Talking with a Thrivent fund manager about why the ‘little guys’ are worth our attention.
Coming up, we learn why small caps are becoming an increasingly attractive investment option.
From Thrivent Asset Management, welcome to episode 51 of Advisor’s Market360™. A podcast for you, the driven financial advisor.
Two episodes ago, we explored the small- and mid-cap area of the market by talking in-studio with two of Thrivent’s fund managers who work in this space. As the current bear market slogs on, we want to think ahead and prepare for the eventual rebound. And as history shows us, small- and mid-cap stocks have tended to lead the market in performance during recoveries.
That’s why we continue our exploration of this segment today by delving into Thrivent Small Cap Growth Fund and having an encore discussion with senior portfolio manager Michael Hubbard. Listen on to learn about how he and team work together to select stocks and the potential difference that active management may make in uncovering the value of small cap stocks.
We decided to start with the basics by asking Hubbard what the goal of the Fund is.
“The short answer – the goal of the Small Cap Growth Fund is to drive alpha through stock selection.”
That description, while short and to the point, belies the difficulty of consistently outperforming the benchmark for the small cap sector of the market. To earn excess returns, a fund manager must have strict discipline and a well thought out strategy. So, what is Hubbard’s philosophy on investing in the small cap market and what is his strategy for researching and selecting stocks for the fund?
“Small cap growth is a really exciting universe because it is a group of companies that are looking to and working to reshape the world and that have the potential to do that. And most innovation and disruption that we end up seeing in the economy and in the country grows out of the small cap growth universe. So, to invest well in this universe, it's a very dynamic universe. We really focus on getting three things right, and our diligence centers around these three things. And the first is what is the real TAM of the company? What is their addressable market?”
When Hubbard uses the term TAM, he is referring to the “total addressable market” for a product or service. So, with TAM being the first thing considered, what are second and third things the team looks at before including a stock in the fund?
“The second thing we focus on is, what's the company's competitive advantage and is it sustainable? We spend a lot of time and resources verifying this, talking to customers, talking to competitors, talking to suppliers, talking to industry experts. And that is a key component of our research. The last piece that we focus on is, what is the return on investment, or ROI, to the company's end customer?”
Hubbard provided some additional context about why his team places so much importance on ROI and a company’s ability to scale up.
“Typically, especially in constrained budgetary environments, the highest ROI projects filter to the top, and the more value you're delivering to your customers, the stickier you're going to be. And so, if you're delivering a lot of value to your customer, they're unlikely to switch just because a competitor offers them a 10% discount. Right? So, it speaks to the scalability or acceleration in growth and the longevity in growth. So, that's the third piece that we focus on in our diligence, is understanding the return on investment to the customer, the value that the company provides to their end customer through their products or services.”
During this discussion of diligence, Hubbard touched on another, less tangible idea and that is stickiness. For our purposes, you can think of stickiness as being a product or service that once used, is hard for the customer to stop using. As an example, Hubbard cited a company called Workiva which is the fund’s largest holding.
“So, what they do is they've created a platform that connects to all the disparate systems that a company might have: their ERP, their CRM, their inventory management, and it also connects to all their office tools that they use for reporting. And so basically, it's a reporting platform that is fully auditable, so that instead of – before Workiva, to put out a 10-K or even if you're a private company, to put out your quarterly report to your investors, you would pull up the Word document, you would go through, you would change 1Q to 2Q. You would change the growth rates. You would change all that stuff. So, Workiva sits in the background and plugs into all the areas that you would get that information. And then it pulls that data dynamically in so that the report generates itself with the updated data. So that becomes very sticky because you're saving a massive amount of man hours and manual labor, and it's fully auditable.”
The stickiness of Workiva means that even if a competitor tries to steal customers by being 10% cheaper, the amount of work required to switch providers makes it unlikely for a company to do so.
Later, we’ll circle back later with more stock examples.
Next, we wanted to get Hubbard’s take on the potential of small cap growth stocks going forward and why he thinks this sector of the market has been transformed by technology.
“There's a couple of things I want to touch on here. So, first is, there's greater growth potential with new technology that is significantly eroding large companies’ competitive advantages. And so, the easiest way to think about that is, if I wanted to start Workiva in 2001, I would have to come up with that idea. I would have to go raise a bunch of money and hire an IT staff to go, and then I'd have to go buy servers, find someplace to put them, pay my IT staff to set up all these servers, and then start running my business and hope that it works out. Today, if I wanted to start Workiva, I come up with my minimum viable product, I swipe my personal credit card on AWS for $20 a month, and I'm up and running and can focus on product development and selling to customers.”
In case you aren’t aware, AWS stands for Amazon Web Services, one example of a cloud storage provider that provides a foundation for many modern web-based businesses. He continues by contrasting the ease of starting a new business with the situation faced by many larger, existing companies.
“So, it's a much different environment for starting businesses. And with the proliferation of tech, existing companies are carrying increasingly larger loads of tech debt. Even the older tech companies have legacy systems that are less efficient, and they have to figure out how to integrate into the new systems and new tech that's coming out. The cloud – as I've mentioned in my example – the cloud democratizes scalable infrastructure. And then Moore's Law continues to provide improved compute, storage, compute and storage at increasingly at equal or lower costs going forward. So, all these technologies allow companies to pursue new ideas, test their products, without having to make large investments in computing, support staff or office infrastructure.”
Something that’s core to Thrivent Asset Management’s investment ideology is active management. What kinds of advantages does hands-on, active management have in the realm of small cap investing? We briefly touched on this with Hubbard.
“Ideally, an active manager should be able to invest in the best companies in their universe and avoid the worst, which should lead to returns above the market or the index over time. And so, for an active manager to do that consistently, I think it comes down to three things: one is patience, two is people, and three is process. And we're very fortunate at Thrivent to have institutional and capital patience. That strong financial position and the returns that we've generated historically have attracted really smart, high-quality people. And we have a very consistent process that each team employs a little bit differently. But overall, it's drive alpha through stock selection and manage risk on the back end. And so I think that's what gives us an advantage over passive and over our peers as well.”
As previously mentioned, we’re now coming back to more examples of stocks. We asked Hubbard for a couple more names that he’s added to the Fund recently along with the reasons for picking these particular companies. The first comes from the food services sector.
“One is beverage company Celsius. So, they make energy drinks, compete with Monster. They've created a much healthier energy drink that doesn't have sugar, doesn't have artificial flavors, doesn't have artificial sweeteners. And they actually have some health studies that demonstrate that it helps you lose weight, boost your metabolism. It's positive for your body. And then they just last year signed an agreement to distribute through the Pepsi distribution network. So, now they're getting rolled out to college campuses, to hospitality, hotels, restaurants. So, it's a classic growth story of a great product, large TAM, value to the customer.”
The next name Hubbard discussed is from the health care sector, a company called Lantheus. The journey to owning this name in the Fund was an unconventional one.
“Their main business when we first started looking at the company in 2020 was a PET scan imaging agent, primarily for echocardiograms. Prospects for future growth seemed poor. About a year later, it showed up on our screens again, we looked at it again. In the meantime, they bought a biotech company and massively diluted their existing shareholders by issuing equity to pay for that deal. But they had gotten a pipeline of products, one of which was in late-phase three for radioisotope imaging agents. So now instead of a PET scan, you're doing a CT, you use their imaging agent, which is called Pylarify, to see. And it's primarily used for identifying cancer, primarily prostate cancer. And we looked at that and we said, okay, we're paying a fair multiple or fair value for their base business, which doesn't grow a lot, but generates a lot of cash. And we have optionality, if anything, in their pipeline works of this biotech company that they bought. And sure enough, Pylarify came to market on time. It ramped much faster than people expected. It's done exceptionally well since their launch.”
We asked for one more recent example of a stock that has performed well for the fund to wrap up. Hubbard offered up Kinsale Capital Group.
“So Kinsale is a specialty excess and surplus specialty insurance carrier. They built a better underwriting platform on a modern technology stack. And so, they can price risk better and faster than any of their competitors and at a much lower cost. They underwrite better than anyone else. So, they're they don't have reserve development, and their loss ratio is better than their peers, and then they do that with a much lower expense load than their peers as well. So, their total combined ratio is industry leading, and their growth has been significant because they're a small player in a very big market, and they're able to gain market share more efficiently given their proprietary and scalable tech stack. It wasn't cheap when we bought it, but it's a high quality company, so it’s been able to deliver significant return despite not being cheap when we bought it in the traditional sense.”
Thanks again to Michael for giving us a better understanding of how Thrivent Small Cap Growth Fund is run and how he and his team work together to take advantage of the unique opportunities available in the small-cap sector.
Thanks for listening to this episode of Advisor’s Market360™. All episodes are available on Apple Podcasts, Spotify, and Google Podcasts. Email us at firstname.lastname@example.org with your feedback, questions and topic suggestions for future episodes. And as always, you can learn more about us at thriventfunds.com and find other insights of interest to you, the driven financial advisor. Bye for now.
All information and representations herein are as of May 23, 2023, unless otherwise noted.
Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.
Past performance is not necessarily indicative of future results.
As of March 31, 2023, the top ten holdings of Thrivent Small Cap Growth Fund were Workiva at 2.79%, Everi Holdings at 2.65%, Lattice Semiconductor at 2.65%, e.l.f. Beauty at 2.63%, Sprout Social at 2.55%, Inspire Medical Systems at 1.99%, Licoln Electric at 1.90%, WillScot Mobile Mini at 1.87%, Progyny at 1.81% and Skyline Champion at 1.80%. A complete listing of the holdings for the Fund is available at thriventfunds.com.
There are risks involved when investing in the fund. Smaller, less seasoned companies often have greater price volatility, lower trading volume, and less liquidity than larger, more established companies. The Fund’s value is influenced by a number of factors, including the performance of the broader market, and risks specific to the Fund’s asset classes, investment styles, and issuers. The Adviser's assessment of investments may prove incorrect, resulting in losses or poor performance. Securities markets generally tend to move in cycles with periods when security prices rise and periods when security prices decline. Common stocks of companies that rely extensively on technology, science or communications in their product development or operations may be more volatile than the overall stock market and may or may not move in tandem with the overall stock market. These and other risks are described in the prospectus.
Investing involves risks, including the possible loss of principal. The prospectus and summary prospectus contain more complete information on the investment objectives, risks, charges and expenses of the fund, and other information, which investors should read and consider carefully before investing. Prospectuses and summary prospectuses are available at thriventfunds.com or by calling 800-521-5308.
Thrivent Asset Management, a division of Thrivent, offers financial professionals a variety of investment products to help meet their clients’ needs. Thrivent Distributors, LLC is a member of FINRA and SIPC and a subsidiary of Thrivent, the marketing name for Thrivent Financial for Lutherans.