Sign up to our newsletter
Research Coverage
May 2024
Important Information:
This webinar contains information specifically intended for institutional clients, asset consultants, advisers, platforms and researchers, who are professional investors and wholesale clients (as defined in the Corporations Act 2001).
I confirm that I am a professional or wholesale investor as defined by the Corporations Act 2001 and wish to proceed.
In this Q&A interview, Adrian Martuccio, Co-Portfolio Manager and Joel Connell, Senior Global Equities Analyst discuss Bell Asset Management’s approach to identifying ‘quality’ companies, how they construct a portfolio designed to perform in a range of market environments and why they think Global SMID Cap Equities are poised to outperform.
In our view, the key reason investors allocate to Small-to-Mid (SMID) Cap Equities is for growth. Over the long term SMID caps have delivered superior revenue and earnings growth versus their large cap counter parts and we expect this to continue in the future.
Within Global SMID caps, there's also arguably an information advantage to be gained due to there being a lot less coverage in a very large investment universe, which makes it ripe for bottom-up stock picking.
Sell-side analysis and modelling can often be pretty simplistic when analysing SMIDs, so as part of our approach, we sit down with company management teams and listen to what they have to say. In these meetings we often have that light bulb moment where an investment opportunity that the market is missing becomes clear.
We find that visiting companies and talking to management teams is an absolutely vital part of our investment process, and we conduct over 500research meetings per year.
From a broader equity portfolio allocation perspective, Global SMID caps can provide additional portfolio diversification, complementing other growth options, such as Emerging Markets and Small Caps, while also helping mitigate some of the concentration risk that exists in Large Cap Growth allocations.
Additionally, the diversification that SMIDs can provide helps avoid, or at least dilute, other risks such as valuation risk in Large Cap Growth, and liquidity risk in Small Caps.
There are over 5,000 companies in the MSCI World SMID Cap Index, meaning there are many places you can go wrong – a really disciplined approach is vital when it comes to Global SMIDs.
Our investment approach starts with strict quality criteria, where we look for quality companies that can capture growth, but we also look to identify and avoid companies that are poorly managed, over-leveraged or have low profit margins.
In our view, avoiding the losers can be just as important as picking the winners.
To us, quality companies are those that possess the optimal combination of these six factors:
We conduct in-depth bottom-up research on an ongoing basis to form a view on each of the above areas, and if a company fails on any one of these six factors, we don’t consider them for investment.
We believe this definition of quality is “all-encompassing” in the sense that it captures all the key risks and drivers that are important to consider when investing.
We also have a strong valuation discipline in terms of the price or the valuation we're willing to pay. Great companies don't always make great investments, so we want to maximise our odds of making a successful investment by minimising the valuation risk.
When it comes to portfolio construction, we try and create a portfolio that has a balanced exposure across the value and growth styles, albeit with no exposure at the extreme ends of the spectrum. We won't include any unprofitable or excessively valued growth company and we won't have any deep value cyclical type companies either.
A lot of quality strategies or quality indices are heavily skewed towards growth, and while we certainly have good growth characteristics for the portfolio, our goal is to deliver more consistent returns over different market conditions, aiming to get that optimal combination of upside participation versus the downside protection.
The overall objective of our ‘quality at a reasonable price’ approach is to deliver those good risk-adjusted returns across different market conditions.
There are obviously different ways to define quality and every investment manager will implement their approach in a slightly different way. Two of the key areas where we may differ are in terms of our valuation discipline, and that we aim to have a more balanced exposure across the value to growth spectrum. By contrast, some quality-focused portfolios or indices can be heavily skewed to growth or a lot of the expensive ‘compounder’ types.
This means that in strong momentum-driven markets, like we've seen over the past year, some of these growthier quality approaches can do quite well. That said, we know that market conditions change over time, so there could potentially be some risk if there is a broadening in the rally across different types of stocks, or if you have a market pullback where investors become more sensitive to valuations.
Looking at passive, or index approaches, there are a few differences to keep in mind when comparing them to active approaches.
Passive strategies are typically built on indices that are quantitative-based and only use historical data. While historical data is important, we think it's just as important, if not more so, to invest based on projections about the future.
Additionally, in terms of the valuation aspect, most indices or passive approaches have little to no regard to valuation when being constructed. Adding the fact that some passive definitions of quality are narrower in focus, this can have the effect of concentrating a portfolio into stocks with similar characteristics, which means they can often be highly correlated.
The discount has persisted for a number of years, but we have a more constructive outlook on the economy now. We’ve navigated the pandemic, the war in Ukraine, inflation and rising interest rates, all of which have fuelled concerns about the financial stability of SMID Caps. With the threat of a recession, the profit sensitivity of the asset class has also been a concern for investors for some time.
During the pandemic many of the SMID cap companies within the portfolio implemented really stringent cost rationalisation plans, and they also focused heavily on cash generation to reduce debt.
So today, as an asset class, their balance sheets have the lowest level of debt in a decade. This means that they're well prepared for this higher interest rate environment. Also, in terms of cost discipline, it has given them really good operating leverage. In the more constructive economic environment that we're now in, this gives us confidence that they're going to be able to generate double digit EPS growth this year and probably in2025 as well. By comparison, we anticipate four or five percent EPS growth for all caps.
We're already seeing some positive signs in the first quarter earnings that are coming out right now. Results are confirming their ability to grow at this rate and if we continue to get strong reporting going into the second quarter as well, it could be the catalyst that helps reverse the discount that's persisted for the past few years.
If we see compound double digit growth and the closure of the valuation gap, it should be an asset class that starts to outperform again, like it has in years gone by.
Overall, we believe investors should consider adding global SMID cap equities to their portfolios, through a disciplined quality-based approach. The combination of resilience, adaptability, and growth potential makes global SMID cap equities a valuable addition to a well-balanced portfolio, with the possibility of outperformance in the coming years.
In this Q&A interview, Adrian Martuccio, Co-Portfolio Manager and Joel Connell, Senior Global Equities Analyst discuss Bell Asset Management’s approach to identifying ‘quality’ companies, how they construct a portfolio designed to perform in a range of market environments and why they think Global SMID Cap Equities are poised to outperform.
In our view, the key reason investors allocate to Small-to-Mid (SMID) Cap Equities is for growth. Over the long term SMID caps have delivered superior revenue and earnings growth versus their large cap counter parts and we expect this to continue in the future.
Within Global SMID caps, there's also arguably an information advantage to be gained due to there being a lot less coverage in a very large investment universe, which makes it ripe for bottom-up stock picking.
Sell-side analysis and modelling can often be pretty simplistic when analysing SMIDs, so as part of our approach, we sit down with company management teams and listen to what they have to say. In these meetings we often have that light bulb moment where an investment opportunity that the market is missing becomes clear.
We find that visiting companies and talking to management teams is an absolutely vital part of our investment process, and we conduct over 500research meetings per year.
From a broader equity portfolio allocation perspective, Global SMID caps can provide additional portfolio diversification, complementing other growth options, such as Emerging Markets and Small Caps, while also helping mitigate some of the concentration risk that exists in Large Cap Growth allocations.
Additionally, the diversification that SMIDs can provide helps avoid, or at least dilute, other risks such as valuation risk in Large Cap Growth, and liquidity risk in Small Caps.
There are over 5,000 companies in the MSCI World SMID Cap Index, meaning there are many places you can go wrong – a really disciplined approach is vital when it comes to Global SMIDs.
Our investment approach starts with strict quality criteria, where we look for quality companies that can capture growth, but we also look to identify and avoid companies that are poorly managed, over-leveraged or have low profit margins.
In our view, avoiding the losers can be just as important as picking the winners.
To us, quality companies are those that possess the optimal combination of these six factors:
We conduct in-depth bottom-up research on an ongoing basis to form a view on each of the above areas, and if a company fails on any one of these six factors, we don’t consider them for investment.
We believe this definition of quality is “all-encompassing” in the sense that it captures all the key risks and drivers that are important to consider when investing.
We also have a strong valuation discipline in terms of the price or the valuation we're willing to pay. Great companies don't always make great investments, so we want to maximise our odds of making a successful investment by minimising the valuation risk.
When it comes to portfolio construction, we try and create a portfolio that has a balanced exposure across the value and growth styles, albeit with no exposure at the extreme ends of the spectrum. We won't include any unprofitable or excessively valued growth company and we won't have any deep value cyclical type companies either.
A lot of quality strategies or quality indices are heavily skewed towards growth, and while we certainly have good growth characteristics for the portfolio, our goal is to deliver more consistent returns over different market conditions, aiming to get that optimal combination of upside participation versus the downside protection.
The overall objective of our ‘quality at a reasonable price’ approach is to deliver those good risk-adjusted returns across different market conditions.
There are obviously different ways to define quality and every investment manager will implement their approach in a slightly different way. Two of the key areas where we may differ are in terms of our valuation discipline, and that we aim to have a more balanced exposure across the value to growth spectrum. By contrast, some quality-focused portfolios or indices can be heavily skewed to growth or a lot of the expensive ‘compounder’ types.
This means that in strong momentum-driven markets, like we've seen over the past year, some of these growthier quality approaches can do quite well. That said, we know that market conditions change over time, so there could potentially be some risk if there is a broadening in the rally across different types of stocks, or if you have a market pullback where investors become more sensitive to valuations.
Looking at passive, or index approaches, there are a few differences to keep in mind when comparing them to active approaches.
Passive strategies are typically built on indices that are quantitative-based and only use historical data. While historical data is important, we think it's just as important, if not more so, to invest based on projections about the future.
Additionally, in terms of the valuation aspect, most indices or passive approaches have little to no regard to valuation when being constructed. Adding the fact that some passive definitions of quality are narrower in focus, this can have the effect of concentrating a portfolio into stocks with similar characteristics, which means they can often be highly correlated.
The discount has persisted for a number of years, but we have a more constructive outlook on the economy now. We’ve navigated the pandemic, the war in Ukraine, inflation and rising interest rates, all of which have fuelled concerns about the financial stability of SMID Caps. With the threat of a recession, the profit sensitivity of the asset class has also been a concern for investors for some time.
During the pandemic many of the SMID cap companies within the portfolio implemented really stringent cost rationalisation plans, and they also focused heavily on cash generation to reduce debt.
So today, as an asset class, their balance sheets have the lowest level of debt in a decade. This means that they're well prepared for this higher interest rate environment. Also, in terms of cost discipline, it has given them really good operating leverage. In the more constructive economic environment that we're now in, this gives us confidence that they're going to be able to generate double digit EPS growth this year and probably in2025 as well. By comparison, we anticipate four or five percent EPS growth for all caps.
We're already seeing some positive signs in the first quarter earnings that are coming out right now. Results are confirming their ability to grow at this rate and if we continue to get strong reporting going into the second quarter as well, it could be the catalyst that helps reverse the discount that's persisted for the past few years.
If we see compound double digit growth and the closure of the valuation gap, it should be an asset class that starts to outperform again, like it has in years gone by.
Overall, we believe investors should consider adding global SMID cap equities to their portfolios, through a disciplined quality-based approach. The combination of resilience, adaptability, and growth potential makes global SMID cap equities a valuable addition to a well-balanced portfolio, with the possibility of outperformance in the coming years.
