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Searching for Quality in Small Caps
Aberdeen U.S. Small Cap Equity Fund
Interview with: Ralph Bassett

Author: Ticker Magazine
Last Update: Jun 01, 10:08 AM ET
Small-cap companies have many opportunities to grow revenues and earnings, but not all of them are resourceful enough to harvest this type of growth. Ralph Bassett, portfolio manager of the Aberdeen U.S. Small Cap Equity Fund, applies a long-term perspective to building a concentrated portfolio of companies with capable management and sustainable competitive characteristics.

“Over time, our objective is to provide our clients with more consistency in performance and greater downside protection – the businesses in our portfolio may not be the most exciting, but neither are they deeply cyclical.”
Q: What is the history of the fund?

A: The Aberdeen U.S. Small Cap Equity Fund was launched in November 2008. We inherited the fund after our firm acquired 26 funds from Nationwide earlier that year, and I have been the portfolio manager ever since.

If anything, our evolution has focused on applying extensive, proprietary, and bottom-up research to gain deeper coverage and greater insight into the small-cap universe of companies included in the Russell 2000 Index. As buy-and-hold investors, we seek to identify those with a long-term and sustainable competitive advantage. We are not in the business of trading in and out of stocks – not on a daily, weekly or even monthly basis.

While other funds may have hundreds of holdings, our portfolio is far more concentrated, with just 40 to 60 companies. Our rigorous stock-selection approach ensures we pick what we believe to be the best stocks for our clients without overly diversifying away alpha. This strategy has allowed the fund to do well in a less risky way, whether in terms of standard deviation or tracking error.

Q: What are the core tenets of your investment philosophy?

A: Our process is based around investment-quality businesses. Quality, especially in small cap, to us means businesses that are exhibiting sustainable competitive advantages and good business models. They are well-managed, which oftentimes is not the case in the small-cap world.

This level of quality is characterized by certain measures, so in aggregate, our businesses tend to have better profitability whether looking at operating margins or returns on capital. They also tend to have lower leverage.

Over time, our objective is to provide our clients with more consistency in performance and greater downside protection – the businesses in our portfolio may not be the most exciting, but neither are they deeply cyclical. Ultimately, we seek companies which will prosper and compound growth over a business cycle and not be as subjected to significant fluctuations in the market or the economy.

Q: Can you explain in a few steps how your investment process works?

A: Our universe includes companies with market capitalizations ranging from approximately $250 million up to $5 billion, and the process used to evaluate them is predominantly qualitative. To ensure the portfolio remains small cap, only companies below the upper level of the Russell 2000 Index are considered, and we sell out of them when they reach $5 billion.

Much of our due diligence focuses on companies in the $500 million to $3 billion range because we want our holdings to deliver and grow over time. Were we to purchase a $4.5-billion company that grew to $5 billion in just a few months, the fund’s performance would benefit but we would still be disappointed because it migrated out so quickly.

Through extensive research, we whittle down 2,000 possibilities to a theoretical universe of 1,000. Our team of 13 has firsthand knowledge of much of the Russell 2000, especially companies deemed investable from a liquidity standpoint; we visit approximately 900 small companies a year.

Going back to our measures of quality, key considerations are a company’s level of profitability and its ability to generate cash flow – eliminating many speculative energy and biotech firms from our purview.

Our process is quite focused on what we own. Because we are buy-and-hold investors, we neither want to give a company too much credit nor pass by others of better quality. As a result, a great deal of time is spent on portfolio weightings and testing of our theses.

Even though the portfolio begins with such a big universe, only a handful of companies – roughly 50 – make it in, so it has high incremental barriers to entry. We always have a list of 10 to 20 fully-vetted names ready to go in, so we aren’t overly reliant on finding new ideas. It’s more a question of timing and portfolio construction for us.

Q: Would you give an example to illustrate your research process?

A: In the small-cap banking industry, we noted a great deal of consolidation taking place. While acquisitions certainly carry risk, they also create opportunities for companies that manage it well – like Glacier Bancorp, Inc., a Montana-based commercial banking services provider.

When we began researching Glacier in 2012, we found it to be an extremely skilled consolidator. Not only had the company taken share from larger peers that were distracted coming out of the financial crisis, it was creating value beyond that, so we added it to the portfolio last year.

Glacier faced little competition in its mostly rural territory, which put a competitive moat around its business. Often, Glacier is the only bank in town, so it forms deep relationships within local communities – communities which our research determined were growing, driven by agriculture, tourism, and commercial real estate lending.

Moreover, Glacier has a good management team. When it acquires a struggling local bank, it minimizes the impact on the community so as not to disturb the strong relationships already in existence. There is no “shift in the banner” – Glacier doesn’t rebrand banks and it keeps their management personnel in place.

Although Glacier is decentralized by the nature of its acquisitions, it is centralized in terms of underwriting, so we were comfortable with the risk it was taking. The company was also quite liquid, which was one of the issues we had flagged in 2012. Because it had a lot of its earnings coming from the securities book – capital it could deploy over time – Glacier wasn’t going to need to chase deposits or raise equity to grow.

Q: Can you cite another example?

A: Another company we have owned that exemplifies our research process is Fair Isaac Corporation (FICO), a data analytics company with a great business that has high incremental margins, and which has benefited from the expansionary credit environment we’ve been in for some time.

However, our initial analysis revealed several hurdles, with this cyclicality being one. When the company walked us through how its business expands and contracts around the economy, we learned that in a contractionary environment, credit card companies and mortgage lenders tend to pull credit reports more frequently because they are worried about losses – so even though the business volume will fall, it is not nearly to the extent we thought.

Additionally, after the appointment of a new CEO in 2012, FICO expanded its reach by entering software-related businesses like fraud protection, lending more stability to its model. The rollout of this product has been fairly successful, and over time, we think it will warrant a higher multiple.

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Sources: Data collected by 123jump.com and Ticker.com from company press releases, filings and corporate websites. Market data: BATS Exchange. Inc