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Quality with Visibility
Tributary Small Company Fund
Interview with: 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
Even if AutoZone or OíReillyís business declines, mechanics still need replacement parts, so we are agnostic as to where they get it from. At the end of the day, cars will continue to break and Dorman will continue to make parts. The delivery method may change as time passes, but we are confident that there will be demand for the products. In the case of significant problems at AutoZone or OíReilly, the notable risk is the inventory that would need to be cleared out. That could cause a short-term hiccup but isnít indicative of the health of the auto parts market.

Q: What is the manufacturing base of Dorman? Is it U.S. or international?

A: A unique feature of Dorman is that it does not do its own manufacturing; it outsources it. Dorman does the engineering and other companies manufacture the parts. The company has a diverse manufacturing base, so it can be flexible if the environment changes, because it doesnít have fixed investments that couldnít be moved.

About 29% of Dormanís manufacturers are in the U.S., while the rest are primarily in China. No manufacturer accounts for more than 10% of the total production.

Q: Can you give one more example from another industry?

A: Another example would be American Woodmark Corporation, a manufacturer of kitchen and bath cabinets. We were looking for businesses with some exposure to housing, but we werenít comfortable owning an actual homebuilder.

While we were exploring this theme, the sector analyst came across American Woodmark. At the time, half of its sales were from repair and remodeling and half were from new construction. So the company had exposure to new construction, but revenues were somewhat more stable and predictable.

The company is a strong free cash flow generator with good market share. The other characteristics that we liked were the solid financial performance including return on equity, the lack of the debt, and the level of net cash. It was evident that they were looking for an acquisition, so we discussed the cash situation with the management to understand the parameters and how they would utilize the balance sheet.

We purchased the stock last year and later they acquired RSI Home Products, a lower-end cabinet manufacturer. American Woodmark didnít have products at the entry level, so it filled out its product line. RSI had higher operating margins and added over $1 billion of sales to American Woodmark. However, the acquisition also increased its leverage. The exposure to repair and remodel will increase, with the revenue split moving to about 65% in repair and remodel and 37% in new construction.

The market liked the deal and the stock rallied substantially on the announcement. We trimmed the position, taking advantage of the rally. The stock backslid in the beginning of 2018 due to rising interest rates and the concern about the impact on the housing market. The stock fell back to a point where it again became attractive to add to our position.

Q: How do you construct your portfolio?

A: We have a long-term investment horizon and our annual turnover is 25% to 35%. We evaluate companies on a three-to-five year horizon. If the investment thesis remains intact and the valuation is attractive, we are comfortable owning companies for long periods of time.

We keep cash below 5% and our sector allocation is similar to that of the Russell 2000 index. We donít feel that our aptitude is making market calls and we donít think that we can consistently outguess the market from a sector allocation standpoint. Instead, we dedicate our efforts to selecting good companies. We feel that we can identify good companies over the long run and do that consistently, so stock selection will likely be the key driver of portfolio performance.

For individual positions, we hold at least 1% and can go up to 5% in a position. Typically, our largest position would be about 3.0%. In terms of sectors, we aim to have exposure to all the economic sectors. The sectors that are more than 10% in the Russell 2000 can have a weighting of 75% to 125% of the benchmark. For the sectors under 10% of the Russell 2000, there is no outside bound or minimum requirement.

Q: What factors drive your sell discipline?

A: We have an intrinsic value estimate on every company we own and the numbers are constantly evaluated and updated by our analysts.

Approximately seventy percent of our sales have generally been for valuation or market cap reasons or a combination of those two. From a valuation standpoint, as a stock approaches its intrinsic value, its margin of safety declines and we would look to reduce the position. If we believe that the stock is fully valued, we would exit the position.

In terms of market cap, we initiate new positions within the strategy with market caps below $2.25 billion and are willing to hold them until they reach market cap of $5 billion. It is not an automatic sale, but as the stock approaches $5 billion, we recognize that it will have to be replaced and begin searching for ideas.

Another reason for sale would be invalidation of the investment thesis because something has changed or emerged about the company that causes us to change our opinion of the business. The last reason for sale would be a merger or an acquisition of one of portfolio holdings.

Q: How do you define and manage risk?

A: We characterize risk as permanent loss of capital or a decline with no prospect for recovery. Thatís what we try to avoid. We control that risk by selecting sustainable businesses at reasonable valuations with solid balance sheets and free cash flows.

We believe that companies that burn cash tend to present higher risk than companies that generate cash. Free cash generators control their own destiny, because they donít have to go to the market for new capital. On the other hand, companies that burn cash depend on the marketís willingness to provide that capital. In certain environments that can become difficult.

On the individual company level, we evaluate the downside scenario for each stock. On the portfolio level, we limit the position size to 5%, but the largest positions are typically about 3.0%. Another risk control is maintaining a diverse sector exposure.

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