A Top Performing Small-Cap Value Fund
“Why don’t we get any good snow around here?” That question was recently asked by one of Steve Scruggs’s four daughters. Scruggs, a CFA® is portfolio manager for the Queens Road Small Cap Value Fund and the Queens Road Value Fund. Although Charlotte, North Carolina, where Queens Road is headquartered, does not get much snow, like any determined investor, Steve “dug in” to try to solve the problem. After some trial and error, Steve converted an old pressure washer and an air compressor into a homemade snow-making machine. A few days later there were piles of fresh snow and a line of kids in the yard waiting to go sledding.
That kind of curiosity about how things work combined with old-fashioned resourcefulness helps to make Scruggs a good investor. The Queens Road Small Value fund has outperformed its benchmark, the Russell 2000 Value Index, over the past 10 years and since inception in 2002, earning an annualized return of 9.59% vs. 8.38% for the Russell 2000 Value Index (as of 9/30/16). Scruggs has served as portfolio manager, using the same value process for that entire 14-year period.
I spoke with Steve on December 4.
You have two funds, the Queens Road Small Cap Value Fund (QRSVX) and the Queens Road Value Fund (QRVLX). Both have been around since June 2002. What is your background and that of your investment team? What led you to create these funds?
The Queens Road Funds are managed by Bragg Financial, our family owned and run investment firm in Charlotte, NC. We were started over 50 years ago and we manage $1.2 billion for private clients and institutions. By the 1990’s, we had a good investment philosophy and an established investment committee and were picking stocks for clients. We were doing a good job, so in 2002, we decided to launch the mutual funds to continue growing our firm.
I have been the portfolio manager since inception almost 15 years ago and I am supported by our investment committee. Benton Bragg and Matt DeVries are analysts on the Queens Road Small Value fund and all of us are CFA’s. Benton and I went to high school together in Charlotte and we both went to business school at Wake Forest. He is also the chair of our investment committee and is an analyst on the Queens Road Value fund along with Ben Rose.
What are the mandates of the two funds? What is your investment process?
The Queens Road Value Fund is a large cap value fund. The Small Cap Value Fund is focused on small companies that are part of the Russell 2000 Value Index. We use a very fundamental, bottom-up process to find companies that we can buy at discounted prices based on a Graham and Dodd approach. We want to buy with a margin of safety. Both invest only in U.S. companies.
We look at both quantitative and qualitative aspects of a company. On the quantitative side, we look at a variety of things. Primarily we’re looking for solid balance sheets, companies that have strong cash flow and serviceable levels of debt and companies that aren’t reliant on the capital markets. We then look at valuation by normalizing operating margins over a full market cycle to arrive at our estimate of intrinsic value. Instead of looking at just the most recent data, we look at operating margins over a full market cycle. We want to buy good companies with a margin of safety.
On the qualitative side, we’re looking for two main things: quality managements and the attractive markets in which the companies compete. We want to see management that can lay out a strategy and execute to that strategy; we want management that is clear and honest and willing to admit mistakes and ones that are willing to take measured risks. We want to make sure that the companies we’re investing in are competing in industries that have favorable economics, are growing and aren’t overly competitive. This helps us avoid value traps.
Your small-cap value fund, the larger of the two funds, has outperformed its benchmark, the Russell 2000 value index, since inception (June 2002) by 121 basis points (9.59% versus 8.38%, as of 9/30/16). To what do you attribute that outperformance?
It’s the discipline and patience that we apply in the portfolio management. We have a very straightforward approach that’s based on fundamental, bottom-up analysis. Sometimes the market seems to focus on fundamentals, and sometimes it doesn’t. But we’re always focused on the fundamentals. Sometimes our investment style will be in favor, and sometimes it won’t be in favor. Our discipline and patience come into play when our investment style is not in favor. We continue to apply it the same way, knowing that in the long run, things always come back to the fundamentals.
I attribute that outperformance to not losing as much in down markets as our competitors. That is the bottom line. It also means we’ll trail a bit when stocks go straight up and investors aren’t paying attention to risk. We’ll lag during those big “momentum runs” when risk is ignored.
But bottom line, when there’s a little volatility in the market, when there’s some worry, some fear, some down markets, we traditionally have not lost as much.
When you go through your investment process today, what is your assessment of the markets, and how do you feel specifically about the overall level of market valuation?
Generally speaking, companies look expensive, and we’ve felt that for some time. We’ve trimmed a number of holdings this year, but it’s really hard to find companies that meet the margin of safety that we require. If you look back to 2008 and 2009, everything seemed cheap. You could buy great companies at cheap prices. Today we’re looking and turning over lots of rocks, but we’re having a really hard time finding good, high-quality companies at reasonable prices.
How has your cash position changed as the markets have reached your estimate of full value?
Our cash position has grown. Our cash position is a byproduct of the investment process. It’s not a call on the market, and we’re not trying to attempt to predict which way the market is going to go in the near future. It’s a matter of not being able to find individual companies on a bottom-up basis that meet our criteria.
Our cash now is right at 25%. It’s ranged anywhere from 2% to 25%. With the recent volatility, however, we are finding some opportunities to put it to work.
You mentioned you don’t try to predict the market, but do you have any expectations for how the market will behave for the remainder of this year and into next year?
As you know, since the election it’s been quite a rally. The market, in general, is very optimistic about the Trump presidency. Having said that, it looks like there’s a 100% chance of a Fed rate increase in December, and it will be interesting to see how that’s going to play out in the markets. We saw what happened last December when the Fed did that, and we are anxiously waiting to see what’s going to happen this time.
President-elect Trump has advocated for large infrastructure spending, for loosening of certain regulations and for tax reform. What affect will those policies, if enacted, have on the markets?
The rally we’ve been seeing since the election is in anticipation of those policies. There is a good chance that we will see some fundamental changes that could be good for both the economy and the stock market. One change is a reduction in corporate income tax, which is going to benefit the market, but for some companies more than others.
The larger companies in the S&P 500 have an average effective tax rate of about 25%. High quality small cap companies with mostly domestic operations pay an effective tax rate closer to the statutory rate of 35%. So, any cut in corporate tax rates will benefit profitable, smaller companies more. The tax cut should have a very positive impact on the market.
We also expect that we might see considerable rollback in the regulatory burden that’s been placed on companies over the last 10 years.
What are the risks to the market of the Trump presidency, particularly with respect to trade policies?
There is the potential to start some trade wars that will benefit no one. Generally speaking, freer trade is better, but Trump is quick to point out that when we enter into these agreements, we’ve got to make sure they are truly fair on both sides and negotiate for everything we can get in them.
Another issue is the strength of the dollar. We’ve seen the dollar rally, and that will make U.S. exports less attractive and could pose problems for larger multinational companies.
The small cap value fund has its greatest concentration in industrials, technology, and consumer cyclical businesses. Why are those sectors undervalued relative to others, and do those positions imply that you’re optimistic about U.S. economic growth?
The sector weights in the portfolio are an outcome of where we’re seeing value at the time. It has to do with the outlook of those individual companies and the industries they’re in as well as current valuations. The three sectors that you mentioned are where we’re finding the most value.
To the second part of your question regarding U.S. economic growth, we are optimistic that U.S. GDP is going to increase from the extremely sluggish growth rates that it’s suffered over the past 10 years, and we think that’s attributable to tax relief and reduced regulatory burden.
Some of the new companies that you’ve added to the fund this year include Oshkosh, Prestige Brands and Harman. Why are they attractive as value investments and where do you see the margin of safety in them?
Just to clarify, we added to existing positions in Oshkosh and Prestige. Harman is one that we’ve added within the last year as a holding. But Oshkosh we’ve owned for over 10 years and Prestige we’ve owned over five. We’ve been adding to those positions because we do like them.
Oshkosh operates in four divisions. In commercial construction, they own JLG Industries which make access lifts - that represents about half of Oshkosh's revenues. With the rebound in commercial real estate construction, they haven’t benefitted as much as we expected. Their biggest customers in that area are rental companies. Usually, given where we are in the business cycle, rental companies would have replaced a lot of their inventory, but they haven’t. This cycle has had sluggish growth. It’s not doing as well as we would expect.
Oshkosh’s second biggest area, Defense, is really doing well. It makes a broad spectrum of trucks from light vehicles to heavy vehicles and medium as well. They’ve won some very large contracts over the last couple of years that they’re delivering on. Trump’s comments on defense spending are going to benefit that segment a lot.
Another segment, Fire & Emergency, makes firetrucks and rescue vehicles, and that area hasn’t been doing so well either since the recession. A lot of that is attributable to reduced municipal spending and budgets. We think Trump’s infrastructure projects are going to provide some relief there and help that unit.
Lastly, the commercial division makes cement mixers and wreckers, sold under the Jerr-Dan brand. In all of its vehicle groups, it is number one or two in its market. Its products are the best in the markets in which it competes.
Oshkosh has very profitable segments, so any reductions in corporate income tax rates are going to directly benefit it.
We just started buying Harman about a year ago. Most folks know them from their Harman-Kardon and JBL stereo speakers, which are very big in home and in auto sound systems. From that it has gotten into the auto infotainment systems – the touchscreen systems that are currently in middle to higher end cars. That’s where we envision the growth, in Mercedes, Audi, some of the Toyota lines and a lot of the Chrysler lines. They’re one of the biggest players in that area.
With new regulations that will be in effect by 2018, every car sold in the United States is going to have to have a rear-backup camera, which means every car will have a display on the dash. That’s the tailwind for a business that we like to see, knowing that every model that comes out is going to have to have, at a minimum, the display. It opens up the door for a company like Harman to offer its infotainment, feature-rich platforms across the full spectrum every car sold in the United States.
We started buying Harman on that thesis. The stock had gotten beat up a lot because of where we were in the car cycle. New car sales looked like they peaked. We started buying it in May at $77 and bought more in June when it dropped to $70 per share. Our thesis was proven correct last month when Samsung came out and offered them about $110/share take-out for the company. It looks like they’ve accepted. It hasn’t been voted on yet, but as of now, it looks like Samsung is going to take over Harman.
The Queens Road Small Value appears to do well during volatile or losing markets. According to Morningstar, it has a 10-year upside capture ratio of 90.81, versus a small-value category average of 113.41, but a downside capture ratio of 86.57, versus a category average of 121.15. How do you provide such strong downside protection? How has it performed during up markets?
It gets back to the disciplined process that I briefly mentioned earlier and the fact that we focus on fundamentals regardless of what the market is focusing on. Strong balance sheets and having a margin of safety in our valuation estimates are what provides that. As you can see by our cash holding, if we can’t find companies that meet that strict criteria, we will let cash build.
There is a cost to it. When markets are going straight up, we’re going to trail a good bit. We accept that, and we hope that the folks who invest with us understand that and are okay with it. We are going to deviate from the benchmark. But as history has shown, we have outperformed in down markets by more than we have underperformed in the up markets. Over the full market cycle, we’ve outperformed both our benchmark and our small value peer category and did so with a lot less risk. Since we started the fund in 2002, there have been 17 down quarters for the Russell 2000 Value Index. The Queens Road Small Value out-performed the index in 15 of those 17 losing quarters. So, it’s not like we got lucky or it’s a fluke or something. We have consistently done a good job since inception protecting capital on the downside.
Many advisors are turning to quantitative or so-called smart beta funds using a factor-driven approach for small-value exposure. What guidance would you offer to advisors who are deciding between a quantitative approach and a more traditional active manager such as Queens Road?
The first thing I would say is that if you’re dead-set on using a quantitative approach, focus on one that has been proven in the market over a long period of time and stick with it. There’s only one or two of those that I can think of. Any time a new flavor-of-the-month comes out, everybody jumps on the bandwagon. We have seen how that process usually turns out – not very well.
But when we look at managers who use those types of processes, a lot of them are very intuitive. They make sense. But it’s a different risk/return profile from our fund. For instance, one fund in particular that I can think of that uses a quantitative-factor approach tends to do the opposite of what our fund does. It does really well in up markets and does poorly in down markets, but it does well enough in the up markets to offset the underperformance in the down markets. There are a lot of different ways to skin this cat.
What is the key factor that separates you from your competitors?
I think the main thing our shareholders should know is that we’ve got a really clear process that’s been proven over time. We’ve been value guys a long time, having run the funds for 14 years using the same process. We’ve seen it work. Our family, our firm, our board and our staff, collectively, are the largest shareholders in the fund. We believe in this process and we’re confident that it’ll work over time.