Small- and large-cap stocks each possess desirable characteristics, but also a trade-off. On one hand, smaller companies offer the potential for more growth and higher returns than large caps. On the other, large-cap stocks have historically produced lower returns, but have been less volatile and have stacked up favorably by nearly any measure of quality. The challenge is to combine the best features of both.
A good starting point for capturing that attractive blend of growth and quality sits just beyond the small-cap market. At Wasatch Global Investors, we see it often: A smaller company may experience some of its best years of growth and transform into a higher-quality business right as it graduates into the mid-cap universe. Those observations are the genesis of our U.S. Select strategy—a concentrated, mid-cap focused portfolio that draws upon our nearly 50-year history in high-quality growth investing.
This investment brief explores the opportunity we see as some of our best ideas grow beyond the small-cap range, and the Wasatch advantage in creating a portfolio that seeks small-cap-like growth with large-cap-like durability.
KEY TAKEAWAYS
MID CAPS: A UNIQUE INVESTMENT UNIVERSE
While every company has its own pace of development, we find that many businesses hit an attractive inflection point as they move beyond the small-cap threshold. For these select companies, our investment thesis is still playing out. The company may be experiencing its best years of growth, while at the same time cycling past early growing pains and becoming an even higher-quality, more durable business.
Broader statistics for the mid-cap universe illustrate the high-growth, high-quality metamorphosis that often takes place. As Figure 1 below shows, mid-cap companies experience higher sales growth rates than small- or large-cap companies. At the same time, in terms of business sustainability, the average return on assets (ROA) of a mid-cap company is significantly better than for a smaller firm, as shown in Figure 1.
This transition is what makes the mid-cap universe a fertile hunting ground for investors. With a selective approach, we believe there’s potential to create a mid-cap focused portfolio that’s ideally optimized for both growth and quality. As we demonstrate in the next section, a focus on quality, in particular, can lead to significant outperformance.
CAPTURED QUALITY: A HISTORICAL DRIVER OF OUTPERFORMANCE
At Wasatch Global Investors, we consider ourselves first and foremost to be fundamental, bottom-up, quality-oriented investors. We define high-quality companies as those with low-debt balance sheets, and experienced management teams that can grow sales and earnings at rates significantly better than the growth rate for the average company in the benchmark indexes. These companies tend to produce relatively high returns on equity, high earnings-per-share growth and high returns on assets. Over full market cycles, the stocks of companies that possess these favorable quality characteristics have tended to outperform. But the level of outperformance has depended largely on an investment manager’s ability to assess the future quality of a business.
Broadly speaking, there are two approaches to high-quality investing. A passive approach like “smart beta” involves selecting a characteristic that defines quality, such as ROA, and simply purchasing companies that already score well based on that operating metric. We call this “purchased quality.” We call the second approach—which is much more difficult—“captured quality.” This approach entails identifying and investing in high-quality companies where we attempt to “capture” future strong operating results by trying to be correct in our research assessments of a company’s prospects going forward. As Figure 2 below shows, the latter approach has been far more rewarding.
The bars indicate the level of five-year annualized relative performance of hypothetical portfolios employing different approaches versus the Russell 3000 Growth Index. The bar on the left shows the relative underperformance at the end of the five-year period if a hypothetical portfolio had simply purchased companies already in the top two ROA quintiles at the beginning of the period. We call this “purchased past ROA.” The bar on the right shows “captured future ROA.” This is the five-year annualized outperformance versus the Russell 3000 Growth Index if an actively managed hypothetical portfolio had bought all the companies that ended up in the top two ROA quintiles at the end of the five-year period. As the two bars indicate, it’s much more powerful from an investment perspective for an active manager to identify those companies that can develop or maintain high-quality characteristics than to passively select all the companies that already exhibit them.
While we acknowledge that no investor can perfectly predict which companies will generate future quality characteristics, we do believe that active management, particularly in small- and mid-cap stocks, offers the possibility of capturing a portion—which would be enough to create a meaningful performance advantage. Notably, we believe our multi-decade history of investing in high-quality small-cap companies gives us a distinct advantage.
As high-quality investors, we’ve already isolated our focus on the most durable businesses. We attempt to capture future quality by homing in on the select companies we believe are most likely to maintain their high-quality characteristics or strengthen them even further. In our view, this research-intensive approach is a less-risky way to capture future quality than speculating about which low-quality companies may, or may not, become high-quality businesses in the future.
THE WASATCH ADVANTAGE: IDENTIFYING COMPANIES WITH THEIR BEST GROWTH AHEAD
As small-cap specialists, we often find companies in which there’s still tremendous headroom for growth as their stocks move beyond small market capitalization limits. At the same time, these firms are building upon their competitive advantages and becoming even higher-quality businesses. In our view, a portfolio of such companies has the potential to provide the growth traditionally found in small-cap stocks, but with higher quality.
Having established the opportunity set, it’s important for us to communicate why we at Wasatch Global Investors believe we’re well-suited to find such companies. For one thing, it’s arguably easier for a small-cap specialist to increase coverage to include larger companies than for a large-cap portfolio manager to move down in market cap to find growth opportunities. This is because a small-cap manager is already accustomed to covering a larger universe of stocks, as the number of small companies considerably dwarfs the number of large caps.
More importantly, as managers of small-cap portfolios, we have a long history of researching companies that have gone on to become the mid- and large-caps of the future. We understand the types of business models, competitive advantages and management teams that make such growth possible. Having followed these smaller companies for years, we know the businesses and their leaders firsthand, which has helped us develop a keen sense of whether their best years of growth are still ahead.
In many cases, the small-cap stocks we’ve identified as being poised for more growth as they move up in market cap have produced considerable alpha. To get a sense of how Wasatch holdings have performed, we looked at rolling three-year periods with quarterly observations for the 20 years ended March 31, 2022. For this analysis, we included all stocks held by the Wasatch Small Cap Core Growth and Wasatch Small Cap Growth strategies. The results are presented in Figure 3 below.
The bars show that when our holdings were below $3 billion in market capitalization, they generated a three-year alpha of 3.0%. When they were between $3 billion and $9 billion in market capitalization, they generated a three-year alpha of 12.5%. And when they were over $9 billion in market capitalization, they generated a three-year alpha of 16.4%. (Three-year alphas are not annualized.) In other words, our holdings actually produced more alpha as they rose in market capitalization—one reason we’re so excited about the mid-cap companies held in the U.S. Select strategy.
SUMMARY
We believe our fundamental, bottom-up research process lends itself to discovering companies that are reaching their best years of growth and building upon the competitive advantages that make them high-quality businesses. To the extent we can identify those companies that will improve or maintain their high-quality characteristics, we believe the U.S. Select strategy can create considerable alpha. Further, a collection of such companies, many of which are in the mid-cap range, may provide investors with a desirable blend of small-cap-like growth with large-cap-like durability.
U.S. SELECT STRATEGY AT A GLANCE
PHILOSOPHY: We believe that over the long term, stock prices are driven by earnings growth. Moreover, we believe the market’s short–term bias presents opportunities to purchase high–quality businesses at discounts to their long–term value. At Wasatch, we’re patient investors in what we consider exceptional companies with the potential to compound earnings over time.
RISKS AND DISCLOSURES
Mutual-fund investing involves risks, and the loss of principal is possible. Investing in small-cap funds will be more volatile, and the loss of principal could be greater, than investing in large-cap or more diversified funds. Investing in foreign securities, especially in frontier and emerging markets, entails special risks, such as unstable currencies, highly volatile securities markets, and political and social instability, which are described in more detail in the prospectus.
An investor should consider investment objectives, risks, charges and expenses carefully before investing. To obtain a prospectus, containing this and other information, visit wasatchglobal.com or call 800.551.1700. Please read the prospectus carefully before investing.
Information in this document regarding market or economic trends, or the factors influencing historical or future performance, reflects the opinions of management as of the date of this document. These statements should not be relied upon for any other purpose. Past performance is no guarantee of future results, and there is no guarantee that the market forecasts discussed will be realized.
Wasatch Advisors, Inc., trading as Wasatch Global Investors ARBN 605 031 909, is regulated by the U.S. Securities and Exchange Commission under U.S. laws which differ from Australian laws. Wasatch Global Investors is exempt from the requirement to hold an Australian financial services licence in accordance with class order 03/1100 in respect of the provision of financial services to wholesale clients in Australia.
The Wasatch U.S. Select Fund’s investment objective is long-term growth of capital.
The Wasatch Core Growth Fund’s primary investment objective is long-term growth of capital. Income is a secondary objective, but only when consistent with long-term growth of capital.
The Small Cap Growth Fund’s primary investment objective is long-term growth of capital. Income is a secondary objective, but only when consistent with long-term growth of capital.
Wasatch Advisors, Inc., doing business as Wasatch Global Investors, is the investment advisor to Wasatch Funds.
Wasatch Funds are distributed by ALPS Distributors, Inc. (ADI).
ADI is not affiliated with Wasatch Global Investors.
DEFINITIONS
Active share is the percentage of a portfolio’s holdings that differ from its benchmark index.
Alpha is a risk-adjusted measure of the so-called “excess return” on an investment. It is a common measure of assessing an active manager’s performance as it is the return in excess of a benchmark index or “risk-free” investment. The difference between the fair and actually expected rates of return on a stock is called the stock’s alpha.
Beta is a quantitative measure of the volatility of a given stock relative to the overall market. A beta above one is more volatile than the overall market, while a beta below one is less volatile.
Earnings growth is a measure of growth in a company’s net income over a specific period, often one year.
Earnings per share or EPS is the portion of a company’s profit allocated to each outstanding share of common stock. EPS growth rates help investors identify companies that are increasing or decreasing in profitability.
Return on assets (ROA) measures a company’s profitability by showing how many dollars of earnings a company derives from each dollar of assets it controls.
Return on equity (ROE) measures a company’s efficiency at generating profits from shareholders’ equity.
Sales growth is the increase in sales over a specified period of time, not necessarily one year.
Smart beta describes investment strategies that use rules-based systems for selecting investments to be included in a portfolio. Smart beta strategies choose holdings based on predetermined financial metrics.