Q: Would you tell us about the history and the core mission of the fund?
The fund was started in June 1987, primarily as a retail fund with little institutional exposure. I joined Delaware Investments (now Macquarie Investment Management) in 1997 and started managing the strategy in May of that year. From our earliest days together, our team established a bias toward companies that want to give money back to shareholders in some way, whether in the form of dividends, share buybacks, or debt pay downs. Fast-forward to today, and you’ll find that our focus has not changed. We still favor companies that generate free cash flow. We want to be treated like shareholders, and we feel that in many cases, we can use returns of capital more efficiently than the companies themselves can.
By the same token, we understand that there are a few industries that traditionally do not generate free cash flow for various reasons. The utilities space would be one, as would energy (the exploration as well as the production sides), because they are always trying to reinvest their money into reserves or acquiring land. More broadly, we tend to avoid companies that love to continually acquire other businesses. Companies that make big acquisitions realize the effects about two years after the fact. By that time, if it turned out to be a poor acquisition, it’s too late for investors to take action.
While we’re discussing our approach to investing, it makes sense to put things in the context of the economic recovery we’re experiencing. We are now in the eighth year of the economic recovery that began after the Great Recession, and it’s quite unusual to have an economy growing for this long. Normally, not only are expansions shorter, but you also see a large increase in capital spending somewhere along the way. This time around, however, capital spending has not increased. The benefit to this is that companies can generate a lot of free cash flow. So we really don’t mind a modest growth rate in the economy.
One more note related to the recovery: Since 2009, the economy hasn’t grown above 3% in any year, providing us with a lot of opportunities because free cash flow has been so prolific. You can see evidence of it in the level of dividends and buybacks that have transpired since then. We’re reaching what I would call a crossroads, where some fairly high profile investors are telling companies to stop with all the buybacks and dividends and start reinvesting instead.
Q: What is the market cap range that you focus on when it comes to investing in small-cap companies?
To me, the popular definition would be the market-cap range within the Russell 2000 Index, taking out the extremes. The Russell 2000 tends to be somewhere around $200 million on the low end and up to about $4.5 billion on the high end. The sweet spot for most of our new purchases tends to be between $1 billion and $3.5 billion.
We have seen a fairly large increase in the definition of a small-cap stock during the last several years, and it will probably continue to increase when the Russell 2000 undergoes its annual rebalancing at the end of June. One noted asset management firm has an upper limit of $7 billion right now, which is quite high, especially when we remember that small caps were once considered to be $500 million and below. Given what the Russell 2000 has done over the last 12 months or so, you can easily make a case for small caps at $5 billion and below.
We do not immediately sell a stock if its market capitalization goes to $5 billion. If the valuations are good, and the fundamentals are good, and the company is doing what we want it to, then it makes sense to let it earn money for us. Now obviously, there will come a time when we can’t justify holding it as a small cap.
Another point of consideration is that we want to make sure we can buy and sell within a reasonable timeframe. A lot of small-cap companies only trade 20,000, 30,000, or 40,000 shares a day, and at that volume it can be difficult to get a position in or out when you want to.
Q: What are the core beliefs that guide you or that you fall back on in times of confusion?
One of our fundamental beliefs is that companies that return capital consistently to shareholders in some form should outperform over time. I am generally indifferent as to whether it is dividends, share buybacks, or debt reductions. For me, cash flow has always been the most honest way to measure the value of a company.
Our team also has a built-in bias against highly leveraged companies. There have been times when buying the most highly leveraged companies has worked very well. And those are the types of periods during which we have generally not been relative outperformers.
Bottom-up fundamental research is the key to our philosophy, with a built-in bias for cash flow. The first page that I will turn to in the 10-K is the cash flow statement. That can tell me what a company has done with its cash and probably give me a good indication of its future capital spending plans.
Q: Would you describe the key steps in your investment process?
Our starting point is a quantitative screen that looks at several variables with a heavy weight toward cash flow. We built the screen ourselves and any potential changes will not reduce the emphasis on cash flow. Main variables will involve measures that relate to cash flow, free-cash flow, and EBIT. Other variables revolve around price to earnings, return on equity, and changes in earnings.
We then take all the companies with market caps between roughly $300 million and $5 billion and rank them by each of those variables. Of those 2,000 companies, we will initially focus on the 400 that have the highest aggregate scores.
A second screen looks at long-term debt to capital, the quick ratio, the actual cash flow number, and the capital spending. Then we can narrow it down to about 250 companies. The scores in the screen don’t change the focus universe much from month to month. There are pretty good odds that a company chosen today will continue to score well three months from now.
Next are the qualitative criteria, where the vast majority of the research effort is spent. We look at the 10-Ks and 10-Qs and talk with management, preferably the CFO. (The CFO has the numbers and can be more conversational about capital spending needs.) Then, if the company is deemed to be an attractive investment for our strategy, we will present it to the whole investment team.
One of the benefits of our process is that many companies come to our offices to give us their stories. We also attend broker seminars and conferences. They’re great ways for us to see some of the companies we hold (or are looking at, or have held in the past), while giving us a chance to meet with managers one-on-one.
Q: Can you highlight some examples to illustrate your research process?
A longer-term holding, and the largest position in our fund at this time, is East West Bancorp (Symbol: EWBC), a West Coast bank in Los Angeles that caters to the Asian-American community. We have owned the stock at two different times. The bank has always been strict in its underwriting practices and has historically had low loan losses and therefore low provisions for losses. It was one of the banks that suffered a fair amount of forfeitures in 2008-2009. However, it was among the first to address it, take large provisions, and come out of it in a good way. (It hasn’t had major provisions since.) Furthermore, the bank’s management looks out for its shareholders. After the financial crisis, it bought back $200 million worth of stock, two separate times, at much lower prices than we see today. The firm’s return on equity is between 12-13%, its shares sell for roughly 15-16 times earnings, and it should be able to expand its net interest margin. Aside from possessing a really good credit profile, the bank also benefits from a management team that does what it says it is going to do.
A newer holding for us is Choice Hotels (Symbol: CHH), which we added during the last two quarters. Choice Hotels has 11 brands, including Comfort Inn, Quality Inn, Clarion Hotels, Econolodge, and the Ascend Collection. About 90% of its hotels are franchised, so you are looking at a company with very little capital spending needs. Choice Hotels only spends around $30 million a year in capital and it has a network of 6,400 hotels carrying its brands. As long as occupancy stays where it is (or increases), the firm can buy back stock because it really doesn’t have any significant capital spending needs. If it does project any capital spending or undertakes more ownership, odds are it is looking to franchise it over the short-term. It doesn’t sound to us as if the company is on the prowl for another brand. So that means the share cap should go down and the dividend should increase. It is sitting with about $200 million in cash. Net debt is roughly $600 million, and EBITDA is around $280 million, so the net EBITDA-to-debt ratio is pretty low.
Q: What do you think about the retail sector, where we have seen companies like Sears and Kmart merge but also struggle with the Amazon effect?
If you look at the companies separately, it made a lot of sense for Sears and Kmart to merge, because they could conceivably take a lot of efficiencies. The reality, however, is that they face remarkable headwinds. One of our analysts says that the whole sector looks as if it is overbuilt. We have remained underweight in retail, and a contributing factor is the online effect.
Q: How do you construct the portfolio? Do you have any maximum position sizes at a sector or an individual holding level?
Any company that we buy is probably going to be a major active weight. We try to have pretty solid risk controls, but also recognize that we have to be able to make some big decisions to place our sector and individual allocations.
Our portfolio usually has between 100 and 125 names. When we initiate a position, the typical weighting is 50-60 basis points with the hopes that over time we will get it to 1% or above (depending on the market capitalization and liquidity conditions). We don’t want to hold too many stocks at 50-60 basis points because it doesn’t offer a lot of potential gain for the portfolio. We will not have any weighting above 5% and have never been close to that. In the past couple of years, we have had a few stocks reach a little over 3%.
For sectors, we will make sure we are plus or minus 10% of the weighting in the Russell 2000 Value Index. I don’t think that is overly restrictive, but it does make sure that we have some allocation to every sector.
I am a fan of low turnover. In the last five or six years, we have been in this 20% to 25% turnover rate, which has been lower than I expected and which I don’t mind. I just don’t know how long we can keep it at this level. It won’t surprise me if it moves up closer to 35% or 40%, which would indicate an average holding period of approximately three years.
Liquidity has been very important for us. Typically, we want to be able to buy or sell in a two-week timeframe. We know there will always be a few stocks that will take longer than we’d like. On balance, though, we want to make sure our portfolio is pretty liquid because often, you need liquidity the most during periods when it’s running dry. We try to avoid running that risk.
