Over time, the Brown Advisory small-cap growth team, led by Christopher Berrier and George Sakellaris, watched numerous successful investments compound and grow out of their investible universe. Many of these businesses were still viewed as compelling investment opportunities, but market capitalization limits precluded incremental purchases. While this was frustrating at times, it produced a valuable asset – a sizeable library of fully vetted “up cap” growth ideas.
This growing body of company knowledge, coupled with evidence that mid-caps “act” a lot like small-caps, sparked a simple hypothesis. The team believed it could generate attractive risk-adjusted returns up the market cap spectrum by applying the same philosophy and process that worked in the Small-Cap Growth strategy. In early 2012, institutional investors provided seed capital to test that theory and our Mid-Cap Growth strategy was born.
Now, more than five years later, the team believes it has produced a body of work that supports the initial hypothesis. So far, the Mid-Cap Growth Strategy has mimicked many of the attractive performance characteristics generated in the Small-Cap Growth Strategy over the past 11-plus years, outperforming its benchmark, the Russell Midcap Growth Index, since inception. More importantly to Chris and George, however, is that it did so through stock-selection and downside protection, which is the team’s ultimate goal.
Chris and George are both seasoned managers - each with over 16 years of experience – but with complementary backgrounds. Chris spent his formative years as a research analyst on a prominent small-cap growth product at a Baltimore competitor. In early 2006, he took over the small-cap initiative at Brown Advisory, pioneering the current approach. George started out in a different field—he earned a degree in physiology and worked in a genetics lab. After joining the investment industry in 2001, he served as director of research at two firms, creating a small-cap growth strategy at one of them before joining Brown Advisory in 2014.
While both mid-cap portfolio managers believe their experience gives them an advantage, other factors set them apart as well. They view the world through a small-cap lens – looking for change at the margins, rather than a reversion to the mean. “Because mid-caps are nearly as dynamic as small-caps, focusing on change gives us a leg-up on some of our peers who take a large-cap approach to picking mid-cap stocks,” George says. Moreover, they are growth managers that, perhaps ironically, are keenly focused on downside protection.
In a recent conversation, George took a deep dive into the unique qualities of mid-caps and explained the strategy he and Chris employ.
Q: Why should investors consider mid-cap growth exposure?
A: Quite simply, we believe that mid-caps tend to have the best risk-adjusted returns. With mid-caps, you avoid the fraud and failure that you see more frequently in small-caps; but many mid-sized companies still have similar growth prospects. We find opportunities in the $1.5 to $30 billion market cap range that look a lot like what we see in the $0.5 to $4 billion range.
Q: Don’t investors get this exposure as a byproduct of large-cap managers going down-cap?
A: Investors that have gone passive in large-caps through an S&P 500 index fund may be underweight mid-caps. Given that this asset class has historically generated the best riskadjusted returns, this structural tilt away from mid-caps can be detrimental over time. Even when investors have mid-cap exposure through an active large-cap manager, their carve-out portfolio tends to be highly concentrated in 10 to 15 stocks and usually tilted to two or three sectors.
Q: Can you describe your investment process?
A: Our process consists of three steps: idea generation, due diligence and portfolio construction.
Idea generation is purposefully labor-intensive and entirely forward-looking. We believe one makes or loses the most money in small- and mid-caps when historical relationships change or forecasts prove woefully wrong. So, we do not rely on backward-looking quantitative screens or sell-side estimates. Instead, the team interviews over 400 management teams each year looking for companies that might fit our philosophy.
If we think a company might conform to our approach, we move into step two—due diligence. This starts with more primary-source work. That includes multiple management interviews, scouring SEC filings, building detailed financial models, and so on. However, the bulk of our time is spent talking to secondary sources, including customers, competitors, suppliers and vendors. Basically, we form a highly-specific hypothesis for each company through primary sources, then we test our assumptions by interviewing other industry participants.
After that, we set target prices and model multiple scenarios. How does one asses a company’s worth without knowing what it will look like in three to five years? While valuation is critical to our approach, it occurs near the end of our process.
In step three, we construct a “prudently concentrated” portfolio with 50-80 investments. We target position sizes between 0.5 and 5.0% and concentrate 20%-40% of the portfolio’s weight in the top 10 holdings. Chris and I spend a great deal of our time ensuring the portfolio is eclectic and diversified—hopefully giving it a chance of outperforming due to stock selection in various market environments.
Q: What is the “3G” filter?
A: We believe there are three traits that give a company a higher probability of compounding earnings over a multiyear period. We call them the 3Gs: durable growth, sound governance and scalable go-to market strategies.
Durable growth captures the company’s opportunity. We target firms that address large markets with growth prospects from secular tailwinds. We also look for companies that prove they can gain share profitably. By combining these two dynamics, we believe growth can stay “stronger for longer.” For us, the durability of growth is more important than the absolute level.
Companies with sound governance are run by the right people to tackle that opportunity. We look for management teams with proper incentives and meaningful ownership stakes. We also seek transparency, candor, and appropriate board structures.
Lastly, scalable go-to-market strategies captures how the right people turn an opportunity into cash flow for investors. The ultimate small- or mid-cap investment is one that generates a surprisingly higher return on capital in the future. We target companies that we believe can generate growth with high gross margins while deploying incrementally less capital.
Q: What are some examples of how this comes into play?
A: One is Cogent Communications (CCOI). Cogent went through a long investment phase many years ago to build a uniform IP [Internet Protocol] network. Now it handles over 20 percent of global Internet traffic and is gaining share as the low-cost provider of dedicated internet access. Cogent’s incremental customer comes in with a high contribution margin. Meanwhile, the company is deploying a steady capital budget. This grows its return on capital. Most importantly, its free cash flow, dividends, and share buybacks are increasing faster than many expect.
Another is Catalent (CTLT), which is an outsourced manufacturer of pharmaceutical dosage forms with a solid reputation. Penetration of outsourcing is only 30% and growing due to various trends in the pharma industry. That’s attractive in and of itself. But what we liked most about Catalent was a rapidly growing biologics manufacturing business we found buried in one of its reported segments. That division is more profitable and is growing faster than the rest of the company. If one looks out three to five years, we believe that they should see a more attractive growth and return-oncapital profile.
Q: What is your downside protection strategy?
A: It consists of three levels. First and foremost are the types of firms we invest in. Our “3G” filter focuses our attention on higher-quality companies. Second, we keep a keen eye on valuation. Given this, our approach more closely resembles “core” than “momentum” growth. Finally—our portfolio construction—we size positions based on potential payoffs and the range of possible outcomes. Companies that have a wider range of possibilities—like clinical-stage biotechnology firms –tend to be small positions. Firms that generate recurring revenue with a narrower set of potential outcomes, like Cogent, become larger position sizes. We believe this methodology lets us generate attractive downside capture (see chart above) and a lower volatility profile than our benchmark.
The views expressed are those of the author and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views should not be construed as investment research. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested. The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.
The S&P 500® Index represents the large-cap segment of the U.S. equity markets and consists of approximately 500 leading companies in leading industries of the U.S. economy. Criteria evaluated include market capitalization, financial viability, liquidity, public float, sector representation and corporate structure. An index constituent must also be considered a U.S. company. The Russell Midcap Growth® Index measures the performance of the mid-cap growth segment of the U.S. equity universe. It includes those Russell Midcap Index companies with higher price-to-book ratios and higher forecasted growth values. The Russell Midcap Growth Index is constructed to provide a comprehensive and unbiased barometer of the mid-cap growth market. The Index is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true mid-cap growth market. The Russell Mid Cap Growth Index and Russell® are trademarks/service marks of the London Stock Exchange Group companies. An investor cannot invest directly into an index. Benchmark returns are not covered by the report of the independent verifiers. S&P 500 is a registered trademark of Standard & Poor’s Financial Services LLC (S&P), a subsidiary of S&P Global Inc.
Universe performance rankings from eVestment. The performance rankings may not be representative of any one client’s experience because the ranking reflects an average of the accounts that make up the composite and is provided as supplemental information. eVestment US Mid Cap Growth Equity represents managers that invest in companies with US Equity products that invest primarily in middle capitalization stocks with fundamental characteristics showing high earnings growth expectations or in fast-growing economic sectors. The expected benchmarks for this universe would include the Russell Midcap Growth, Russell Midcap, or the S&P 400 Growth. Managers in this category typically indicate a “Primary Cap Emphasis” equal to Mid Cap and a “Primary Style Emphasis” equal to Growth. The minimum criteria necessary for inclusion in an eVestment Universe are 1) minimum of one year of performance history, and 2) updated portfolio characteristics for the product. All products meeting the criteria are evaluated for inclusion. Managers voluntarily populate performance data into the database for inclusion, and the number of managers in each period only consists of managers that were in the universe for that entire period.
Down-market capture is a statistical measure of an investment manager’s overall performance in down-markets. The ratio is calculated by dividing the manager’s returns by the returns of the index during the down-market and multiplying that factor by 100.