 

In August 2014, a Brazilian company’s offer to acquire Chiquita changed the dynamic that was occurring at the time—the merger plan with Fyffes. As Chiquita was nearing a merger agreement with Fyffes to complete the transaction in 2014, the Brazilian company ultimately offered a price that we, as shareholders, decided to back rather than wait for a potentially better outcome through the merger with the Irish company. 

Q: Would you share some other examples?

I would like to quote Vanguard Health as an example. Investors were concerned when the company had almost 50% of its assets related to a Detroit hospital system. At the time the management team was very oriented towards return on invested capital. Whenever they bought their hospitals, they would start improving capital allocation, or they would look for ways to expand its patient population it serves. 

The company would invest to add certain machines and technology, which in turn would add different physicians or doctors who were now interested in coming to that hospital and providing a service that was not there before. That in turn invites new patient populations who previously went to different hospitals or facilities.

Vanguard went through a massive turnaround and cultural change, and we learned of that through our information gathering. We met with the management in Nashville several times and the management of Detroit Memorial in Detroit, Michigan. We toured the facilities to understand the catalyst of change, why the hospital performance had been deteriorating, and how it was starting to turn the corner.

It took a couple of years to reflect the cultural change in the stock price, but we managed to see the change both from a cultural and from an improving return standpoint. Ultimately, Tenet Healthcare bought them out because they saw the value that was being created, the focus on return, and the long runway to continue to improve returns.

In retrospect, Vanguard screened well and the company had completed its public offering in 2011. Within a year of its IPO, the stock went down from $18 to below $10—something that invited us to take a deep, hard look. We started to get involved at the $11 price range and continued to have the confidence to add to the position as it started pulling back. 

Another example is St. Louis, Missouri-based ESCO Technologies Inc, which operates as a conglomerate with three divisions – filtrations, RF Shielding and Testing, and Utility Solutions. Historically, the company had a weak capital allocation track record and a couple of acquisitions that generated returns below the cost of capital. Aclara was the prime example of the inconsistent results and impact on returns. There were ebbs and flows of positive contracts and the company offered a meter technology to help utilities save money or be more productive with their employees in the process. However, in general, the return on invested capital was deteriorating 

The company was not highly differentiated and did not have a consistent return on capital profile. However, they learned their lessons well and got some discipline from a capital allocation standpoint. ESCO announced in the spring of 2014 that they were shifting focus to improving capital returns and being compensated to do so. As a result, management decided to divest Aclara in the second quarter. 

The divestiture immediately removed a very low return generating business. From a shareholder standpoint, we got $130 million for a business that was not living up to return expectations. You bring cash into a company that did not have a lot of debt and it immediately took the return profile from being reasonably below cost of capital to that of a pathway to getting above cost of capital over the next several years. This nice positive change occurred simply by making that one portfolio decision of getting rid of Aclara.

If you take into account how they look at acquisitions outside of Aclara, they have been quite satisfactory from the returns perspective and those acquisitions are producing returns above their cost of capital. We have visibility into a balance sheet that is unlevered. They could be putting new capital into acquisitions that will earn 12% to 18% return levels. Again, it is all about the focus from management and readjusting the culture to meet return goals. In conjunction with culture changes, you often have to change management incentives and link part of compensation that is tied to creating shareholder value. Bringing in new people is not enough; it is also teaching existing people how to be an appropriate steward of capital that makes the difference. 

Q: What is your portfolio construction process?

With about 85 names on average, we have a high active share component in our portfolio. We can have industry allocation down to zero but we are limited to how much we can have in each sector. Our outperformance is mainly stock selection driven and not sector allocation based. 

We are return focused in how we build our portfolio and we may avoid certain sectors, such as biotech, that are not attractive to us from a risk-adjusted return perspective. In fact, we might own one or so names in biotech, but they will have to be unique. They will have a lot of underlying cash flows from existing products so that we are not taking the binary event risk related to regulatory product approval.

In terms of other industries, we will not own insurance companies because we cannot understand the risk involved, particularly in small caps. In the large-cap space, insurance companies are better diversified and do not have the same risk profile, but with small caps it is hard to assess the downside risk. And, if we cannot assess the downside risk appropriately, we will not invest in that industry.

Q: How do you define and manage risk?

From our perspective, risks are rooted in the markets and the companies that we select. We do not believe that market risk is applied universally in the same way. We actually think that some companies, particularly in small caps, can reflect more market risk than others. 

In our risk control process, we try to assess both types of risks by running scenario analysis to understand peaks and troughs, from a return perspective. We try to understand execution at the business level in each company and we look at possible outcomes with the arrival of a new management team. If they come in and say all the right things but cannot create a transformation from a cultural standpoint, what does that mean in the scenario?

Everything we do backs into a risk-adjusted return profile, as we want to make sure we are being paid appropriately for the risk we are asked to take. We understand what our upside and rewards are in conjunction with assessing what our risk happens to be. What happens if returns continue to compress? What happens if we go into a recession? What sort of negative impact will occur on that side? 

In line with our philosophy, we are prepared to only take risk when there are catalysts of change and we can see a pathway for improving returns. We want a ratio of three-to-one reward to risk in order to put it into the portfolio. If a company has 60% upside potential, as we assess from the scenario analysis, and it only has 20% downside, that would be a candidate for purchase.

As it compresses, and as you stop being paid appropriately, when the upside is perhaps 30% but your downside is also 30%, you will see us exiting. If we have overweighted the position heavily, we will start trimming the position in advance of that, but if we are not being paid appropriately and the risk adjusted return has gone to zero, there is really no point in holding the company any longer.

Over time our performance has provided better downside capture, so that when bad things happen we are not going down quite as much. We save capital in the process and reinvest it accordingly, making sure that when the upside occurs we are able to participate. All too often, people are trying to invest with the upside in mind, without thinking about what sort of risk is being taken in a particular investment.