Despite the recent volatility in large cap U.S. stocks, performance leadership has been driven by the top ten contributors in the S&P 500 more greatly than any other period in the past ten years. Shares of large technology companies continued to march higher in August, causing large cap indexes and many investors to be highly concentrated in their ownership of these companies. While the businesses themselves are in many cases remarkable, the price being paid for their shares appears stretched and, for long term investors, they may prove to be poor investments in the coming years. We believe that it is prudent for investors to look elsewhere, to less crowded segments of the market, for quality businesses at more reasonable valuations.
A Crowded House
In writing The Intelligent Investor, Benjamin Graham noted that “to enjoy a reasonable chance for continued better than average results, the investor must follow policies which are (1) inherently sound and promising, and (2) not popular on Wall Street.” In 2020, the stock market popularity contest has rewarded investors in the crowded trades of large companies including Apple, Microsoft, Amazon, Google, and Facebook. The market capitalization of these five companies in the S&P 500 roughly equals the market caps of the indexes bottom 375 businesses and go well beyond the levels of concentration seen in 1999. Apple alone has a market cap greater than the entire Russell 2000 index of smaller companies. But, as Graham would remind us, these short-term fluctuations of stocks do not equate to wealth creation.
2020, Cornerstone Macro
Concentration in the largest companies is not the only similarity between today’s market and that of 1999. The underperformance of small cap companies and, in particular, small cap value stocks, is also similar. The third quarter has had a “buy anything” tenor that lifted small cap value stocks by 7.56% in August, yet as measured by the Russell 2000 Value index, stocks of these companies are still down 17.71% for the year through August 31. Further, they have delivered annualized returns of -1.39% for the past three years, significantly lagging the 11.71% annualized return, before the reinvestment of dividends, for the S&P 500.
A shift away from the concentrations in large technology companies began in the early days of September. Whether that shift continues or not is unknown. We remain in an environment of low interest rates where investors have seemingly few alternatives as they seek growth opportunities. In uncertain times it pays to own quality businesses, those with growing revenues and high and persistent returns on invested capital, as an antidote to uncertainty. Shares of large technology companies have basked in that uncertainty for much of 2020 but it may be the appropriate time for a degree of distancing. QSV sees many compelling small and mid-sized companies available to those who do their homework. High conviction holdings in our strategies include:
Broadridge (BR) provides investor communications, proxy voting services and technology solutions to corporate customers as well as those in banking and asset management. Its competitive advantages include high switching costs; a 98% client retention rate helps support returns on invested capital of 18%.
Masimo Corporation (MASI) is a medical technology company that develops, manufactures, and markets non-invasive patient monitoring systems. Hospitals and customers such as Philips and General Electric rely on its products and the company is positioned for growth with its next generation pulse oximetry product (precision measurement of blood oxygen), a market in which it operates as a duopoly with Medtronic. The company has operating margins exceeding 20% and is targeting margins of 30% over the next five years. Returns on invested capital are 20%.
Tyler Technologies (TYL) provides technology and management solutions to the public sector with a focus on local governments. Recurring revenues represent 65% of sales and Tyler has a 98% customer retention rate. While risks of lower government spending exist, the company’s business is well diversified and represents a small cost to ensuring that less cyclical services such as courts and justice and public safety run smoothly. Returns on invested capital are currently 13% and Tyler is accelerating investment in research and development to drive new product development.
Xilinx, Inc. (XLNX) is a long term, high conviction holding for QSV that has grown into a large cap stock. The company designs and develops programmable logic semiconductor devices used in military, industrial, automotive, wireless and wireline communications. Current tailwinds for the business include further development of shared data centers and the build out of 5G networks. XLNX enjoys a competitive “moat” that is sustainable due to high switching costs among its customers. This advantage supports returns on invested capital of 18% and shares are at a discount to our view of the company’s fair value.
Where do the markets go from here? QSV cannot predict the near-term movements of stocks large or small. We do know, however, that small and mid-cap companies, particularly small and mid-cap quality businesses, have rewarded investors with strong long-term returns. The opportunity exists for investors to assess their current asset allocation and harvest gains from the popular large cap companies that have
become the crowded house of the investing world. Reallocating to high quality smaller businesses that have been less popular of late is the type of distancing that we believe will benefit prudent investors.
About QSV Equity Investors, LLC
QSV Equity Investors is an employee-owned asset management firm that invests alongside its clients in high conviction portfolios of quality small and mid-capitalization businesses. QSV manages these portfolios of publicly traded companies for individuals, family offices and institutions. Based in Oakbrook Terrace, Illinois, QSV was founded in 2016 by Jeff Kautz and Randy Hughes, investment professionals who previously held senior roles at Perkins Investment Management and have invested together for over 20 years. For more details on the specific performance and characteristics of QSV’s strategies, including a fully GIPS compliant presentation, please contact Dave Mertens at firstname.lastname@example.org.