Q: What is the history of the fund and the investment team?

My team and I have been together for nearly 10 years. Prior to joining Baird, the team managed a small-cap and SMID fund at Transamerica Investment Management with a value investment focus. Our assets under management grew to $3 billion. 

We have a long history of working together as a team and joined Baird Investment Management about three years ago. We launched the Baird Small Cap Value Fund in May 2012, and for now, most of the assets that we manage are on the institutional side in separate accounts. Currently, we have $110 million of assets under the strategy, of which $25 million are in the mutual fund. 

The fund is different from its peers in one fundamental way. We tend to end up in the small core category, even though the fund is called the Small Cap Value Fund and we consider ourselves value managers. If you look at valuations for the businesses we own, they are very low, even lower than our value benchmark during any quarter. The anomaly is that we tend to own companies that have growth characteristics, but as we are not paying up for that, our valuations do not look like a core fund, but our companies certainly do.

Q: Where do you look for opportunities?

Companies with market cap between $100 million and $2.5 billion fall in our universe of small caps, and we do not limit our stock selection to the value benchmark.

Market cap is the first consideration in terms of what companies we can own and, in addition to that, we are looking for enough liquidity to be able to invest in a name in a relatively short amount of time, roughly one week. For the most part we own companies that have research coverage from the sell-side brokers; while they may be underfollowed, they are not completely neglected. 

What draws me to the small- and mid-cap space is my belief that the market is much more inefficient, which creates many more opportunities to exploit our investment process and philosophy. It can be done in large cap, but finding opportunities where the market is missing a major trend and has significant earnings upside happens more frequently in smaller companies.

Q: What is your investment philosophy?

We have a well-defined investment philosophy, which starts with our belief that value and growth investing do not have to be mutually exclusive. We combine the best of both worlds of great businesses and buying them at very attractive valuations.

We are looking for great businesses, defined primarily by looking at return on equity and operating margins. We think that companies earning a high return on equity or return on invested capital over time implicitly have some sort of competitive advantage, high barriers to entry, and potential for organic growth. As we seek to buy those good businesses at attractive valuations, that means we want to buy them at a high earnings yield. These companies also have to have significant upside potential in terms of profitability versus what the estimates suggest. 

Buying high return-on-equity businesses, buying companies with low price-to-earnings ratios, and buying companies with positive earnings surprise and positive earnings revision are all tenets that have been proven to work over time. As a result, we are looking to incorporate all three of them in every new investment we make in the portfolio. 

Q: How do you apply your investment strategy and process?

For us, idea generation can be something of an art form. We begin with database screening in search of ideas based on our criteria—return on equity, low price to earnings ratio, and earnings surprise. But oftentimes ideas come to us from meeting with sell-side analysts who are traveling through and talking about the names that they cover.

We also attend conferences, and it is not uncommon for us to have a macro economic outlook that leads us to look within certain industries and sectors for ways to take advantage of what may be a contrary viewpoint.

If we just screen for companies that have high returns and forward earnings growth rates and low P/E, we will often find that they just missed Wall Street’s most recent earnings estimate and their revisions are negative. It is rooted in human nature to extrapolate a trend, and this is the opposite of the type of company that we want to invest in. As part of the process, we are screening for companies where the P/E may currently seem high but there is some catalyst or inflection point poised to push earnings higher than the estimates. We will expand our valuation parameters on the front end a little bit to allow for companies that might have below normalized earnings.

Furthermore, we want to see that they have historically been great businesses and that there is a positive recent experience, such as a recent positive earnings surprise, revenue acceleration, or margin improvement. It may be that we are bullish on the energy space and we think that the build-out and the infrastructure for energy here in the U.S. is in a long-term secular trend, which may lead us to look at pipeline companies.

Q: What is your research process?

Our best ideas end up being vetted out by the whole team. We conduct almost all of our research together rather than individually. Although everyone is responsible for individual sector coverage, we have found over the years that when the other analysts on the team are involved in the entire research process, we exchange many more interesting ideas and viewpoints as we walk away from conference calls and meetings with management. That is a much more intensive process with an additional layer of scrutiny compared to one analyst doing all the research. It is also a much more efficient way to bring everyone’s biases to the table in order to hear the whole story. 

We apply our own proprietary research model for all the companies that we own, looking out two years and modeling earnings with return on equity as our primary focus. At any point in time, we break return on equity down to its three primary components. We try to paint with a broad brush and look for changes that can occur either in net margin, or in asset turns, or in financial leverage, which can significantly move earnings away from market expectations. 

Q: What kind of companies meet your criteria?

To return to my pipeline company example, if we are looking for a business in that sector and we see a lot of new awards coming for pipelines, then we might have a more bullish revenue outlook for the business. That is simply because it is a fixed-cost business and higher capacity utilization comes with higher revenues and at higher marginal income levels. Ultimately, that would lead us to have a significantly higher earnings per share estimate for the business. Those are the companies that we are most eager to invest in.

We own a company called Motorcar Parts of America, a stock that may have been missed by a value investor if they were purely running screens. At the time we bought it, the company was losing money and all the trends were absolutely terrible, with every possible key metric indicating a downward trend. Even though it looked like a terrible business on the surface, there was a lot going on underneath that was exciting.

Motorcar remanufactures alternators and starters and sells them to the aftermarket industry into the big retails such as Autozone and Pep Boys. They have a great core business that had been operating with high margins growing nicely above the industry with mid to high single-digit revenue growth, but a few years earlier they had made an acquisition of a business called Fenco. 

At the time, Fenco was a troubled business and, thinking that they could turn it around, Motorcar put capital into that business and started losing money. Consequently, the overall business went from earning $1 a share to losing money at the time of our purchase. However, all the losses were on the Fenco side, which fortunately they had set up as a separate legal entity, so at the time we made our first investment in the company, Motorcar was closing Fenco and getting back to their core business.

It was very easy for us to see how Motorcar could get back to earning north of $1 a share, which was what the core business was doing. As we looked down the road a couple of quarters, after divesting Fenco and getting back to profitability, they had an opportunity to refinance their debt. We felt this could add another $0.20 to $0.25 to earnings.

A company losing money is not a company we would typically want to own. However, a company with core earnings power north of $1 and another 25% upside from debt refinancing that is trading at a low multiple to that potential looks very appealing to us. We felt Motorcar could earn close to $1.50 a share over the next couple of years, given the organic growth and margin expansion.

Q: How would you describe the growth strategy of Motorcar?

Not only has Motorcar executed all its plans, but the company has also added some new products in the meantime. At present they are not looking to buy another business and instead have concentrated on distributing products. They have a lot of capacity and great distribution into the retailers, so they benefit from this network by buying wheel hubs from Asia and distributing effectively. It is a low margin business because they are just distributing, but there is also a very high return on invested capital because they are using their existing facilities. 

The turnover for our strategy over the last 10 years has ranged from 25% to 40%. On average we hold a stock for a period of two to three years. However, there are certain core holdings that have been in the portfolio virtually the whole time. It is not uncommon for us to be in a name for longer periods because we know it might take some time for our thesis to play out when we are searching for a catalyst or a very large change.

Q: Would you share another example of a company you like?

For the past 18 months we have been excited about ways to play the build-out of 4G infrastructure and the upgrade to 4G phones, not only here in the U.S., but also as a global trend getting a foothold in other large markets like China. 

TriQuint recently merged with RF Micro Devices to form Qorvo, and we had already held TriQuint in the fund. In addition to manufacturing RF chips for smartphones, which is their primary operation, they also make other devices such as tablets. Unfortunately, it is a name we will have to sell, as it is now a $10 billion market cap. To use as an example, what we like about TriQuint is its exposure to a huge secular trend towards upgrades to 4G phones, both here in the U.S. and internationally. Each 4G phone has almost three times the content of RF chips as a 3G phone, meaning that you go from $0.30 to almost $1 for a 4G phone. Of course, as the number of frequencies increases, so does the need for radio frequency chips to communicate with the towers. 

Such stocks have performed very well for us because we were ahead of the curve and we had anticipated that they would see much stronger revenue growth as the iPhone 6 was launched, followed by similar advanced devices from other competitors. That corresponded with the huge investments that China Telecom has been making in building out their 4G networks. Once that was made available to the public, Chinese consumers switched over to 4G services at 30% growth clips on a quarter-over-quarter basis.

While this space is not typical for us, because we are usually underweight in technology, we have found an opportunity to invest in some high quality names. Another name we own is Integrated Device Technologies, a manufacturer of chips for wireless charging. Although wireless charging has been around for a while, it has not gained a strong foothold, but we think we are on the cusp of that happening. 

Integrated Device Technology is also rumored to be, and we are highly confident they will be, in the iWatch made by Apple Inc. Wearable devices need wireless charging because nobody wants a port where water can potentially get in. IDT has been receiving huge interest from the likes of Samsung and Hewlett Packard, and they are going to be integrated into furniture that has a charging pad in it. Presently, Starbucks is rolling out wireless charging pads in their stores. In fact, we think over the next 12 to 24 months wireless charging will become mainstream. 

Q: What is your portfolio construction process?

Our benchmark is the Russell 2000 Value Index. While we are benchmark aware, we’re not uncomfortable looking differently than the benchmark when it’s consistent with where we are finding value. We have some criteria that keep us from straying too far from the benchmark, such as a weighting position of 20% in any one industry, not more than 30% to any one economic sector, excluding financials, and no more than 8% at market for an individual holding.

Our portfolio typically has 40 to 50 names, but we have been on the low side of that so our average position sizes are about 2.5%. We are not uncomfortable adding to our winners as we gain conviction that the catalyst for change is starting to play out and we take advantage of the research we have done there and add to holdings. Where we do not see catalysts playing out, we are usually quick to exit that name. 

Q: Do you take macroeconomic developments into consideration?

Our macroeconomic outlook also plays a role in the portfolio. In times when we have a contrarian outlook for a given economic sector, or maybe for the overall economy, we try to incorporate that sentiment into our earnings models for individual businesses. That often helps us focus our attention on a sector displaying outsized potential. When we find opportunities such as in an IT name, where we have identified a positive trend and our outlook is validated, we may add to our positions in that space.

We are not uncomfortable being overweight in an economic sector that is consistent with our outlook. However, if we have a negative outlook, for example on the economic growth outside the U.S., our portfolio will certainly reflect this conviction. For this particular reason we have been trying to avoid exposure to emerging markets and Europe. 

Our ambition is to maintain a portfolio of 40 to 50 businesses that we feel can provide exceptional growth opportunities over the next couple of years. This strategy creates a high active share because we own names that are not in our benchmark. Our active share versus the benchmark has been consistently above 98% over time.

With its long-term focus, our strategy compels us to be vigilant about making sure that we do not let any short-term gyrations in the market dictate our investment strategy. We know that over time the fundamentals of the business will drive stock prices, but in the short run you can get caught up in certain market dynamics, which can often lead you astray.

We have a fair amount of volatility on a quarterly basis, but over time our goal is to add 250 or 300 basis points of alpha over the benchmark over a three-to-five-year period.

Q: What is your sell discipline?

Our sell discipline is centered around the fair valuation concept of seeing businesses get the most out of what we are looking for—positive earnings revisions, coupled with P/E expansion as the market recognizes the true growth rate of the business. When we have run out of the opportunity for both of those factors, fair value has been realized.

We model all of the companies that we own internally and we update those models periodically to reflect changes in the business and the current price.

Q: How do you define and manage risk?

One of the best ways to control risk is to buy great businesses without paying a premium for them. By investing in those types of businesses, you are inherently lowering your downside risk. We are also aware of our benchmark and that keeps us with a nicely diversified portfolio.

On a weekly basis, we run what we own versus our benchmark to compare our performance in individual sectors. We run cross-correlations to see what our exposures are in the portfolio, keeping in mind that you may be equal weight in energy but also have industrials that have energy exposure, or you might also have banks in an energy-related space. This may correlate even more highly in market conditions similar to what we witnessed in late 2014, when oil prices declined.

We tend to do well in down markets. In fact, we have a downside capture ratio of around 82%. One of the difficult market scenarios for us is a situation where low quality stocks do very well. For example, coming out of the tech bubble, we did very well, but the first year following the tech bubble, when biotech and low price stocks did extremely well, our portfolio underperformed. Fortunately, we then followed that up with three years of top quartile performance as quality names regained the lead.