SMID Sailing: Celebrating 10 Years
A decade after the launch of a SMID value strategy at Cambiar Investors, Co-Portfolio Managers Andrew Baumbusch and Colin Dunn sat down to discuss the asset class and what makes their approach unique.
Can you talk about the SMID style at Cambiar? What are the parameters for investments and where could SMID fit into an individual investor’s asset allocation?
Colin: We target companies in the market cap range between $2 billion and low double digits, so $12-$15 billion. We typically buy 40 stocks in the SMID Value portfolio, and run an equal-weighted strategy, with all new purchases entering at a 2.5% position. We think a SMID allocation could fit alongside a small-cap allocation for many clients.
Our research shows that there is an equal alpha opportunity to be generated versus what many people observe in the small-cap asset class. However, we think this alpha opportunity is paired with a higher quality company set. SMID businesses tend to be more mature, possess a better margin profile, and higher returns on invested capital, and these companies also can gain better access to the capital markets. The relatively lower market capitalization (relative to large caps) is often a function of a more focused business niche. In aggregate, our observations have been that SMID companies tend to have increased durability and less volatility than small-cap companies, yet offer similar alpha potential.
Over the last 10 years, the Cambiar SMID Value strategy has outperformed its benchmark over just about all periods. To what do you attribute the performance?
Andy: The ability to preserve capital in downturns is a critical component to compounding returns over a long arc. We are conscious of not just capturing alpha in up markets, but also giving up less on the downside. One of the things we are especially proud of is that our down capture stats line up quite favorably relative to the Russell 2500 Value Index.
We have also consistently invested in the research effort at Cambiar. It is a core asset of the firm and as such, we are continually looking to upgrade with both new hires and, for those who have been around a while, continuing to challenge our own underwriting approach, looking to explore each sector with dynamism – not resting on our laurels.
How’s the approach evolved since the launch of the strategy back in 2010?
Andy: The major tenets of the SMID Value strategy have not changed meaningfully. At the margin, we have made tweaks in terms of the number of holdings; at one point we were 30-35 names vs. the current range of 35-40 positions. But in terms of the underlying approach to stock selection and portfolio construction, we continue to try and just get better at it. By that, I mean continue to make sure that the portfolio delivers balance and has exposure to a variety of factors that can deliver excess return. That is something we have continued to iterate as we have more observations and data-based tools to evaluate performance in a historical context and try to incorporate in a real-time context.
Price is what you pay, value is what you get and we’re really focused on what we get.
Still, 40 positions is a fairly concentrated portfolio …
Andy: We are looking for high performing businesses that, over time, demonstrate better financial and operating metrics in the form of their margin and cash flow profiles. These attributes reflect either an internal innovation engine and/or franchise position that has supported the durability of such metrics over long periods of time.
It is not as though there are hundreds of opportunities consistently available across the market, so we tend to end up with a narrower set of names. That said, we believe a portfolio of around 40 names can provide the high active share that is relevant to an investor who is seeking to potentially meaningfully outperform an index. Secondly, within those 40 stocks, we look to provide a varying degree of return sources, whether that is across sectors or by the nature of a particular business and where it fits within its own industry.
Colin: That’s right. Active share is a very specific intent on our part. We think, as an active manager earning the fees we do to deliver alpha, you need to focus your bets accordingly.
What factors do you think contributed to growth’s outperformance for the last decade or so and do you think that value will eventually have its day in the sun again?
Andy: To us, that is one of the interesting things less discussed around the growth and value dichotomy: we believe that value benchmarks are simply not appropriately capturing companies that, over the last few decades, have been able to do more with less. Traditional book value measures for companies 40 or 50 years ago reflected high levels of infrastructure, metal, machines, etc… to generate output. Yet the world has evolved in areas like healthcare and technology, where asset-light business models are part of the reality. Many of these businesses possess a lot of the attributes we are seeking, in terms of high margins and free cash flow.
It is almost definitional to some degree that asset-light businesses do not often require a lot of capex, so a lot of the growth from investment ends up flowing through the P&L, vs. accumulating on the balance sheet. It does not mean that they are more expensive, per se, it just means they are structured differently.
Colin: First and foremost, the whole growth vs. value concept— investors shouldn’t have to choose. Unfortunately, value investors have been painted with this low-price brush. Which is one factor, whereas the characteristics you get for that price is really the value you are getting.
There’s an age-old saying, “price is what you pay, value is what you get,” and we’re really focused on what we get. Our investment team is charged with uncovering companies that possess a structurally advantaged position which can translate into good returns and free cash flow—and then determining a fair price to pay for these attributes.
One should always be price-sensitive; decades of market history suggests that valuation matters. But value investors should ultimately care about where value is being created in the economy and focus on getting clients exposed to those specific areas.
Sectors where historically you might focus on price-to-book—financials and real estate are two examples – dominate the value index. Those are capital intensive sectors that are bounded to some degree in their ability to grow by GDP and they tend to have a lot of leverage. Whereas technology and healthcare, two sectors that dominate the growth index, are very IP oriented – not a lot of book value required to get the business up and running, and very often are creating profit from scratch or taking profit from elsewhere.
These conditions allow them to grow at an above-average rate. They also tend to have, given the lack of capital intensity, the sort of business models we like. They’re delivering terrific value for the customers, which manifests itself in a nice margin. And the capital lightness of the business can yield good returns on capital. Sometimes you pay more for that, but are you paying a reasonable price for what are superior characteristics?
Andy: As price-sensitive investors, we are constantly thinking about valuation. We are not looking to overpay for the characteristics we seek, but at the same time do not want to sacrifice quality to achieve low statutory valuations within the portfolio. We are looking to be patient and time the entry when price against attractive fundamentals makes sense.
That’s a good segue to the current market opportunity. COVID must have forced you to re-think everything. Talk about the sectors where you have the strongest conviction this year?
Andy: We have used the volatility, particularly toward the end of the first quarter, to opportunistically add several names to the SMID portfolio. It was exactly what we espouse, in terms of being patient until such time an exceedingly attractive price emerges for what we would view as an exceedingly attractive asset.
So late in the first quarter, we identified opportunities in industrial- and transportation-oriented businesses that we felt were experiencing a near term hiccup in volumes but were likely to see a relatively quick recovery in terms of the underlying fundamentals. And to some degree, that has started to play out.
We also bought a couple of healthcare businesses that we had been following for a long period of time and finally saw prices get to a level where the valuations were sensible against forward dynamics. We also got into a couple of technology businesses.
So, in terms of the opportunity that we saw, in that late Q1 period, it was diverse. We saw this phenomenon of autocorrelation not just between asset classes but within asset classes. There was a time when all SMID stocks were going down. The ability to use that as an opportunity and be ready to pounce is precisely what we want to deliver as a research team to our clients.
And where are we now in that scenario?
Andy: Markets have bounced back significantly, in part due to improving fundamentals in a handful of businesses like the transportation names we talked about and also because there is a great deal of support being foisted on us by central banks and other fiscal government tools. That has generated a high level of low-cost liquidity that has pushed down risk-free rates, supported elevated valuation levels, and caused people to look outside of fixed income for risk-adjusted forward returns. The equity markets have undoubtedly been a beneficiary.
How do the two of you work together?
Colin: It starts with a shared set of principles about how to invest capital to deliver superior returns to clients. With this mutually agreed upon shared vision as a filter, we constantly discuss incremental ideas, brainstorm on areas of opportunity and review current holdings that may be nearing price targets or are not working out as planned. We also regularly discuss if the portfolios are performing to our expectations. Finally, we both recognize there is room for different points of view and thus try to bring humility to the table when evaluating alternative opinions.
What makes this a Cambiar strategy?
Andy: One consistency across the firm is the goal to outperform over a three- to five-year investment cycle. We are a high active share manager, which from time to time is going to leave us at loggerheads with what the particular benchmarks might be doing, but the idea is if we can get invested on behalf of our clients in businesses that can generate very high returns themselves, we can almost allow the companies to do the work for us as much as we do the work in terms of picking specific stocks.
To the extent we can identify great businesses and buy them at appropriate attachment points, the financial histories and competitive positions of those businesses suggest that they should continue to outperform their industry peers and competitors.
Such industry-leading returns should then be accompanied by outperforming stock prices that may not be evident over shorter periods of time but tend to be clear over longer arcs. Again, that is largely what all products at Cambiar seek to deliver and what we will keep aiming for over the next 10 years with the SMID Value strategy.
To learn more about the Cambiar SMID Value Portfolio please visit the following page:
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