Some of the disadvantages that small cap companies once faced when competing with their blue-chip rivals have been significantly diminished by recent advances in technology. The cloud has made startup and data storage costs infinitely less expensive, while artificial intelligence (AI) applications have helped cut costs and time-to-market for small companies in a wide variety of ways.
“With the proliferation of technology,” said Hubbard, “the environment for starting businesses is much different today. The cloud has democratized scalable infrastructure and opened the door for any firm that understands how to use these technologies to their advantage. That’s evident in the declining life expectancy of companies in the S&P 500. In the 1950s, the average length of stay on the S&P 500 Index was about 60 years. Today,” added Hubbard, “it’s just seven.”
In researching companies in the small cap growth universe, Hubbard and his team, including co-Portfolio Manager Siddharth Sinha, focus on three key areas: the total addressable market (TAM) of the company, the company’s competitive advantage, and the return on investment of the company’s products or services to its end customer.
“We don’t rely on what management says or what some consultant says,” Hubbard explained. “We do our own bottom-up analysis in order to understand the customer profile, the number of customers, the pricing they can get for their products, and the scalability and sustainability of their business model.”
To assess a company’s competitive advantage, Hubbard and his team conduct extensive in-depth research, talking to customers, competitors, suppliers, and industry experts.
In determining a company’s projected return on investment (ROI), Hubbard pays particular attention to the revenue potential and scalability of its products and the stickiness of its customers. “The more value you’re delivering to your customers, the stickier the customers. If a company is delivering a lot of value to its customers, the customer is unlikely to switch even if a competitor offers a lower price.”
For example, one of the Fund’s recent holdings, Workiva (WK), provides a business information management software solution. “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 connects to all the office tools used for reporting,” Hubbard explained. “It’s also used for SEC compliance reporting and global risk management and reporting, as well as ESG reporting. That type of application becomes very sticky because it saves companies a massive amount of man hours and manual labor, it’s fully auditable, and it is deeply integrated into a company’s workflow.”
While Hubbard and his team stay on top of macro factors, such as economic cycles, they don’t try to predict market movements. “We try to understand where we are in the cycle. Are we at the beginning, at the end, or are we somewhere in the middle? We know that the dynamics of any one of those cycles will present headwinds to some companies and tailwinds to others.”
To pare the field to the most attractive small cap growth prospects, Hubbard and his team run a range of screens to try to uncover companies with the potential to excel when the economy shifts gears.
“The goal,” said Hubbard, “is not to make a big macro bet on, for instance, interest rates or unemployment. But we try to use those situations to find some quality stocks that are out of favor and add them to the portfolio. We know we may be early on those, but we use risk management on the back end to make sure we’re not making an outsized or implicit bet based on these macro factors.”
One promising name the Fund picked up while the stock was out of favor was Celsius (CELH), an energy drink producer. “They compete with Monster in that market,” said Hubbard, “But they’ve created a much healthier energy drink that doesn’t have sugar, artificial flavors, or artificial sweeteners. They’ve grown significantly over the last several years, they’ve ramped up distribution, and they’re getting their products into new stores and channels. Now they’re rolling their product out to college campuses, hospitality, hotels, restaurants.
“It’s a classic growth story – great products, large TAM, and value to the customer. Then, just last year, they signed a distribution agreement with Pepsi” added Hubbard. “So now they’re getting exponentially larger distribution, more stores, more shelf space, and better placement. All those things have a multiplier effect on the trajectory of the company’s growth.”
Time to sell – happy or not
The ongoing need to selectively prune the portfolio to make room for new prospects generally boils down to what the Fund team terms the “happy sale or the unhappy sale.”
The former includes companies that become so successful they outgrow the team’s expectations and are fairly or excessively valued.
The latter are simply stocks that, for one reason or another, failed to live up to the original thesis the Fund team mapped out.
In making both buy and sell decisions, the three most important factors Hubbard considers are operating performance, valuation, and sentiment. “Our goal is to find stocks with a 50% upside over the next two to three years.
“When we invest in a company,” Hubbard explained, “we have an investment thesis that lays out how we think a company’s competitive advantage, market opportunities, and ROI will manifest itself in their financial statements. That’s the operating performance.”
To assess the second piece, valuation, the Fund team runs screens, tracks historical trends, monitors free cash flow, and reviews a wide range of other factors to determine an appropriate target price for the stock.
“Then the third piece is sentiment,” said Hubbard. “The way we think about sentiment is ‘what do we believe or what do we think we know about this company that the market doesn’t fully appreciate?’ And ‘is the market starting to understand our original thesis?’”
On a regular basis, the Fund team analyzes the progress companies are making on those three factors to see how their thesis is playing out. If one or more of those factors are failing to live up to their expectations, the Fund could unload or lighten their position. That’s the unhappy sale.
“But if operating performance is high, valuation is high, and we don’t have anything that truly differentiates our view from market,” noted Hubbard, “That’s an easy reduction. That would be a happy sale.”
Risk mitigation – embracing discipline & diversity
Small caps typically carry more risk than the larger, more established companies, due to greater price volatility, lower trading volume, and less liquidity. But Hubbard believes risk can be mitigated by investment managers with the discipline to:
- Identify the most promising emerging growth companies and apply a consistent, disciplined research and valuation approach to every prospective investment,
- Diversify broadly among industries and sectors,
- Take profits when successful holdings outgrow the small stock cap range,
- Take losses and move on when an investment disappoints.
The Fund owns, on average, about 85 names, and each of the 10 largest positions represent about 1.8% to 2.7% of total assets. Portfolio turnover ratio was 48% as of April 28, 2023 – which is well below the industry average – as the management team employs a long-term investment approach.
While the job of ferreting out the next market leaders from a pool of unproven prospects can be challenging, Hubbard tries to take a diligent and open-minded approach.
“For me, I think the key is staying humble and maintaining your curiosity. It’s easy to become calloused and judgmental and write companies off or to overlook trends that are changing. But it’s such a dynamic universe that you can’t let yourself get sucked into your own biases or your own judgments because, in the small growth universe, change happens fast.”