Q: What is the history of the fund?
Although the portfolio has been around since 2000, it was launched as the Virtus KAR Mid-Cap Core Fund on June 22, 2009, and I have been managing it since.
We invest in high-quality, mid-cap businesses with a sustainable competitive advantage so the companies can grow, protect, and nurture markets over long and multiple economic cycles. It is crucial to us that businesses not only hold up while the economy is good, but more importantly, do so through difficult times.
The portfolio offers lower risk than the benchmark, along with higher returns – and this doesn’t happen by accident. It happens as a result of owning only great businesses that we believe are higher in quality with lower risk overall.
Currently, our total assets under management for this fund are approximately $101 million. Kayne Anderson Rudnick Investment Management, LLC is the fund’s investment subadvisor.
Q: What core principles guide your investment philosophy?
Preserving capital is critical to our philosophy, and it is achieved by mitigating the downside through our focus on high-quality companies. Certain business models lend themselves to this – for example, those having a strong brand, a network effect, or high switching costs. But typically, the businesses we invest in have commonalities: they are usually not capital-intensive and their competitive advantage comes from attributes such as trade secrets and greater efficiency.
Why is this important? Companies with lower capital intensity usually generate a lot of free cash; they don’t need to access the markets to raise equity or debt to run their companies or grow their businesses. In difficult economic times, their income statements hold up much better because they tend to have lower fixed costs and higher variable costs in their structure. When revenues get pressured, their cost structures can easily be adjusted to sustain profitability better than companies with high fixed costs.
High-quality businesses with solid financials are great, but they also need sound management teams that are good capital allocators. We are diligent in avoiding companies that make expensive acquisitions outside of their core competencies. Over time, this strategy can dilute the return on capital, which is not shareholder friendly.
Q: How would you describe your investment process?
We find companies in a variety of ways – utilizing screens, going to industry conferences, having companies come to our offices, and looking at the competitors, distributors, or customers of our existing holdings.
Our investable universe of 3,000 to 4,000 companies is winnowed down to several hundred names which we then research. The 25 to 35 stocks that make it in the portfolio are those we believe to be the highest-quality businesses in the mid-cap category. This quality is the reason the fund delivers excess returns with significantly less risk.
Because the names already in our portfolio are consistently performing, we can be quite picky. With low turnover of 25% to 30%, we only need a few new names every year. Anything new that goes in must enhance the quality of the portfolio, and because of our bias, that is a high bar to achieve.
Though our screens are quarterly rather than daily or weekly, they’re important because there are always companies coming into our market-cap range. By remaining diligent and making sure we screen properly, we don’t miss anything.
In addition to being the portfolio manager, I also work shoulder to shoulder with the analysts on every name in the fund – I am as invested in a name as the analyst working on it. Just like the analyst, I go through all the documents and participate in the calls, so everyone’s on the same page and has the same amount of information.
Because we are high-conviction managers, this process can take a while. Getting to know a name doesn’t happen in a few days and we don’t make five-minute decisions. It can take weeks or sometimes months to go through a company’s 10-Ks and 10-Qs so we fully understand their business.
In the end, if something goes wrong at a company, we want to know why – and if we don’t understand a business, it’s impossible to determine whether an issue is transitory or structural. Stocks that go down due to transitory issues can represent opportunities, while those that fall because of a structural situation need to be sold – so it’s important for us to understand and differentiate between the two.
Q: Can you illustrate your investment process with several names?
Right now the fund is overweight healthcare, a sector where we need to be discerning. Because we only buy profitable companies, we tend to stay away from bio-techs; they’re generally not profitable and are in the discovery stage of their business cycle. Also, we typically avoid businesses which rely on government payments because those payments can vary, preferring to invest in those which receive private pay or focus on reducing healthcare costs.
One of our healthcare names represents much of what makes an investment attractive to us. Zoetis Inc, which spun off from Pfizer Inc. about four years ago, is a leading pharmaceutical company for livestock and companion animals.
We waited about 18 months after the spin off before buying Zoetis so we could understand what the company would look like as a standalone entity. Following the spin-off, there was still a lot of excess cost to get out of the system, and we believed that would contribute to higher margins going forward.
The company also has that “trade secret” factor we look for. Currently, its leading drug is Apoquel, an anti-itch allergy medication for dogs. The drug epitomizes the firm’s strong research and development; at Zoetis, R&D isn’t a fixed cost but a driver of growth. Also, the companion animal market is growing substantially. Pet ownership is huge in the United States and is growing worldwide – furthermore, it’s a cash business.
We think Zoetis will be a nice two- or three-year holding for us or perhaps we will continue to hold it for much longer.
Q: How is alpha being generated here?
Although its valuation is high, we don’t need to see a multiple of 50 to 60, or even an expansion from 30 to 50. If we can get it from 32 to 33 or 34, we are growing earnings per share faster than the market and this will be the catalyst for the stock going forward.
Valuation is a real measurement of a stock, and over time, high-quality stocks trade at premium valuations unless something structural is going on with the business. When a valuation gets high, we tend to trim our position; later, if valuation becomes lower, we’ll possibly add back to it.
When we have sold great businesses which are outgrowing their markets based on valuation, most of the time it is a mistake. Consistently, we have found that these stocks continue to perform well until something structural happens – and that’s the time to consider selling.
As a result, we never like to get too dogmatic on valuation; sometimes high-quality businesses trade at higher-than-normal valuations for sustained periods of time. Because Zoetis came with all those tailwinds, we were comfortable with its valuation. We might trim it a bit at some point, but the only reasons we would substantially trim our position or sell it outright would be if we were worried about the pet ownership market or any structural issue with the business.
Q: Can you cite another example?
Although we tend to stay away from many retailers, we have owned Ross Stores, Inc., the discount apparel and home fashion chain, for several years.
Internet and online sales are killing retailers every day – companies are going bankrupt or closing hundreds of stores. Ross, on the other hand, is expanding its new stores by 5% to 10% each year, and its same-store sales typically increase between 3% and 5% annually.
Ross isn’t fancy. It offers value-based apparel through stores with low operating costs in places like strip malls. Though situated in middle-income areas, Ross attracts a wide array of shoppers.
The company is proficient at buying closeouts and overages, and because the clothing in stores is always changing, it creates a treasure-hunt experience that shoppers truly enjoy.
One thing Ross does particularly well is to initially price inventory correctly to avoid multiple markdowns later – merchandise becomes less desirable the more often it is marked down. Because Ross buys at such low prices, it can be more aggressive on the initial cost where it makes the highest margins.
We worked on Ross for a while, and after discussions with its management team, became comfortable with how conservatively they run the business. It is a name we have held for quite a long time; it has done well for us and we anticipate holding it even longer.
Q: Does selling at a lower price impact its gross and operating margin?
Inconsistencies in gross and operating margins are driven by the merchandise retailers sell. But because of Ross’s niche, we don’t see that kind of price fluctuation in its apparel and goods.
The consistency of its system is actually quite mind-blowing. Ross’s operating and gross margins are unbelievably stable and continue to increase – its gross margins, currently around 28%, have grown over the last 10 years.
It all goes back to same-store sales – to Ross’s consistency and the population it serves – which protect it from the online threat other retailers face. During difficult times, people go to Ross to save money. Oddly enough, even when the economy is doing great, the company still does well because it meets shoppers’ expectations by consistently delivering the same types of product.
In the end, Ross does a superior job of handling lower-end merchandise and marketing it appropriately – and this shows in its numbers.
Q: How do you construct your portfolio?
To us, construction centers on populating the portfolio with the best names, and we also like to be fully invested. The fund usually won’t have more than 10% in cash, as that would be counterintuitive to our thinking. We are not a cash manager, but instead believe our high-quality companies will protect us when the markets are going down.
Currently, there are 31 names in the portfolio. Though individual positions may not exceed 10%, the largest we’ve gotten to is approximately 7%. At that level, we would be likely to trim a stock. Unless something structural was going on, we might take it down to 4% or 5% and reallocate those funds to a new name or one that offers us a better risk-reward proposition.
New positions are typically 2% to 4%, depending on valuation. With a great stock trading that trades at a premium, we’ll initiate a 2% position, but will go to 4% if it’s a good business that’s also at a great valuation.
As active stock pickers, we don’t try to emulate our benchmark, the Russell Mid-Cap Index. This doesn’t mean we ignore it; we try to stay within a certain percentage of its various sector weightings.
We don’t own stocks in every sector represented in the benchmark. Utilities, for instance, are capital intensive, have a lot of debt, and are regulated by the Public Utilities Commission (PUC), and we don’t typically own businesses like those.
Energy is another sector we tend to avoid because most companies are heavily tied to commodity prices. Core Laboratories N.V., which provides reservoir services to the oil and gas industries, is one exception. We own Core Labs because it offers a value-enhancing proposition to drillers and doesn’t have much debt. When oil was $27 a barrel, the company still had 18% operating margins.
Q: What types of risk do you focus on and what do you do to contain risk in the portfolio?
We think about risk on an individual stock basis. By building the portfolio out of names which typically have lower business risk, balance sheet risk, and credit risk, the overall risk to the portfolio is mitigated. In the end, we are bottom-up investors who don’t try to make macro calls on the economy.
Our job is to find the companies that will weather the next economic recession by identifying how they will sustain business through that cycle. To assess how each company will fare in the next downturn, we look at their performance during the last recession. Evaluating risk in this manner allows us to determine whether a company has evolved, or diversified its revenue stream, or completely changed its business in ways that will help it hold up even better during the next recession.
