In it for the long term

Hermes US Small & Mid Cap fund lead portfolio manager Robert Anstey tells Adam Lewis that he aims for high-quality companies with consistent cashflows rather than shooting stars

Robert Anstey 700

We have seen some strong performances from small caps recently, do you still see value in the market?

Despite some market turbulence, small and mid cap stocks have continued to lead year-to-date. The Russell 2500 is trading at 17 times this year’s estimated earnings, which is slightly above the historic range of the past 20 years. However, relative to bonds, equities look inexpensive because they offer the prospect of growth and inflation protection.

Small and mid caps tend to trade at a premium to large caps because of superior growth prospects. While the current rally began in April 2009, it is important to remember the gains of the past four years have started from a very low base after one of the worst bear markets on record. Yet this does not feel like we are at the end of a bull run. We have not seen the normal behaviour we would associate with the top of a market cycle: increased M&A activity, a flood of IPOs, investor exuberance and rising
interest rates. This market has been much more cautious, driven by company buybacks rather than investor inflows. Investor and corporate confidence has not yet fully returned.

While valuations have become stretched in some areas, our large investment universe of 2,500 stocks means we are able to find attractively valued, cash generative businesses that we believe will perform well through the cycle.

‘Quality’ is a term often used by investors today, what does that term mean to you?

We look for high-quality companies, try to buy them at a discount to our assessment of intrinsic value and then own them long-term. Our average holding period for an investment is three to five years. Our definition of ‘high-quality’ is a company with a durable competitive advantage, or what Warren Buffett would term “an economic moat”.

Where other small-cap investors may be focused on ‘shooting stars’, we prefer to focus on companies which exhibit consistency and stability in their cashflows over time. We believe if we are right on the ‘moat’ together with this consistency, then the growth will take care of itself. The tortoise usually beats the hare. We have a strong focus on risk and aim to generate outperformance with relatively low risk for this asset class.

What areas of the market are you finding the most compelling ideas?  

“Where is the value?” is a question we ask ourselves every day. Our inclination is often to look at what is out of favour for the next idea. We are finding value in financials, particularly regional banks and insurers; energy, which has been one of the worst performing sectors over the past year or so; some areas of technology, which were particularly beaten up after a dismal first-quarter earnings season; and aerospace, which offers visibility for a few years.

One of the attractions of investing in small and mid cap companies is that we can buy businesses which are direct beneficiaries of the strength in their local economies. Some US states are strong and resilient, while others are only just beginning to emerge from a long period of weakness. North Dakota is a good example of the former. Unemployment is a mere 3.2 per cent (the lowest in the country), the state budget is at a record $1.5bn (£990m) surplus and taxes are falling. The state is a beneficiary of the advent of fracking and is constructing its first new refinery since 1976. North Dakota is producing almost 800,000 barrels of oil a day, second only to Texas.

How do you take advantage of this theme?

MDU Resources is a good example of how investors can access this growing prosperity. It is a diversified natural resources company, drawing much of its revenue from North Dakota. The business has strong cashflow, generated from each of its divisions: utility and pipelines, energy exploration and production and construction. Its utility business is the main provider of electricity and natural gas in the state. Also noteworthy is MDU’s E&P business, which has the huge Bakken shale formation in its backyard. MDU will benefit from the new refinery, which is a joint venture between itself and refiner Calumet, processing 20,000 per day of Bakken crude oil.  

The diversified nature of the business often deters analysts, who tend to like greater homogeneity. However, we see MDU’s diversity as one of its attractions:  the utility arm provides investors with stability and security but the company also has the cashflow, experience and discipline to deploy this into other areas. It offers both deflationary protection through the utility, and inflation exposure through aggregates and energy. 

What about in technology?

Within the technology sector, we have a top 10 holding in Flir Systems, the global leader in infra-red cameras and thermal imaging systems. In many ways, Flir represents an open-ended growth company, where the potential opportunities and uses for its products are endless. It sells into numerous verticals, such as the automotive industry,
to government security agencies and into the marine industry.  

Finally, what is your outlook for the US economy?

There has been much discussion this quarter about Federal Reserve policy. We find it hard to understand why rising interest rates should be a surprise to investors at the tail end of a multi-decade bull run in bonds. As long-term investors, it seems about as certain as anything is in life that interest rates are unlikely to stay at these low levels. The Fed’s statement was actually rather positive in our view, as it signals that it is much more confident in the economic outlook.

A gradual rise in interest rates would actually be very beneficial to many of our companies. Indeed, we believe that regional banks and insurers – two sectors that we are overweight – should benefit from a gradually rising rate environment. Conversely, while investors have been chasing higher yielding investments like Reits or Master Limited Partnerships, we are finding little value in these groups today and these are the sectors which are most impacted.

We are somewhat concerned as we work through the second quarter earnings results that companies may fail to live up to lofty expectations, and we are always alert to the opportunities that this creates. Within the portfolio, we have been recycling our profits from those areas which have performed strongly into those where we see more value. Our focus, as always, is on finding cash-generative businesses that will outperform long-term.


Robert Anstey is lead portfolio manager of the Hermes US Small & MidCap f