Q: What is the history of the fund?

The Madison Small Cap Fund, which was launched in December 2006, seeks high-quality companies trading at a discount to their intrinsic value with the potential to generate above-average returns with below-average risk over a longer investment horizon. 

In the small-cap market segment, the so-called value traps are one of the biggest risks. To avoid these, we exhaustively research the quality elements of a company and look to ensure that no secular change to the business has occurred, which would indicate its future will not look like its past. By spending significant time with management teams and being extremely selective, we try to ascertain that whatever has created a valuation opportunity is in fact short-term in nature and that a company will most likely return to its historic return levels or growth trajectory.

At its inception, the fund was exclusively offered through the credit union channel. In 2013, brokers/dealers in other fund supermarkets were included. Wellington Management Company LLP has been the fund’s subadvisor since it was launched. Assets under management (AUM) were $108 million as of March 31, 2017.

Q: What are the underlying principles behind your investment philosophy?

To us, longer term is key. Our perception is markets that are efficient over the long run will ultimately reflect the economic value of a company’s underlying business. However, they are inefficient when investors focus on less relevant, short-term data points like quarterly or forward-projected earnings. Our aim is to increase the likelihood of finding and exploiting the mispricings that result from these inefficiencies. 

Second, when situations are driven by change or uncertainty, the significant resources we bring to the research process help us understand the nuances involved. Examples of this include things that can’t be replicated by a more data-driven or quantitative approach, like management transitions.

Lastly, the fund’s mandate is to invest in small-cap companies, an area that typically receives less investor attention. At the time of purchase, a company must have a market cap between $100 million and $2 billion. If any of our holdings reaches $4 billion, we sell it primarily to stay true to our investment mandate; once a company reaches that level we no longer view it as small cap. 

This has generally proven to be a good investment discipline over time. If we purchase something below $2 billion and the company reaches $4 billion, it’s already appreciated at least 100%. Few companies, though, would get to that $4-billion level as 100%+ upside can, at times, be relatively rare to find, though the market environment offers different opportunities at different points in time. At purchase, a target is usually not higher than that percent appreciation and the regression to the mean is fairly powerful.

Q: What is your investment process?

We are a team of three, myself, Shaun Pedersen, and Edmond Griffin, dedicated to this product alone and have worked together at Wellington and in the small-cap asset class, for a long time. This collective experience gives us an advantage as we consistently apply the fund’s philosophy to exploit an asset class we know well. 

I act as the lead portfolio manager and fiduciary for the client, but on a day-to-day basis, our process is not PM-centric. Rather, an “analyst first” mentality drives the process because we believe the person who did the work on a name is best qualified to decide whether it’s a good fit for the portfolio. 

The investment process itself focuses on quality. Our long-term approach is evidenced by the portfolio’s turnover of 20% to 25%, indicating a four- or five-year holding period. We are not thematic. Our focus is a bottom-up, stock-by-stock process rather than a sector top-down approach or managing the portfolio with a macro or market view. 

Over the long term, we feel that the fate of small-cap stocks tends to be idiosyncratic with general short-term market or macro forces. Although these still provide opportunities, they’re not something we believe can add a lot of value when managing the portfolio.

We remain disciplined to our philosophy through different market environments and never try to force anything. Sometimes the market will favor our style and other times it won’t, but our best alpha generation comes from sticking to this discipline over a cycle.

Q: Would you explain how you put your research process to work?

Generally, 80% of the ideas start with the three of us and the remainder are sourced internally, tapping into the expertise of the firm’s global industry analysts who cover sectors across the globe and the market-cap spectrum. They give us a sense of what the competitive landscape might look like in different markets for a small-cap company that may have a significant portion of revenues overseas. Though we are not big users of Wall Street research, we occasionally source ideas and seek assistance from outside firms focused on small-cap stocks.

Meeting with management teams is a great resource we rely on for idea generation. On average, 25 to 30 companies come through Wellington’s global offices each day, though not all fit our philosophy or market-cap range. Other investment ideas are garnered through attending conferences and taking field trips.

We use the volatility and liquidity inherent in this asset class to our advantage, and don’t like markets that are straight up. Our research process identifies opportunities created by volatility and helps us identify companies that are depressed due to one or more short-term factors. 

The process also naturally lends itself to us being providers of liquidity. When other investors with different time horizons and risk parameters are exiting a position, we are buying. Then, if our thesis plays out, we are selling positions typically to investors who see valuation differently or are seeking more momentum.

Q: What metrics do you focus on when researching companies?

We look at both quantitative and qualitative factors. Quantitatively, one of our favorite metrics is return on assets (ROA); a sustainably high ROA is a good indicator of the underlying quality of a company’s business, with “sustainable” being the key term. This finding also suggests a company has significant free cash flow generation. 

For us, the balance sheet is a quality factor – we don’t like companies with too much leverage. Obviously, we evaluate a company’s debt within the context of its business to see if it makes sense. For example, a food company with a highly predictable demand stream can probably afford to have more leverage than a high-ticket capital goods company that is more subject to the economic cycle.

Management teams are an important qualitative factor. We sit down with management and figure out their history and strategy for creating long-term shareholder value, which is where we want their focus to be. Many small-cap company management teams want to get bigger just for the sake of it, or have their eyes on short-term earnings. We avoid investing in them if these efforts don’t create shareholder value in the long run.

Other qualitative metrics we consider point to more durable business models which help limit downside. These include the market share a company has and whether it’s sustainable, and its history of staying ahead of the learning curve in regards to its product or service offerings. We tend to like businesses with fairly long product lifecycles that have greater predictability. 

We never exclude anything outright, but any company within almost any sector with an outcome that is binary will, most likely, not be something that would interest us, nor would one in area that historically has struggled over a cycle to generate attractive return on investment.

Q: Can you provide examples to illustrate your research process?

One example is a company which is a contract research organization (CRO) in the healthcare industry. It typifies how we find opportunities by focusing on a high-quality business with a transitory issue that leads most investors to handicap it negatively, but through our research, we can confirm that the matter is indeed short term.

Essentially, CROs are outsourcers for the pharmaceutical and biotechnology industries; they can do parts of the non-core work less expensively, more efficiently, and faster than the drug companies can themselves. This CRO focuses on the later stages of clinical trials investigating a drug compound. 

We’d met with its management team over the years, and as the analyst, I’d spent even more time with them. The company had a global footprint along with good quantitative and qualitative metrics. It had a strong balance sheet, was generating a high return on assets over time, had significant free cash flow generation, and was one of the top five suppliers in its industry. There was also a tailwind in the industry. 

Moreover, it had entered into a significant strategic relationship with a large pharmaceutical company. This was a real positive – the pharmaceutical company was going from 40 vendors to two, with this CRO being one. In our view, this validated the quality of its work. 

But in the short term, the CRO’s earnings would take a hit. It had to ramp up for this relationship by hiring many expensive PhDs as project managers. As well, there’s always execution risk when new work like this comes in, and a lot of investors didn’t want to wait to see how that turned out. As a result, when the relationship was announced, the stock price fell.

We worked with our internal healthcare team and continued learning about the company through additional meetings with management. Our findings indicated a short-term disruption to the earnings stream, but the relationship and the changes it required would be good for the company in the long term.

Another example that illustrates our research process can be found in small-cap banks in the aftermath of the financial crisis. Some of the portfolio’s existing holdings were hurt and we were also looking into new names at a time when great uncertainty surrounded their credit profiles and how they would perform. 

We identified candidates compatible with our philosophy, and further, looked for those which could continue to perform based on their history of loan underwriting and reserve positions. With the help of an internal analyst dedicated to small-cap banks, we gained insight into management teams and their performance in past credit cycles. 

Many were trading below tangible book value, which is fairly unusual. To us, this signaled opportunity: buying small-cap banks with adequate reserves below tangible book value would not only limit the downside, but also leave enough attractive upside once we came through the cycle.

Q: Would you describe your portfolio construction process?

Because of the high bar we set for quality, the fund’s investible universe is fairly limited. We prefer to find better businesses to hold on to and concentrate the portfolio there. 

We begin identifying companies by looking at the least efficient segment of the market – that $100 million to $2 billion market-cap range I mentioned. Then we determine the opening position size, when to change a position, and set targets to exit a position.

Because the portfolio isn’t managed from a top-down sector perspective, it doesn’t have maximum or minimum sector weightings. However, it is constrained at the industry level and won’t be more than 20% a particular industry.

Typically, the portfolio has 60 to 90 holdings. At purchase, the minimum starting position is 0.5% and maximum is 3.5%; we also have a maximum of 5% at market value. Always keeping position sizes under 5% is a risk management tool for us.

Because we don’t want to manage cash, it will not be above 5%. Being fully invested in this space is a good discipline: by staying under 5% and not allowing cash to grow, we are forced to always seek opportunities through new inefficiencies. 

Though we have some flexibility to invest in non-U.S. securities that can be traded on U.S. exchanges, our investments remain solely in developed markets. 

The Russell 2000 Index is the fund’s primary benchmark, but we don’t manage to it. Our portfolio construction reflects an absolute mindset in regard to both return and risk: we are trying to find a reasonable absolute return over a longer-term investment horizon of four to five years while avoiding permanent loss of capital. 

Q: What does risk mean to you and how do you control it?

To us, the ultimate way to mitigate risk is through valuation. Using quality as our starting point, we buy companies with valuations that already incorporate most of the company-specific and business risks we have analyzed. 

We view risk analysis as a source of information and as insights in dialogue, as opposed to constraints to running the fund. However, when constructing the portfolio, it is critical that we are well diversified across different types of risk. A lot of time is spent making sure our holdings are not all subjected to the same kind of risk; we look for unintended exposures that might point to an unidentified risk at the portfolio level.

Finally, Gardiner Holland, our product manager, flags anything that looks inconsistent with our investment philosophy or process through independent portfolio and factor analysis and stress testing.