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High-Quality Businesses With Short-Term Valuation Opportunities
Madison Small Cap Fund
Interview with: Timothy McCormack, Shaun Pedersen

Author: Ticker Magazine
Last Update: Jun 06, 11:51 AM ET
Although the small-cap universe is made up of a large number of companies, few names receive analyst coverage and investor attention on a consistent basis. Moreover, these stocks are easily ignored or avoided if the companies fall off from the growth trajectory or face temporary problems. Timothy McCormack explains how the Madison Small Cap Fund offers opportunities to long-term investors with the help of resources to research broader investment perspectives.

ďOur perception is markets that are efficient over the long run will ultimately reflect the economic value of the underlying business, but when investors are focused on less relevant short-term data points, they are inefficient.Ē
Q: What is the history of the fund?

A: 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 fundís 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?

A: 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 companyís 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 canít be replicated by a more data-driven or quantitative approach, like management transitions.

Lastly, the fundís 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, itís 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?

A: 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 fundís 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 ďanalyst firstĒ mentality drives the process because we believe the person who did the work on a name is best qualified to decide whether itís a good fit for the portfolio.

The investment process itself focuses on quality. Our long-term approach is evidenced by the portfolioís 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, theyíre 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 wonít, 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?

A: Generally, 80% of the ideas start with the three of us and the remainder are sourced internally, tapping into the expertise of the firmís 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 Wellingtonís 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 donít 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?

A: 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 companyís business, with ďsustainableĒ 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 Ė we donít like companies with too much leverage. Obviously, we evaluate a companyís 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 donít 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 itís 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.

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Sources: Data collected by 123jump.com and Ticker.com from company press releases, filings and corporate websites. Market data: BATS Exchange. Inc