Quality with Visibility
Tributary Small Company Fund
Mark Wynegar, Michael Johnson
Author: Ticker Magazine
Last Update: Jun 11, 11:22 AM EDT
|Small-cap stocks are an asset class with great potential for an active manager, because they tend to offer more opportunities for investing in mispriced companies. Mark Wynegar and Michael Johnson, co-managers of the Tributary Small Company Fund, rely on an in-depth research process to identify quality companies trading at a discount to fair value. A key element in their process is developing an understanding of each business and a high level of confidence in each investment.
ďOur objective is above-average returns, below-average risk, and long-term time horizon. A key aspect of our philosophy is the belief in active management.Ē
Q: How has the fund evolved since inception?
The fund was established on June 10, 1996. Originally, it was run by another team and had a slightly different investment style. It was a deep value, concentrated fund, which owned less than 30 holdings.
I joined the organization in 1999 as a portfolio manager; Mike Johnson joined the organization in 2005 and became co-manager in 2007. In mid-1999, we opted for a diverse sector exposure and increased the holdings to a range of 60 to 70 names. We also felt that the fund needed to be fully invested, so we decided to keep less than 5% in cash.
Our concept is to own good businesses at attractive valuations. We aim to find quality companies trading at a discount to our estimate of their fair value.
Q: What core beliefs drive your investment philosophy?
Our objective is above-average returns, below-average risk, and long-term time horizon. A key aspect of our philosophy is the belief in active management. We believe that small caps are a great asset class for an active manager. In this asset class, there is a higher probability for companies to be mispriced. Through fundamental bottom-up research and through our ability to understand the companies, we can identify good investments and add value.
We are value managers, but we donít just focus on cheap stocks, because we want to avoid value traps. Instead, we look for a combination of good business and attractive valuation. Good businesses have the tendency to appreciate over time and to provide more downside protection in weak economic environments. Stocks trading at a discount produce outsized returns as the value gap closes and they also offer a margin of safety, which helps to control risk and manage volatility. Our principle is to purchase an appreciating asset at a discount to its fair value.
We like to understand the business that we own and to be able to figure out where that business is headed over the next three to five years, so visibility is important to us. We like owning quality businesses that generate good returns on capital. We look at the financial statements, particularly the balance sheet and the cash flow statement, because we feel a high quality company generates free cash flow over the long term and has low debt.
Although we donít draw a particular line regarding the appropriate level of debt, we make sure that the company has enough free cash flow to comfortably cover the interest expense over the long term. The debt of the companies we own tends to be less than that of the benchmark.
Q: What is your investment process?
We are primarily a bottom-up, fundamental research driven firm. We look at stocks as individual businesses, but we donít ignore the macro picture. We incorporate our macro view for the industries or sectors that might be affected as a part of the company research process.
We begin our investment process with about 1,900 to 2,000 stocks. We utilize a quantitative process to discover companies that look attractive from a historical and financial perspective. We also find investment ideas through company research, discussions with company management and analysts, as well as from attending conferences. We pay attention to market sectors and aim to understand whatís going on in those sectors. Essentially, we find ideas by accumulating knowledge.
The analysts on our team are primarily responsible for identifying and researching investment prospects and for monitoring the holdings in the portfolio. When they find ideas that they are interested in, they write a short report describing the basics of the company, the opportunities, the risks and the valuation. Mark and I read the reports and discuss with the analyst the pros and cons of each potential idea.
We prioritize the analystís research, eliminate some of the ideas, and clear the analyst to go back and perform a full fundamental review on one or more of the businesses. That review involves going through the 10-Ks, 10-Qs, the earnings reports, Wall Street research and the companyís presentations. We also talk with Wall Street analysts and/or the companyís management team.
After the analysts have completed a full report, they distribute it to the entire investment team. After we have had a chance to review the report, all the analysts and portfolio managers meet to discuss the idea. Everybody on the team has the opportunity to ask questions and to play devilís advocate to that idea. At that point, the formal research process on the idea is concluded and Mark and I determine whether or not to include it in the portfolio.
The team process is important in vetting ideas; it is one of our key risk control mechanisms. Even in our weekly news meetings, the entire team discusses and evaluates companies and earning releases and asks critical questions about the businesses we own. Our team is incentivized based on the overall strategy performance, so everybody has a vested interest in the outcome that we deliver to our clients. Those discussions are designed as a way to spot potential risks in proposed ideas or in current holdings. We feel, however, that the final decisions should be made by the portfolio managers.
To summarize, our process is both quantitative and qualitative. On the quantitative side, we look at valuation, returns on capital, interest coverage, earnings estimates and long-term growth. From a qualitative standpoint, we need a good understanding of the business. We look for visibility and consistency over the long term. We also evaluate the experience and the strategy of the management team, its openness, and its results.
Q: Could you illustrate your research process with a few examples?
In the last couple of years weíve owned Dorman Products, a consumer discretionary company participating in the aftermarket for replacement parts in cars and light trucks. The initial idea for Dorman came from the quantitative side. The stock historically had high returns on capital with solid growth. It screened out from a financial standpoint as a higher-quality company.
Initially, we were attracted by the consistent performance. When a car breaks down, it needs to be fixed and parts have to be replaced, so people are dependent upon Dorman. It is a less cyclical consumer discretionary story and we found solid consistency and visibility over the long term.
Another positive factor was that the balance sheet had no debt. They also have a great management team, which owns about 11% of the companyís stock. We feel comfortable with management teams that are also shareholders, because it means our and their interests should be in alignment.
Q: Why do you believe that Dorman represents a good growth story?
Dorman has been growing organically at a slightly faster pace than the industry. It has a small share of the total market, so it can continue to increase its share. The size of the auto and truck aftermarket business is about $350 billion, while Dorman has less than 1% share.
The company has done a great job coming up with products that are equal to or better in quality than the original equipment manufacturer parts. It has good relationships with the distribution channels and has been able to organically grow its business over the last 10 years. With such a low share of the overall market, it still has a long way to go. We believe that it can continue to develop products and grow organically for a long time period.
Q: Is distribution an issue for Dorman?
Distribution has been an issue for the stock lately, but that issue has provided an opportunity to add to the stock. We believe that many of the controversies surrounding AutoZone, Inc or OíReilly Automotive Inc are misunderstood. We believe those issues are more related to commodity products rather than the higher value-added products produced by Dorman.