Investment Objectives
The US Small and Mid Cap strategy seeks to create wealth through capital appreciation.
To meet this objective, the team will focus on:
- Finding businesses that have strengthening competitive advantages.
- Identifying management teams that have an impactful ownership mentality.
- Owning a focused portfolio of quality, smaller- and mid-sized businesses.
Portfolio Manager
Who should invest?
Small- and mid-cap companies offer diversification to a large cap portfolio because they can be earlier in their lifecycle, compete in different (sometimes niche) profit pools, have a more domestic focus, and are often the target of acquirers (though we do not pursue investments for this reason). These companies have also demonstrated periods of outperformance versus large-caps (the “size factor”) and even done so with less risk (in the case of mid-caps).
Still, small- and mid-cap companies can experience significant volatility, especially those that are earlier in their life cycle, have a narrow product set or geographic customer base, or compete against large rivals. In their quest to become larger companies, small- and mid-caps often suffer growing pains that are part and parcel to maturation and can create compelling purchase opportunities. We believe a long-term holding period is required to reap the benefits of this asset class.
Philosophy and Strategy
Small- and mid-sized businesses exist among larger, more powerful, better-resourced foes. To keep from being squashed, let alone thrive and generate market-beating returns, it takes a special combination of attributes, along with a fighting spirit. This belief shapes the US Small and Mid Cap SMA philosophy:
- Evidence of strengthening competitive advantages is critical to defending profits (or building attractive future economics) and keeping larger competitors and new upstarts at bay.
- Management teams that have an owner’s mindset, including a deep understanding of customer’s changing needs and obsession with serving them, is a key to driving the durable growth and astute capital allocation necessary for long-term ownership.
Our team seeks to identify businesses with these attributes and own them patiently. We don’t like these businesses because they are smaller, we like them because they have what we feel are strong and properly incentivized management teams, with strategy-relevant and often advantageous cultures, show nimbleness and adaptability, promise to execute well over different parts of the business cycle, demonstrate attractive long-term economics, and appear likely to one day be even more relevant businesses.
We look to buy companies at a discount to their intrinsic value, which we gauge based on future earnings power or expected cash flows.
Portfolio Management Process
Portfolio Construction
We think like business owners and are long-term investors looking to find companies that we can own for many years as they become larger, better businesses and compound at attractive rates. To ensure a diversified portfolio, we will consider the following characteristics:
- Market Capitalization: In normal times, roughly 70% of the strategy’s allocation will be to mid-capitalization stocks, which we define as $5 billion to $35 billion at time of purchase. Up to 30% of the portfolio can be to small-capitalization stocks, which we define as less than $5 billion at the time of purchase.
- Industry: No single industry will account for more than 30% of the portfolio.
We also consider less standard characteristics designed to achieve resiliency across market environments. Among these are macro sensitivity, mispricing patterns, skew of expected returns, quantitative factor exposures, company lifecycle and cash flow profile, and customer and product/service demand attributes, among others.
We expect to own around 30 companies and endeavor to be near fully invested.
Investment Selection
Our investments will be chosen based on in-depth, bottom-up, fundamental research and a commitment to respecting the strategy’s goals and objectives. This means seeking out Quality businesses with expanding competitive advantages led by management teams who have an owner’s mentality.
A business owner thinks and behaves differently than an agent. Owners make decisions with a long-term mindset, demonstrate excellence in capital allocation, and have a deep understanding of and commitment to serving customer needs. They also understand the importance and power of the ownership mindset extending deep into the organization. We will apply a long-term outlook and invest in companies we believe can build business value over many years, enabled by strengthening competitive positions and compelling reinvestment opportunities.
Position Sizing
The primary determinants of position sizing are business quality, strategic execution, and risk. Most positions will be between 1.5% and 3% of the portfolio at purchase. The higher the quality of the business, the more proven it is and lower the downside range of outcomes, the more diversifying it is for the portfolio, and the more undeniably large the discount to intrinsic value is to us, the larger the starting position can be.
Under normal circumstances, we will not allow a single position to persist beyond 10% of total assets or the top 10 positions in aggregate persist beyond 60%.*
Position Management
Given our preference for high-quality businesses that we expect to grow larger, we expect the US Small and Mid Cap SMA strategy to exhibit low turnover. We will adjust the portfolio over time as new information about each company’s business becomes available.
We look to add to positions in businesses with improving competitive positions, business performance, financial profiles, and customer orientations which in turn improve the prospects for the firm’s own profitability and growth.
We will sell positions in businesses that suffer deteriorating competitive advantages, have a declining commitment to serving customers, exhibit poor capital allocation choices, or suffer from poor execution.
In general, we will consider adding to positions where we have evidence that our thinking on the path of future performance is proving accurate, price presents attractive relative and absolute returns, and the portfolio’s overall risk level can support the risk profile. In general, we will consider trimming positions where we have doubts about our analysis or the path of the company’s execution, price presents less attractive relative or absolute returns, or the portfolio’s risk level cannot support the risk profile. We will sell entirely where we have evidence that our thinking and analysis related to company Quality and our Thesis is flawed. We also monitor financial strength, end market health, and the expectations embedded in share prices.
While we may trim or add to positions to achieve more balanced sector, business, and risk factor diversification, we will not mechanically sell a position that exceeds our market cap ceiling or position size maximum guideline. Business Quality, and the above considerations will always remain the primary drivers of position management actions.
Investment Risks
The value of investments in the US Small and Mid Cap SMA strategy may increase or decrease, which will cause the value of the investor’s portfolio to increase or decrease. The investor may lose money on their investment and there can be no assurance that the strategy will achieve its investment objective and goals.
Investors should recognize that liquidity is often lower in smaller-capitalization stocks, which sometimes manifests itself as higher volatility than with larger, more efficiently traded companies. We ignore the natural ups and downs of individual stocks and the portfolio if the price moves are not due to either deteriorating business performance or worsening economic conditions.
Historically, smaller companies have tended to have a more domestic focus, which can become a risk if the home market is experiencing a poor economy or subject to any variety of broad, macro events.
The company attributes we seek in our investments have historically given the portfolio a growth style bias, which at times is less rewarded in rich valuations by the market and may suffer periods of mean reversion after periods of outperformance.
Companies earlier in their corporate life cycle can exhibit greater uncertainty due to unproven markets, a focus on a single or small set of products and services, and more financially equipped competitors. While these companies have had enough success to reach the public markets, there is no guarantee that the path forward will be an easy one.
The Strategy’s market capitalization structure guidelines differ from its benchmark, the S&P Mid Cap 400 Index. This, combined with a focused portfolio of around 30 stocks, will cause performance to deviate from the benchmark.
Please see Appendix B to our Investment Advisory Agreement for a discussion of additional risk associated with this strategy. A link to the Investment Advisory Agreement is provided at the bottom of this page.
*To the extent we invest more heavily in particular sectors or industries of the economy, your performance will be especially sensitive to developments that significantly affect those sectors or industries. While investing in a particular sector is not a principal investment strategy of any Model Portfolio, client portfolios may be significantly invested in a sector or industry, such as the information technology sector, as a result of our portfolio management decisions. Similarly, a Model Portfolio’s investments may become concentrated in a small number of issuers. To the extent that we take large positions in a small number of investments, account returns may fluctuate as a result of changes in the performance of such investments to a greater extent than that of a more diversified account. Returns realized by a client account may be adversely affected if a small number of these investments perform poorly.
Each client portfolio is subject to an account minimum, which varies based on the strategies included in the portfolio. Motley Fool Wealth Management retains the right to revise or modify portfolios and strategies if it believes such modifications would be in the best interests of its clients, and we may modify allocations within a client's account subject to the constraints of each client's current risk score and objective. Clients should be aware that their individual account results may not exactly match the performance of the Model Portfolios.