The Stock Market Sweet Spot
Ken and Kirk McDonald, Mid Cap Portfolio Manager, land in the middle of the investment landscape. They set their sights on mid-caps, an often overlooked asset class that offers a sweet spot in the market and acts as a balance between growth and stability. Later in the episode, Kirk and Ken take a look at Argent’s Mid Cap market performance and dive deep into Fair Isaac Company, the FICO credit score inventor.
Ken Crawford, CFA: Welcome to Conversations with Ken, a podcast where we discuss relevant topics and investing. I’m Ken Crawford, Senior Portfolio Manager with Argent Capital Management.
With me today is Kirk McDonald. Kirk, welcome.
Kirk McDonald, CFA: Hi Ken, thanks for having me.
KC: Tell everyone who is listening what you do at Argent.
KM: At Argent Capital, I am the Portfolio Manager for our Mid Cap investment strategy. So, it’s investing in companies that are middle-sized. Think market caps with the range of $2 billion to $20 billion typically when we buy into it, as opposed to the Apples and Amazons of the world that now have trillion dollar valuations.
KC: Right where I live. And last podcast, we had Peter Roy – Peter Roy, Small Cap Manager. I think when people think of small-caps, they think of perhaps more volatility, but more growth. And when they think of large-caps, they think of perhaps less growth, but more stability. So where does mid-cap fall in, in terms of investor appeal and why should I put money in your strategy?
KM: Thanks for the question, Ken. Mid-caps, like so many things that get stuck in the middle, or like say, the middle of nowhere, for example, they get forgotten about and overlooked, but they end up being the sweet spot of the market because of that. Compared to large-cap stocks, these companies have much more room to grow.
Compared to small cap stocks, they have a management team that’s throwing the ability to grow it from a smaller company up to a medium-sized company, and they’ve developed the products and services that people want. Now they’re bigger and more established, so they have access to capital, or more capital, than small-cap companies do. So they can reinvest that capital to grow faster than their large-cap counterparts and for many more years, typically than the large-cap counterparts.
At the end of the day, they end up being the best-performing US domestic equity asset class. They beat the Russell 1000 (large-cap stocks) and the Russell 2000 (small-cap stocks) as well. The Russell Midcap, which is those medium-sized companies, ends up being the best-performing asset class and a good place to look for investments.
KC: Huh. Well, maybe after this, I’ll reach into my pocket.
So, performance last year a little bit tough for the market. How did you do in 2022?
KM: 2022 was like a tale of two halves, but really, the first quarter versus the last 3/4 of the year.
The first quarter of 2022, the Argent Mid Cap strategy had a tough quarter. We underperformed the stock market by a considerable amount. That was because some of our long-term holdings that had done very, very well in 2020 and 2021 actually took it on the chin based on fears that when the Federal Reserve started raising interest rates, it would absolutely crush the economy and some of those stocks, in particular, many of which are home building exposed stocks.
But our strategy is to really buy what we call an enduring business and own it forever, if we possibly can. We actually held on to all those businesses because, at the end of the day, they were enduring businesses. Those companies had the ability to grow cash flows, had a management team that was a good allocator of capital of those cash flows, and they had some sort of a moat around the business or a competitive advantage compared to other players in the marketplace. So we held on to all those stocks. The first quarter was tough, but in the last three quarters, we outperformed the Russell Midcap benchmark and have continued to do it through the first almost three quarters of 2023 as well with the same stocks actually.
KC: So you held on to those stocks a little bit tough, and then they’re doing well. How is doing well in 2023 for you?
KM: For now, it’s very, very good, and it’s mostly the same companies that we held when we had that tough quarter in 2022. They’ve all come back and then some and continued higher, because they the enduring businesses have proven their ability to make money in low interest rate environments and high interest rate environments.
KC: So it wasn’t a function of turning and burning the portfolio when you had a difficult beginning in 2022?
KM: No, absolutely not. We find it’s very, very hard to find an enduring business, and it’s even harder to find an enduring business that’s priced reasonably; it’s a good investment. When we find those, we hold on to them, and we don’t try to churn.
KC: That sounds like a fairly sensible investment approach, something that Large Cap tries to follow as well. Are there any companies in the portfolio that come to mind in particular when you think about better and enduring businesses?
KM: There’s one that we were able to buy in early 2022 that really, really took it on the chin based on fears that the higher interest rates would crush its business. That was Fair Isaac Company, the inventors of the FICO credit score. Some people don’t like them because ma ybe they think their credit score isn’t quite as high as it should be, but I happen to love their business.
As the inventor of the credit score, they have 90% market share in all consumer credit scores, but about 10% of their business at the peak of the real estate market was tied to credit scores for mortgages. There was a fear in the investment community that higher interest rates would crush the residential real estate market and crush Fair Isaac’s business, but at the end of the day, when at the peak, it was only 10% of their business at the time that was investing in it.
In February of 2022, it was down to 6% of the business, but the company had an organic growth rate of anywhere between 8% to 15% quarter on quarter. So even if 6% went to zero, they would still be able to grow, right? But certainly, the residential real estate transactions were not going to go to zero. It was a good opportunity for us to buy a very beaten-down stock and hold on to it.
And from an enduring business perspective, it definitely has those three characteristics we’re looking for. For growing cash flows, they’ve grown their free cash flow 24% a year for the last five years through the end of June. The management team is a very good allocator of capital, and they reinvest in the parts of the business where it can grow. They create new credit scores; they have 23 credit scores altogether. They also have created a software business that utilizes all of this data, so decades and decades of consumer data, and they built a decision-making software that they licensed to people, which has been a good investment. It grew there, annualized recurring revenues 60% year on year in the recent quarter. And when it comes to that competitive mode that we talked about, 90% market share is fantastic. It’s very hard for anybody to break into it.
And also going back to the mortgages, it’s required that any mortgage that Fannie Mae or Freddie Mac buys, the two government mortgage agencies, it has to have a FICO credit score attached to it. You don’t get a better mote than a government mandate.
KC: A guaranteed market share.
KM: Exactly. So we think Fair Isaac Company is a good example of an enduring business.
KC: Well, that sounds great. I appreciate the update on mid cap, and I appreciate your time, Kirk.
KM: Well, thanks, Ken. I really appreciate being on the podcast. I hope you have me back.
KC: We’ll see. We’ll see. For all of you, thank you for listening and tune in again next month. Thank you.
Thank you for listening to Conversations with Ken. For now, stay safe, stay well, and thank you for investing your time with us.
Opinions reflect the portfolio managers’ judgment on the date broadcast and are subject to change. A list of stocks recommended by Argent is available upon request. You should not assume that these recommendations are or will be profitable.