We talk with investment team leaders about how they’ve delivered competitive performance in the small- and mid-cap space.
Thrivent Asset Management has a strong track record in the small- and mid-cap space, and today we unpack how the investment team works together to drive performance as we speak in-studio with two of Thrivent’s fund managers.
From Thrivent Asset Management, welcome to episode 49 of Advisor’s Market360™. A podcast for you, the driven financial advisor.
Today we are excited to have two very special guests from Thrivent’s investment team joining us on the podcast: Graham Wong, CFA and Mike Hubbard, both Senior Portfolio Managers who work on different funds in the small- and mid-cap space.
Host: Welcome to the podcast gentlemen.
Hubbard: Great, appreciate being here.
Wong: Thanks for having us.
Host: We appreciate you both taking time out of your busy schedules, so with that, let’s jump right in. Which funds do you work on, and how long have you been in your current role? Graham, we’ll start with you.
Wong: Yes, so I'm on [Thrivent Mid Cap Value Fund]. The fund was launched in March of 2020, so a little over three years. Prior to that, I was on [Thrivent Large Cap Value Fund] for over six years.
Host: Nice. And how about you, Mike?
Hubbard: I work as the lead manager on [Thrivent Small Cap Growth Fund] and a co-PM on [Thrivent Mid Cap Growth Fund]. I moved to these roles in the fall of last year. I’ve been at Thrivent for about five years now and started as a portfolio manager on [Thrivent Small Cap Core Fund].
Host: Great. Let’s talk about the market. It seems that many of the trends we saw in 2022 have persisted into this year, such as volatility and inflation. Do you see more or less of the same as we look forward to the rest of 2023?
Hubbard: With the current level of business uncertainty and the [Federal Reserve, or Fed,] continuing to increase rates and reduce its balance sheet, it's unclear by how much and how long the economy will be impacted. However, we know that investor sentiment tends to swing a lot faster than the actual economy fluctuates. And these swings can create opportunities for us as investors. So, regardless of the market environment, there are always great opportunities to find quality small-cap growth companies, and we're really excited about that.
Host: Thanks. Graham, do you have anything you’d like to add?
Wong: Yeah, I think our focus is a lot on inflation. We think inflation this cycle is really structural and that's driven by a few things.
One, the tight job market, which is because of demographics aging and also the lower participation rate.
[Two,] the de-globalization trend, which is due to political fears and supply chain fears, and also higher offshore labor costs. So, we have companies moving back to the U.S. While that's good for many companies, that's really bad for inflation. Cost is going to go up.
Lastly, spending on renewable energy. We're spending a lot of money on infrastructure which means we're gonna need a lot of steel, copper, aluminum – and by the way, those things are very energy-intensive to make. So, during this energy transition, we're going to actually have higher commodity costs and higher energy costs.
Host: Okay. The chance of a recession later this year or next is certainly something that our listeners have on their minds. The Federal Reserve, or Fed, has continued to raise rates this year in an effort to tame inflation. And we’ve heard they are willing to risk recession in their battle against inflation.
Graham, what do you think the chances are that we see the economy dip into recession later this year?
Wong: Right. So, we're bottom-up stock pickers. What that means is that we don't make large macro bets. What we do ask is where we are in the cycle right now, and how should we position with the companies that will be better in this part of the cycle.
So, a few things. Right now, we think we're late [in the] cycle. We have an inverted yield curve that usually is a recession signal. We have inflation that is very high – highest since the early 80’s – which means there's high risk of the Fed making a policy mistake. And then lastly, we have the bank and the commercial real estate sectors [which are] really suffering because of the high interest rates, and they could be the two sectors that lead us into recession.
Now, with all that said, the market tends to lead the economy, and right now a lot of downside is priced in. We think a soft recession is likely priced into the market already.
Host: Okay. Mike, are you more or less on the same page?
Hubbard: Yes. I tend to agree with Graham. One thing I'd like to add and point out is the unprecedented levels of fiscal and monetary stimulus that were injected into the economy through the pandemic.
To put this into perspective, the Fed's balance sheet was roughly at $1 trillion [before the Great Financial Crisis]. They took that to $4.5 trillion over six years, so $3.5 trillion added to the balance sheet over six years to combat the Global Financial Crisis. When the pandemic hit, they took their balance sheet up by $5 trillion in less than two years. And on top of that, you had significant fiscal stimulus. So, what this led to is a large expansion in asset values and incomes, which drove demand. At the same time, you had the pandemic driving supply shortages, and that combination led to the inflation that Graham mentioned earlier. So, the Fed can't fix supply chains. But the Fed can raise rates, withdraw capital from the system, until they destroy demand that's creating that imbalance against the broken supply chains and the shifting supply chains that Graham mentioned.
Host: Okay, thank you. So, whether we have a recession or not, eventually there’s going to be rebound, and we want to equip our audience with what they need to stay ahead of the game. Historically, we know that small and mid caps have tended to lead the market during recoveries.
To lay the foundation, I’d like to first ask: what exactly gives small and mid caps the extra “buoyancy” that could give them an advantage over large caps during market rebounds? Graham?
Wong: You're completely right. Small caps have led recoveries. They've led it the last three down cycles and their recovery. The reason is, there's a higher percentage of small caps that are not in that stable cash flow stage yet compared to large caps, so they tend to be more economically sensitive. My second point would be, smaller companies tend to rely more on financing to grow their business. In a recovery where lending is loosening and interest rates are lower, small caps tend to benefit more in that environment, so we expect small caps to lead in the recovery as well this cycle.
Host: Knowing the track record of your teams and your funds in this space, Mike, can you tell us what exactly do you look for in investment opportunities? Specifically, the qualities you look for as you analyze stocks.
Hubbard: Absolutely. The growth universe is full of amazing and innovative companies that have the potential to change the world. And often these companies consume a lot of capital as they build their products and scale their organizations. These companies also have high valuations driven by the potential for world changing, life changing results in the long term.
So, in this universe, it's important to get three things right. First is, what is the real TAM, or the target addressable market, that the company can go after? And this is not what management tells us or what some consultant puts on a slide deck; this is real bottom-up analysis that we do and focus on every day. We spend a lot of time here.
The second key is, what is the company's competitive advantage, and how sustainable is it? And again, here we spend a lot of time talking to customers, we talk to competitors, we go to industry trade shows, we talk to industry experts. And this is one area where Thrivent's resources really pay dividends for us to afford us the opportunity to do that level of research on a company's competitive advantages.
The third piece is, what is the ROI to the end user? In other words, how much value is that company providing to their end customers through their products or services? And this answers two questions: how fast can this company scale their products or their services? And how durable is the growth, or how sticky are their products or services, right? Because high return-on-investment projects are always going to rise to the top of the list, especially in uncertain economic times. And if a customer is happy in generating a lot of value from a product or service, they're less likely to risk switching to something else that's unproven, even if they can save a little bit of money.
So, that speaks to pricing power and the durability of growth for these companies. That's really what we focus on in a growth universe, making sure that we're getting those three things right.
Host: Mike, where do you see opportunities and risks? If I could add, since we typically lump the small and mid cap segments together in conversations like this, I’m curious to hear what nuances separate them, especially since you work in both segments.
Hubbard: Absolutely. In small-cap growth, we're always looking for disruptors and innovators – the next set of ingenious founders and companies.
Right now, Covid put a massive amount of stress on the healthcare system in the U.S. and globally. And so, we're seeing some interesting companies in [the small-cap space] that have come up with better ways to reduce stress on the healthcare system, reduce costs, make patient experiences better, improve quality of outcomes.
Additionally, you saw a huge benefit to software company valuations through the pandemic as people went remote and [started working] from home. A lot of that's come out as interest rates have come up. And so, we're starting to see some opportunities in software to pick up some high-quality software companies at more reasonable valuations.
In terms of small versus mid – I think Graham touched on it earlier – mid-cap companies by definition tend to be more stable. They've been around, they've graduated up into a higher market class. Most of them have been through multiple economic cycles. You know, we deal with – in small cap – a lot of companies that were just formed a couple years ago or even less than a year ago.
So, our universe turns over a lot because not every small-cap company makes it to “mid-cap land.” Obviously, a lot of them either stay small cap forever or a lot of them go away – in particular, in the growth universe. So, I think that's one of the main differences, which again, Graham touched on earlier.
Host: Okay. Besides market cap, another dimension to the investment focus we see across our funds is the growth versus value spectrum. Is there a significant gap between growth and value stocks when we’re looking at who might lead the pack during a rebound?
Wong: Between the value and the growth sector is the makeup of the sectors. The value funds and benchmarks hold a lot more cyclical sectors such as Financials, Materials, and Energy. So, historically, in an early recovery, the value benchmarks and sectors tend to have a little bit more upside.
The other point I would point out for this cycle is that the banks make up a large percentage of the value benchmark, and the banks have been an outlier to the downside so far – year to date, the bank group is down 20%. So, in an environment where interest rates are lower, that really alleviates the pressure to the banks – we could see a larger rebound in the banks that would benefit the value sector.
Host: Okay. Let’s talk more about your talented investment teams. As we consider what sets Thrivent apart, it’s clear that the team is a big part of that. Not only because of how you collaborate, but also the breadth of experiences and backgrounds represented.
Mike, what are your thoughts on the benefits of such diversity?
Hubbard: I think diversity is critical to our process, and I think what sets our process apart from others is that we approach investing like scientists who are conducting experiments. So, we come up with an investment hypothesis and then we go out and we look for disconfirming evidence. And disconfirming evidence can often be more influential and useful, and you often learn more when you take that approach. And if you talk to any scientist that conducts experiments, they will tell you that they learn the most from the experiments that didn't work out how they thought.
And so, diversity of thought and background is key in that because you're constantly pushing back and saying, “What are the risks? What are the downsides? What are we missing? How could this go wrong?” It keeps us from the opposite of the spectrum, which is the confirmatory bias. A lot of investors will look at a company, they'll come up with a conclusion – “This is a good company. I want to own it.” And then they'll go out and subconsciously find confirming evidence of why that it's a good company and [why] they should own it.
If you don't have diversity in that pushback of thought, you can end up – everyone ends up falling into the confirmation bias, which leads to groupthink in some cases, and you can end up owning companies and not realizing or appreciating what the downside risks are.
Host: Thank you. Graham, your thoughts?
Wong: Yeah, the only thing I would add here is that we also have a group of investment professionals that have a diversity in terms of experience and expertise. So, for example, we have a very strong senior analyst group – many of them have more experience than the portfolio managers themselves, and they are sector specialists. For example, Dave Heupel is our specialist in Health Care. Now, supporting them, we also have a group of junior associates who are younger, but they're hungry and they're being trained to rigorously model and analyze.
Also, the last part of that is, we have the PM team. We have a talented group of [PMs on the PM team] who are more generalists, who are able to tie things together to make investment decisions.
So, putting all together, we think we have a strong investment team with different expertise and a [diversity of experiences and backgrounds].
Host: Do you feel like this diversity helps you avoid “groupthink”?
Wong: Absolutely. We definitely do. We enjoy the debates, we enjoy different views, and it's always not – it never gets personal. It's always about the investment case, the facts, rather than biases.
Host: With diversity on one side of the coin, collaboration seems to be on the other. Mike, what can you tell me about how your investment team collaborates?
Hubbard: Well, the short answer is that we root ourselves in data and facts.
Our head of equities has [a theory that I call] the triangle of feelings. What this means is, if you think about a triangle, at the tip we'll put our opinion on a discussion topic, typically a company or a stock. Below that, in the meatier part of the triangle, we have facts. And at the base of the triangle, which is the biggest part of the triangle, we have data.
So, opinions are the least important part. Everyone is expected to bring data and facts to the discussion. Typically when you let data and facts speak, the answer is pretty clear in which way you should go. And so, that's what roots all of our discussions and it makes them productive in terms of having the necessary push-back to make the process work, but not creating a bunch of friction and conflict [which is] unnecessary and detrimental to the process.
Host: Okay. Anything to add, Graham?
Wong: Yeah. So, when people say “collaboration,” immediately they think “more meetings.” And most people I meet especially don't like more meetings. I think collaboration, when actually done properly, should be more productive, improves productivity.
What I mean here: for us, collaboration means working side-by-side with the analysts. When we're tackling a stock or a subject, we're on the same due diligence calls. We're on the same email chains, tracking down information. We're building models together. So, the product of this is that we don't need anybody brought up to speed. Everybody's kind of working side-by-side together. And there's no more important resources than our time – our analyst's time. So, by doing this right, we don't need them to write a thick report or have a marathon meeting just to bring people up to speed.
Lastly, I would say: while we collaborate as a team, we're also very efficient in making decisions because the ultimate buy/sell decision falls to the PM. And this is important because this allows us to be nimble to invest during times of volatility.
Host: Okay. When comes to recession or other types of market turmoil that you might face, how do you maintain discipline during storms? Mike?
Hubbard: The short answer is the same way I did in the Marine Corps. You trust in your team, you trust in your process, and you trust in your training. At Thrivent, we're also blessed to work for a patient organization that doesn't add unnecessary short-term pressure and takes a long-term view to managing our investment teams which is aligned with our investment philosophy as we're looking at potential investments.
Host: Okay. And Graham, how do you stay focused and resolute?
Wong: Yeah. To start out, back to risk management: we don't take market bets. So, during market volatility, we still let stock picking drive our performance. We don't have to ride the down with the market because we're not taking that kind of bet.
However, during market dislocations, we do look for opportunities, right? For example, during Covid, we looked at companies that were really beaten up by the market being shut down; for example, airlines, hotels, amusement parks. So, we really dive into [into this and ask,] “Which of these companies do we think can survive and also gain share when we reopen?” Recently, the bank crisis: we really scrub the banks that we feel have strong risk management, have strong balance sheets and have strong deposit franchises that were lumped into the bad basket that we can take advantage of and own them.
But, you know, back to your question about how we have conviction: I think the conviction comes from two things. One, our team really focuses on downside analysis. So, [for] every stock we own, we have to have a quantifiable and limited downside. And secondly is, we really scrub the balance sheet and cash flow statements. So, the market really likes to look at the income statement, which is the EPS – earnings power – and then the [price-to-earnings or P/E] multiple off of it. We always look at all three financial statements.
And why is that? In a downturn, there's nothing more important than free cash flow generation, and there's nothing more important than how healthy [a company’s balance sheet is]. So, we have to ask the question, “Can this company refinance now that interest rates are so high? Can they afford the interest expense? Can they do this without having to cut their dividends?” If you ask these tough questions and analyze the financial statements, you can really limit your downside and have conviction.
Host: Thank you. I’d like to wrap up with an open-ended question for each of you. What’s something that’s helped inspire or shape your career in investing? Maybe it’s something you’ve learned from a mentor, or a lesson you took from a pivotal event – sky’s the limit.
What do you have, Graham?
Wong: I'm going to answer this question a little differently. I think my biggest mentor is actually the market itself. The market obviously can always be humbling, right? But I lived through the Great Financial Crisis, the Dot Com Crash, and what those times really taught me is the risk of asset bubbles and the importance of risk management as an investor.
It also taught me to be skeptical – something Mike talked about earlier – of groupthink and consensus views. If you go back [to the Dot Com Crash,] people really thought that Enron and Lehman Brothers in Silicon Valley were impeccable franchises, and that was before they went to zero.
And lastly, it taught me to ask tough questions, to challenge consensus views, and to back that up with our own rigorous analysis to support our views. What this has all done is it's shaped me to be a better and safer investor.
Host: Okay. And Mike, how about you?
Hubbard: That's a great question. I'll draw on my experience as a Marine again. When I joined the Marine Corps, I did not expect to learn anything that would be relevant to investing, that's for sure.
But one lesson from the Marine Infantry Officer course that really stuck with me, and I think is exceptionally relevant: the ethos of marine officer training is that a 70% solution executed violently now is always better than a 100% solution later. And this may sound counterintuitive, right, when you're talking about literal life and death decisions. However, there's two key things you have to understand. One, you're fighting a living, breathing, thinking enemy. So, the more time you give them, the more time they have to prepare or to attack you. And second is, there's no such thing as a 100% solution when you're dealing with the future and uncertainty.
So, how does this apply to investing? Well, we are constantly fighting the market, right? And the market is a living, breathing, thinking organism that is constantly repricing information. And so, a lot of times I think investors come to the false conclusion that waiting for more information is a costless decision because the market's getting additional information – other investors are getting additional information. It's not just you that's getting additional information.
How do we put this into practice? We try to stay focused on the two or three most important key drivers for this company or this stock. For us in the growth universe, it comes back to the TAM, the competitive advantage, and the return on investment to the end customer, right? And, can we get those things right and make the best decision we can with the information we have? And then we layer on a robust risk management process that Graham has mentioned that helps us protect and prevent excessive downside risk.
Host: Gentlemen, thank you so much for your time and thoughtful answers to our questions.
Wong: Thanks for having us.
Hubbard: Thank you very much.
And to our listeners, thanks for listening! We hope you enjoyed this interview with our experts and learned something new. Was it helpful? Is there anything else you want to hear from our portfolio managers? Share your thoughts and feedback by emailing us at firstname.lastname@example.org. All episodes of Advisor’s Market360™ are available on Apple Podcasts, Spotify, and Google Podcasts. 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 10, 2023, unless otherwise noted.
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