Commentary - June 2023Greenspring Mid Cap Fund
Portfolio Managers Chip Carlson, CFA and Michael Goodman, CFA of the Cromwell Greenspring Mid Cap Fund describe what kind of mid-cap companies they prefer, their investment process, and why mid-caps are considered the “sweet spot” of the market.
What kind of mid-cap stocks do you prefer?
As bottom-up, fundamental managers, we seek well-capitalized mid-sized businesses running strong, market-leading franchises with high barriers to entry, generating significant free cash flow, and possessing robust balance sheets. We search for strong management teams with solid track records of deploying free cash flow in shareholder-friendly ways, including capital expenditures, debt repayment, opportunistic share repurchases, accretive acquisitions, and dividends. We also look for management incentives that are well-aligned with creating long-term shareholder value.
We believe an emphasis on free cash flow generation is an important selection criteria when searching for companies that have the potential to create long-term value regardless of the economic environment. These companies can use their strong financial position as a competitive advantage to create a larger, more valuable business compared to their competitors, especially during tough times.
As of June 30, 2023, the portfolio’s largest sector weighting was Industrials. The Fund’s holdings within this sector are diversified among many companies within various sub-industries, including waste management, engineering and construction, and manufacturing. Many of these companies possess leading market positions with rational competition. Importantly, many of these businesses have a company-specific or industry catalyst that may drive greater cash flow, which we believe will help push their stock prices higher.
What is your investment process for finding these companies?
Our goal is to produce attractive returns over an entire market cycle with less volatility. We take a bottom-up, research-intensive approach, applying a time-tested, disciplined and rigorous security analysis that includes a comprehensive valuation framework while being mindful of macroeconomic and industry considerations.
We focus more on metrics such as earnings before interest, taxes, depreciation, and amortization (EBITDA) and free cash flow than a company’s annual sales or earnings, as cash generation allows a company to create lasting value.
Although we have a value-oriented investment style, our view of valuation goes beyond absolute levels, concentrating on what is most appropriate for a specific company. Key variables include business model consistency and predictability of free cash flow, growth prospects, industry peers’ valuations, the current interest rate and market environment, and investor sentiment.
Why are mid-caps the sweet spot across market capitalizations?
Compared to their larger peers, many mid-cap stocks are less efficiently followed by Wall Street analysts, leading to a lack of comprehensive research coverage. This trend is being exacerbated as many research firms have reduced coverage of mid-cap companies in recent years to focus on companies with larger trading volumes.
Compared to smaller companies, mid-caps generally possess healthier balance sheets with better access to capital. These companies may also have deeper, more experienced management teams, which helps them better navigate through periods of economic weakness.
In addition, mid-cap companies are often uniquely positioned in mergers and acquisitions activity by being able to generate meaningful benefits from buying smaller competitors. However, they are also big enough themselves to be attractive to a larger acquirer.
How do you evaluate capital allocation when it comes to paying dividends, buying back shares or engaging in merger and acquisition (M&A) activity?
Importantly, we prefer to invest in companies that historically have used their free cash flow to benefit shareholders. Therefore, the actions they take—paying dividends, buying back shares, engaging in M&A transactions—depend on multiple factors and priorities will vary over time. For example, in the case of share buybacks, are companies opportunistically purchasing their stock during periods of price weakness? How does the economic environment or the level of interest rates affect their use of cash flow? As it relates to M&A activity, the management team should have a long-term strategic plan to ensure that acquisitions achieve adequate financial returns while enhancing the company’s competitive position.