John Weiler: Welcome to our webinar, TSME Portfolio Manager Discussion: Active Opportunities in small- and mid-cap equity. I'm John Weiler, your host, and I'm happy to be joined by Chad Miller, senior portfolio manager for Thrivent Small-Mid Cap Equity ETF, ticker symbol TSME. Today we're going to discuss opportunities in the small- and mid-cap space and how active management may help push beyond index performance.

We want to hear from you and have opened the webinar up for questions. Ask them at any time and we'll get to as many as we can. With that, Chad, welcome to that today's discussion. Looking forward to it.

Chad Miller: It's great to be here. Thanks for having me.

Weiler: All right. Let's dive right into discussing where TSME looks for opportunities. I know a lot of financial advisors like how TSME can increase efficiency in their portfolio construction by selecting one ETF that covers six equity style boxes. When it comes to market capitalization, what is the range of company sizes that you consider?

Miller: Yeah, great starting point. So, one of the advantages we have as a small- and mid-cap fund is we can fish in the small end of the market cap range, and then we can go all the way up to the higher end of mid-cap which nowadays is about $90 billion. So, we can start around $500 million or so. And we can move all the way up into, you know, borderline of large-cap. And so that gives us a really broad net to cast across and look for opportunities. The other thing we can do is move between value and growth. So, across those six style boxes where we see the best opportunities, we can dedicate more of our time to those areas.

And across all of that, a few of the things that we're looking for in our individual companies is a few of the things listed on the slide. So, we look for underappreciated companies, and a lot of times we define that as a company having a dynamic competitive moat. And so they have a number of different things where they differentiate in the business. And I think that's more valuable versus having just one or two competitive advantages that could be at risk of being disrupted over time.

We take a stakeholder analysis approach to the companies that we look for, and so we want to go through and see companies that have strong governance, a strong management team. They can create value for their employees and their customers. They understand the areas they are operating in and create the right structure for those companies. And what we believe is that those companies that create the most value through their ecosystem, that translates down to shareholder value over time.

The other thing we look for in a company is the talented leadership team, and the key areas that we try and dig into there are to find management teams that really drive a strong culture into the business. A lot of companies are very employee-centric nowadays, so that's their strongest asset. We want to see those leaders being long-term focused. And a lot of that that we try and analyze is what they're doing with their capital. So, where are they investing organically or inorganically? And what are the returns that they're going to get out of those investments? Because we know that as a long-term shareholder, the investments they're making today in the business are going to be our returns over the next three to five years. And so we want to see a company that really understands that area of their business and is making the right capital investments.

And then the last element we try and analyze when looking at a company is having attractive valuation. So, we like to do a lot of different scenario analysis when we're evaluating the companies and see if everything plays out well for them or to the upside case, what could that mean for the stock in the business and see how that flows through. And the flip side is we look at the risks. If there are areas of uncertainty or things that could change in the market, we want to see what that looks like over the long term. And we compare all of that up. We want to see the risk reward positively skewed, and we're understanding the risks in the company. And we believe that over time, if you're in the best risk/reward stocks that that should accrue to shareholders.

And so if we sum all of that up, if we can create a portfolio with companies that create value for stakeholders, they have a talented leadership team and we buy those that attract evaluation—that should be a strong set up for our shareholders over the long term.

Weiler: All right. That makes sense. Related to that is how does your team determine the best opportunities when it comes to evaluating growth value?

Miller: Sure. So, as we mentioned earlier, the big benefit of being able to look across the different style boxes, one of the tools that we utilize to help direct where we spend our investment time is what we call our valuation spreads.

And this measures the cheapest company relative to the average company in the benchmark. And when you see if spreads are closer to the dotted line on the middle of this chart, that's telling you that the spread is fairly narrow and that the cheapest company relative to the average company—there's not a significant gap there. So, in those times, you should lean to more higher quality companies that often have a growth tilt. So, they have some company-specific drivers where they can create value and grow over time. That's where we happen to be currently in the marketplace.

The spreads are fairly narrow when you look across the broader market, and one of the companies that we found fairly recently is a company by the name of Limbach. This is a company that's taken a different strategy from other competitors in the marketplace. They focus on mechanical, electrical and plumbing infrastructure on buildings. And so, what they've done is focus on the recurring revenue that goes on with maintaining and expanding building infrastructure, as opposed to chasing the new construction, large dollar contracts, but typically much lower margins. So, they're going in with the facility owners and the companies and understanding the critical infrastructure needs of that building. What's going to need to be maintained, repaired and upgraded over time and understanding their growth investments. And that's positioned them as a really unique company to grow with existing clients, to expand their footprint, and then also look for inorganic opportunities in the marketplace for companies they can bring in and bring their strategy to those acquired assets.

Weiler: Sure. All right. Interesting. Next let's, let's take a look at the recent market volatility in the rate environment. So, how are there certain areas, or are there certain areas, rather, in the market that look more attractive to add or increase exposure in TSME?

Miller: So, we try to be very opportunistic with volatility that we see in the marketplace. And we've got a few different frameworks that we try and utilize. We've done a couple market studies where we've looked at where, what drives value over the longer term. And what you find is that it's usually a small slice of the market that really compounds and drives value over time. And those companies tend to be more centered in four primary industries—typically industrials, technology, consumer and health care. And that makes sense intuitively to us because those sectors are more differentiated, they can scale. There's a lot of different market niches they can get into and drive value. The inverse of that being sectors that we’re underweight, like real estate, financials and energy, where those businesses are much more commodity focused. There's not as big of a differentiator. And a lot of those industries require a lot of capital to grow and outperform the market.

And so, the learning there for us is when we think we have one of those select compounders, we should invest and make that a strong weight in our portfolio and be willing to look through short-term volatility. Add if we think the risk/reward is positive. And it also tells us that since those winners are much more likely to show up in those four sectors, all else being equal, we spend more of our time focusing on those categories. So you'll see as the fund is positioned today. We're overweight, you know, three of those as you look at industrials, tech, consumer discretionary. And we think what we've been able to find there is a really unique list of companies that have exposure to lots of different end markets, lots of different drivers for them. And those are going to be stronger allocations versus some of the other industries where we're underweight.

So, as we see different events come up that present opportunities, we look to be adding to those types of names in the portfolio.

Weiler: Got it. All right. That makes sense. Now switching gears of the fun part, at least in my opinion, can you walk us through a more recent addition to TSME and tell us what you saw in that company that led your decision, and why it fits into your investment process?

Miller: Yeah. So one of the overall macro factors we've been following over the last three to five years is just the focus on labor in the importance of that, and especially in the craft labor side, where you have a lot of investment going on in the utility data center, aerospace and defense, specifically in the U.S., based on different policy changes and strategic initiatives by companies.

And so, we came across a company by the name of Universal Technical Institute. It's the largest trade school company in the U.S. And they've taken the strategy to identify where there are specific demands that are outstripping supply in the marketplace. In some of those industries we mentioned. And they partner with the largest companies that are in those industries. So, a Boeing or a car manufacturer or someone on the health care industry. Those companies are willing to come in and partner with Universal Technical Institute as they are training up their graduates. So, they'll eventually graduate and become employees of those customers because they see that as a critical strategy for the outlook of their success of the company. And so that's a company that has made an initiative to really invest in those trade schools. They're going to see significant growth over the long term. And the partnership opportunities are increasing by the day there.

So, that's a recent example of a name that we found that we think fits our process, where the company has a strategy to reinvest in the business and grow and creates a ton of value for their graduates that are coming through their program. And then the companies that they partnership with that are eventually hiring those graduates.

Another example is a company by the name of Modine that we've owned in the fund for a long time. And what we saw happening there was a new leadership came in, the governance structure changed, and it was a company that had done a lot of R&D investing in the past, but it was too wide and spread across a number of different industries. And the new management team came in, realized that they had great technical capabilities on the R&D side, but it needed to be focused. And so, they spun off some of the lower value areas within the portfolio, focused on the areas where they could really differentiate and drive value, with those being around HVAC and data center specifically. And so that has totally reshaped the company over the long term. And they continue to make organic and inorganic investments in the right areas where they have a specific right to win. And that's been a strong investment for the fund.

Weiler: Got it. Okay. It's always interesting to hear those specific company stories. I appreciate that. Next, what are the biggest factors that you see impacting your ETF in the foreseeable future?

Miller: Sure. So, as everyone on the webinar is aware, the markets have been fairly volatile over the last few months. And even looking back further. And so there's a number of factors that we see impacting the market in our companies. Those geopolitics. There are AI and what's happening on the build out there and the potential risk to some companies.

We're monitoring trade deals, you know, that could be in discussions and potentially occur in the next month or so with the U.S. and China and trying to understand how our companies are positioned for all of those factors. The way we approach all these different issues is to take it down to the company level and to analyze what this could mean if it gets resolved in a positive fashion. And what are the risks if it, if we don't get a trade deal, for example, do we have companies where their success is really dependent on that? Those cases, we probably will look to move away from those companies. But I think in general, we just want to understand the impacts of these different factors. And if the risk/reward is still positive on the individual company basis, as these issues come up, we could see volatility then backs our companies.

If we understand and are still confident in the next three to five years, we use that volatility to add to our highest conviction opportunities.

Weiler: Got it. Okay. All right. I noticed I heard two letters. So, let's expand out one of those big factors. Those two letters are AI. We'd love to hear a little bit more on that. So, it seems like you and your team have really leaned into that AI space, and it's already provided some nice alpha. Can you share maybe a little bit more with us on the structural tilt TSME has made into the early AI winners, and the impact they've made on your ETF already?

Miller: Sure. So, I think one of the benefits of our process with trying to focus on strong leadership teams is you let the leaders find opportunities where they can in the marketplace. And we've had a number of companies that maybe didn't have a ton of exposure to AI, but when they realized the trends that were happening and saw the growth coming through, they really focus on that a lot and realized that they had a differentiated offering and went into that to drive out growth in that sector.

So, I think as we focus on talented leadership things, that's kind of a proof point of that. If you own those companies, they're going to get you into the best markets over time. And what we've seen in AI is we've focused on companies that can benefit from this build out in the near term. We've done a market study trying to compare what we believe are our AI winners relative to the benchmark AI winners, and see what the exposure is there.

We compared a lot of different business models, correlations, holdings across different AI indices to see how much AI exposure is in the benchmark. And if you look at our fund relative to the benchmark, we're a little bit overweight AI winners at this point called 300 to 400 basis points. We think the important point within that is that if you look at the profitability, the returns, the free cash flow of our AI winners relative to the benchmark, we, we hold much higher quality companies.

So, they're in a better position. They're less speculative than some of the initial AI winners, and they have a strong management team and strategy to outperform the market. So, if AI cap-ex is up 5%, they should be able to grow that. If it's up 20%, they should have a strategy to outgrow that. And so, we're comfortable with the high level analysis. We've done our exposure and then bringing it down to the company level, those individual companies that we own there. And some of the factors we’re watching to monitoring the direction of cap-ex, and AI, is really focusing on the scaling laws of the new models that come out weekly, even daily at this point, to see if those models continue to improve over time. That just increases the TAM that those players can go add over time, where if you look at version one, it was somewhat limited. Now as you look at the massive improvements they've made in a very short time, the TAM and the business that they can go offer and disrupt overtime is just increased dramatically. So as long as we see the scaling laws continue and then we see that to flow through into the hyperscaler revenue, we think there's a decent chance that the cap-ex continues in the near term.

Weiler: Wow. Yeah, it's interesting and very exciting. Obviously we're reading about that all the time in the news. So great to get to your perspective on that. Let's switch gears over to our submitted questions from listeners. First one comes from Scott who's asking, how do you view short term rates set by the Fed and the impact that it has on your fund?

Miller: Sure. So, I think our biggest direct exposure from rates is probably on the residential housing construction industry. And we do have a fair number of companies that are tied into that industry. We've done the same thing we did with AI, where we compare our exposure to the bench and look at those individual companies and make sure that we're comfortable with that exposure.

And I think our focus has been a lot more on finding those companies who can drive growth, irregardless of what the end residential construction market does. So, they have companies that can outgrow the market based on their value proposition. They might have some price. They might be able to do inorganic acquisitions of competitors are facing pressure with construction being relatively low.

So, we think we have a collection of companies that have a strategy to outperform irregardless of rates because of those companies’ specific drivers. And then we do the scenario analysis to make sure that risk/reward is positively skewed for those individual companies. So that's our approach. If rates go up a little bit, we believe most of them still have a strategy to perform that.

And certainly if rates do continue, their steady march down like we've seen looking back over the last 12 months or so, these companies will all be beneficiaries.

Weiler: Sure. All right. Yeah, that makes sense. All right. Next, we have Phil wanting to know, do you have a requirement to maintain a certain amount of exposure in mid- and small-caps.

Miller: Yeah. So as we touched on a little bit earlier, one of the benefits of the fund is just not having many hard restrictions. We can go where we see the best value. That's applicable to this question as well, where we don't have any hard restrictions to say, ‘you need to own X in small and X in mid.’

And so, that gives us the flexibility to go where we see the best opportunities for shareholders, which I think is the ultimate goal of any investor to get active investor, to get our shareholders in the best opportunities over the long term. And so we've had a number of names that we've owned since the inception of the fund, and what we're able to do is identify a small- or mid-cap company that we think has a really long growth runway, and we can stick with that company as it moves up from the small-cap into the mid-cap.

One example of a company that fits well into that is Quanta Services, which is a company that realized a long time ago the importance of labor and skill in the utility industries, where you saw, due to budgetary pressure and cost constraints on the utility customers, that they weren't able to invest in the training and development programs that were required to understand the growth outlook of their companies.

Quanta went in and actually acquired one of the largest craft labor training companies in the USA. And so they're really have become the largest trusted partner to utilities as they look to build and expand their grid to meet increasing energy demand. And that's a company where we've started as a fairly small company and has grown up into near and upon large-cap today.

Weiler:  Interesting. Quanta. All right. Love those those holding examples. That's great. Let's see. We've got another question coming in here. This one is how do you how do you manage volatility in the market, especially based on the recent geopolitical events? I know you kind of touched on this earlier. Maybe elaborate that on a little, a little bit would be great.

Miller: Yeah, it's a great topic to talk about. And I think it's important for shareholders to understand that one of the benefits as an active manager in the public markets is you get to take advantage of volatility. And so, when we see those opportunities arise in the marketplace, as a long-term investor, we do a lot of scenario analysis to understand what is causing that.

And we certainly need to re-underwrite the thesis and understand, is it broken or something changed or are they not going to be able to drive value? But if we're in higher quality companies that have a lot of differentiation, oftentimes they can use this volatility or difficulty in the marketplace to become even stronger. So, they have a strong balance sheet, have strong profitability. They might be able to invest organically in their business. They might be able to take out a competitor.

And so, as you look at the success of the fund to date, one of our big ways we've driven value is to lean into when we get volatility. You saw it about a year ago to the day on Liberation Day, with the tariff news coming out and the uncertainty around that and a draw down in the marketplace, and really we were able to go through and talk about on an individual company basis, are they strong enough to get through this, even though there's uncertainty in the near term?

And largely we found the answer was yes. And so we took the opportunity to upgrade the portfolio, shift into some of our highest conviction names. And that's been one of the big growth drivers of our performance inception to date. So that's really how we approach volatility. And I think that, you know, investors should think about that as a time where we really, active management is important for that reason to take advantage of those market environments.

Weiler: Right okay. All right. Got some more questions coming in here which I love it. Joe has a comment here. I believe this fund used to have an ESG focus. Do you have any ESG focus with your investment now?

Miller: Yeah. So we still have a lot of focus on the governance. We think that is very important to long-term success. You want to see companies with the governance structure that works for them. It doesn't have to be universal across different companies, but a governance structure that is, you know, understanding the risks and opportunities and driving the right value over the long term.

And then we tackle, you know, environmental and social within our stakeholder analysis. So, we're considering the impact on the employees, the customers, what kind of value they drive, how are they partnering and how are they seeing in the communities that they do business in?

And so that's our approach to, you know, some of the topics that might fall within the ESG. We focus a lot on governance. And then we understand the stakeholder impact, and we want to see companies that can address those risks. And then also where things are changing in the economy, they can identify opportunities where they can drive value.

Weiler: All right. Our next question comes from Heather. Heather's wondering can you comment on the benefits of active versus passive management, particular in the SMID space?

Miller: Yeah, that's a great question. So, what we've seen historically in SMID is that number one, it's been an attractive asset class to be in. If you look over the long-term the returns have been in the low double digits, which is very competitive when you look at all investing options.

So, that's a great starting point to be. You also see that that is a somewhat less efficient area of the market. Just because it gets less focus and there's less active management than on the large-cap side. So, you see inefficiencies that come up over time. The other benefit is some of the topics we've looked at earlier. You can find those companies that really have a long runway and differentiator with. That's where you get the opportunity to compound value over time.

So, I think all of those factors blend together to make SMID a pretty rich target area to invest in. And our reason why we're excited about TSME having active management in that space.

Weiler: All right, all right. That sounds good. Great conversation. We are at time. So, I want to first of all thank Chad again for joining us today to talk about small- and mid-caps. And thank all of you for joining us. If you want to continue the conversation, please reach out to your Thrivent Asset Management sales consultant or learn more at fp.thriventfunds.com. Thanks again and have a great day.