Severson recently answered a few questions about why he remains committed to the mid-cap sector:
Institutional investors are often under invested in mid caps. Why is that and why should institutions have dedicated mid cap exposure?
Traditionally, pension consultants guided clients to own small and large caps and assume clients would end up with some mid caps at the top end of small cap portfolios and the low end of large caps. The problem is these investors don’t get dedicated mid exposure, especially in the sweet spot of $3-10B. Mid caps represent 30% of the market, but our experience has been that institutional investors average only 10%-15% of portfolios in mid caps.
We believe this is a mistake. Many mid cap companies grow at rates well above GDP growth. Most are profitable and demonstrate rapid earnings growth and margin expansion. Their cash flow can fund new growth, leading to higher quality earnings than you might find in smaller, less mature companies. Also in more difficult times, they are more durable. They don’t have to make radical changes to what they do. Post 2008, many of the companies we owned continued to hire management talent, open stores or spend on R&D.
How do you screen to find companies that meet your growth targets?
Our focus is quality growth, which translates into companies that have durable and sustainable advantages. This limits our universe to 350-400 companies. Given our team has covered the mid cap space for a significant amount of time and have researched the sectors for much of our career, we already have good familiarity with this universe. We also review the benchmark on a regular basis. Combine these factors with our ability to leverage research analysts, investment conferences and management visits, and we are able to find high quality companies. From this, it is important to review, where we have exposure and where we don’t. We ask ourselves if there are other ways to enhance a sub industry that is working. We also look at industries we aren’t invested in for reasons why our thesis might change.
Your strategy is well diversified relative to the index and you own most sectors. What is your strategy?
We first look for individual companies that meet our tests of quality, durability and growth. Then, we look at the benchmark and consider diversification – both at the sector and subsector. We want to make sure we include companies that provide a different demographic or a different geographic exposure. At the sector level, we tend to have a philosophy of “leaning” and not taking big positions to help control risk; typically, our sector positions range from 75% to 125% of the benchmark weight.
We remain widely diversified because we don’t think we will get good risk adjusted numbers by making big sector bets. Instead, we seek alpha from stock selection by finding the best growth stories. We may moderate our position sizes if headwinds are too strong, but try to stay involved with good businesses over the long term.
What is your “Tier Board?”
My partner Doug Guffy developed what we call the “tier board.” We use it to help with risk control by separating the weight of portfolio positions into three tiers based on conviction and fundamental prospects. New positions typically start with a small weight, usually 1%. We will add capital based on strengthening fundamental performance and support from key tools we employ that add an element of objectivity to our process. My co-manager, Ken Hemauer and I review every stock in the portfolio weekly and assign it to one of the tiers with the input of the sector analyst. For risk control, the reverse is also important – we may choose to move a stock to a lower tier by harvesting capital from a position that is facing near-term headwinds, but remains a long-term winner.
Discuss a few representative stocks in the portfolio.
Stericycle, Inc. (SRCL) is a medical waste disposal business. They collect anything that can’t go into a landfill and must be treated before disposal. We believe this company has a very durable business and represents a long-term secular opportunity. The industry has high barriers to entry. They’ve added some new services to maintain a mid-teens growth rate. Further, they plan to grow globally and have made acquisitions in Europe and are looking at Japan making the growth potential much more open ended. Yet even though Stericycle is a great business, there are times when it isn’t going to be a great stock. Back in 2008, the stock actually went up, but at other times may face weaker performance. Our goal is to invest as much as 3 ½% when we have a tailwind and reduce our position to 1% during weaker cycles, thus holding on to a good company at a much lower exposure.
Fastenal Company (FAST) came public in 1987 as a supplier of fasteners and other industrial supplies. They have the attributes of a retailer with storefront locations but are also tied to the industrial economy. They relentlessly remake themselves adding new SKUs, additional sales people or new inventory technologies. Managers are given flexibility to recognize customers unique to their market and customize the store to reflect local demand. They have a strong sales culture, unusual for a distributor, and try to maximize sales per box. Fastenal regularly has same store sales 2-3 times normal retail rates.
Oceaneering International Inc. (OII) provides specialized services for E&P customers. They are one of only a few companies globally with a fleet of any size providing critical and specialized service in harsh conditions, miles below the ocean floor. We believe they have a great business with defendable margins.
You tend to hold companies a long time. Discuss a few you decided to sell?
Paychex Inc. (PAYX) we owned for a very long time and sold when growth slowed. The company’s growth rates were above average given strong secular growth. But ultimately it got big enough that they maxed out their growth potential; their secular growth rates begin to decline, hurting multiples. Not every company will become Apple. Most companies will peak.
Cintas Corporation (CTAS) is another company we owned and sold when their business became more cyclical. They very effectively penetrated a lot of the market. In order to grow, they moved into some ancillary services with some success. But these investments changed the nature of the company to be more of a cyclical versus a secular grower, and we thought the growth opportunity was more limited.
With the economy improving, are you buying more cyclical plays?
We have a 15% overweight in industrials and a slight overweight in energy. We believe the US manufacturing renaissance is real. The lift from housing might also help. We own housing HVAC distributor Watsco, Inc. (WSO). We also like Regal Beloit Corporation (RBC) as both a manufacturing and housing play as they make motors for both HVAC and industrial applications. We believe the double whammy of rising home prices and 401k account balances could also support investor psychology.
About Chuck Severson, CFA
Severson has over 25 years of investment experience. He is currently a Senior Portfolio Manager on Baird Investment Management’s mid cap growth product. Severson earned a Master of Science Degree in Finance in 1987 and BBA degree in 1982 from the University of Wisconsin – Madison where he was a member of the Applied Security Analysis Program. He earned the Chartered Financial Analyst designation in 1991. Severson and co-manager Ken Hemauer manage more than $500 million in institutional separate accounts and the Baird MidCap Fund.
Baird is an employee-owned, international wealth management, capital markets, private equity and asset management firm with offices in the United States, Europe and Asia. Established in 1919, Baird has approximately 2,800 associates serving the needs of individual, corporate, institutional and municipal clients. Baird had more than $100 billion in client assets on March 31, 2013. Committed to being a great place to work, Baird ranked No. 14 on FORTUNE’s 100 Best Companies to Work For in 2013 – its tenth consecutive year on the list. Baird’s principal operating subsidiaries are Robert W. Baird & Co. in the United States and Robert W. Baird Group Ltd. in Europe. Baird also has an operating subsidiary in Asia supporting Baird’s investment banking and private equity operations. For more information, please visit Baird’s Web site at rwbaird.com.
Mid-cap companies may be hindered as a result of limited resources or less diverse products or services and have therefore historically been more volatile than the stocks of larger, more established companies.
Past performance is not indicative of future results. The Russell Midcap Index measures the performance of the 800 smallest companies, by market capitalization, in the Russell 1000 Index. The Russell 1000 Index measures the performance of the 1,000 largest companies in the Russell 3000 Index. The Russell 2000 Index consists of the smallest 2000 companies in the Russell 3000 Index. Indices are unmanaged and are not available for direct investment.
Robert W. Baird & Co. makes a market in the securities of the companies referenced.
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