The CEO of Wasatch talks small-cap equity investing in the age of the ‘Magnificent Seven’ and how his firm sorts through thousands of companies across the globe.
Our guest this week is JB Taylor. JB is CEO of Wasatch Global Investors based in Salt Lake City, Utah, specializing in small-cap stocks. JB is also a portfolio manager on the Wasatch Core Growth Fund, which receives a Morningstar Medalist Rating of Gold. He is a member of the firm’s global research team, and he serves on the firm’s board of directors. JB joined Wasatch as an analyst in 1996 after graduating from Stanford.
Background
Small-Cap Funds
“A New Era for Small-Caps?” Wasatchglobal.com, Nov. 28, 2023.
“After a Rough Year, Do Small-Caps Deserve a Closer Look?” Wasatchglobal.com, Jan. 13, 2023.
“Market Scout—'Value’ Funds in a Growth Shop,” Wasatchglobal.com, Oct. 6, 2023.
Investing Globally
“Market Scout—On-the-Ground Research in India and China,” Wasatchglobal.com, July 7, 2023.
“India: A View From the Ground,” Wasatchglobal.com, July 6, 2023.
“China: A View From the Ground,” Wasatchglobal.com, June 27, 2023.
Other
Dan Lefkovitz: Hi, and welcome to The Long View. I’m Dan Lefkovitz, strategist for Morningstar Indexes.
Christine Benz: And I’m Christine Benz, director of personal finance and retirement planning for Morningstar.
Lefkovitz: Our guest this week is JB Taylor. JB is CEO of Wasatch Global Investors based in Salt Lake City, Utah, specializing in small-cap stocks. JB is also a portfolio manager on the Wasatch Core Growth Fund, which receives a Morningstar Medalist Rating of Gold. He is a member of the firm’s global research team, and he serves on the firm’s board of directors. JB joined Wasatch as an analyst in 1996 after graduating from Stanford.
JB, thanks so much for joining us on The Long View.
JB Taylor: My pleasure to be here.
Lefkovitz: Well, let’s start by talking about small caps as an asset class. You’ve been a small-cap investor for a long time now and Wasatch has really made small-cap investing its specialty since its founding. So maybe you can talk about why you find the asset class so rich with opportunity?
Taylor: Sure. The reason we love small caps is not just their size just because they’re small. We love small caps because there are literally thousands of companies in the small-cap universe to pick and choose from as we’re trying to assemble a portfolio of what we think are the very best growth companies going forward. And it really stems back to our founding. Our founder, Sam Stewart, founded the company back in 1975 here at the University of Utah and he was an academic. He had never run money before and he was really a contrarian because at the time, efficient market theory was all the rage and being taught in the finance department. And he taught a separate class that was called Security Analysis and he really believed that if you did great fundamental research and turned over a lot of rocks to try to get to the gems, you could find individual, interesting companies that you could understand, talk to the management teams, understand their competitive advantages and predict which ones would grow for a long period of time. And so, it’s not so much that we love small caps versus large. It’s that the small-cap space has always been just this really rich, fertile place for us to turn over a lot of rocks looking for these gems.
Benz: We wanted to get your perspective on the asset class. Currently, small caps have meaningfully underperformed in the US for many years now. Can you talk about what you think is the key to the underperformance? What has contributed to that?
Taylor: The last 10 years, you’ve had this unbelievable run in the big-cap stocks, but specifically the mega-cap stocks. And everyone is talking about the “Magnificent Seven,”—Apple, Microsoft, Google, Meta, Amazon, Nvidia, Tesla. And certainly, these are phenomenal companies and all the momentum in the market is gravitated toward these companies, and for good reason. They’re great companies with great competitive moats. If you look back over the last 10 years, the combination of cloud computing, a smartphone in every hand, and now the advent of AI, there’s a lot of reasons that these companies have been able to grow to enormous scale and then enjoy the benefits of that scale.
But if you look at the history of large cap versus small cap, there does tend to be cycles. If you go back over the last 100 years, the average performance period of large beating small or small beating large is about 10 years on average. And so, the longest period of large-cap outperformance was 14 years, and it was that period leading right up into the internet bubble and burst, which was followed by 10 years of small-cap outperformance. And now we’re in year 13 of large-cap outperformance. So, from that standpoint, just from a timing, small cap certainly seem interesting and that we’ve run a long time now with the large-cap companies doing quite well.
The other thing that’s interesting about large cap versus small cap right now is that from a relative valuation standpoint, small caps are extremely attractive. We haven’t seen small caps broadly this cheap versus large caps at any point in the last 25 years. And again, it’s going back to right before the dot-com bust. The small-cap index is trading at about 13 times earnings today. And the large-cap index in total is trading at about 20 times earnings. But if you take that Magnificent Seven, they’re trading more like 40 times earnings. So, a huge valuation discount.
And then the other interesting thing about this large-versus-small phenomenon is that you’ve got about 30% of the S&P 500 and Russell 1000 is in these seven stocks. And that’s an enormous concentration. Historically, if you go back, the top 10 names of the Russell 1000 in any given year are not a great place to invest going forward over the next five years. The success that gets companies to the top of that index, it’s hard to repeat. But the exception has been the last five years, you’ve had momentum carry year to year in the top weights of the Russell 1000. So again, this idea of a lot of momentum crowding into the top of these stocks. The last time that you had this crowding and that momentum carrying in the top 10 stocks of the big indexes was again, going back to that run-up up to the dot-com bubble and burst, which the period after that was just a phenomenal time to be investing in small-cap stocks.
The last point I’d make is, if you think about what is expected of these companies, at Wasatch we’re looking—in the small-cap space—we’re looking for companies that can double in size over the next five years and then the companies that have the headroom and the management team and the execution ability to double again in the subsequent five years. So, say, a 4x increase in size in terms of revenues and earnings over the next four years. And if you’re expecting that type of hurdle from the Magnificent Seven, it’s pretty fascinating. Those companies are worth $12 trillion in total today. And they would have to grow to something like $48 trillion, which is more than every company in the S&P 500 combined today. And the revenues would have to grow to something like 20% of US GDP. So, the expectations placed on those seven companies are huge, trading at 40 times earnings. And who knows if they’ll grow that fast. That seems like a really tall task.
But the one thing to think about is, there’s $12 trillion invested in just those seven companies. The entire small-cap index that we hunt through is valued at about $2.5 trillion. So, you have two companies, Apple and Microsoft, both at $3 trillion in market value that are larger than our entire small-cap universe. And it doesn’t take a lot of reallocation from big cap down the cap spectrum to drive performance when that momentum finally turns. And it’s not that those companies need to do poorly. They just need to maybe not outperform for a little period. And at that point, it will be pretty dramatic. It will be like filling a bathtub with a swimming pool. It will fill up really fast.
Benz: We want to delve into some of those themes. But I was thinking about how the period that you were discussing—the underperformance in small caps coincides with investors having a very strong appetite for just total market index funds, call it a day with respect to my US equity exposure. So, do you think that there is any sort of interplay there in terms of why small caps have gotten left behind and why the “Magnificent Seven” have been so triumphant? Do fund flows play a role?
Taylor: I’m sure fund flows play a role. I think the market loves momentum. Investors love momentum and they typically jump into a theme. And as long as it’s working, that continues. Certainly, it’s harder work or it seems riskier going down into the small-cap space, picking and choosing and hunting for individual opportunities. But we think it’s absolutely, for us, the right thing to do. But all I would say is, markets tend to go in cycles in terms of where the momentum is in the market. And it tends to overstay its welcome. We’ve seen that time and time again. So, I don’t have a great answer into the fund flows. Certainly, it’s been tougher, I think, out in the small-cap world than it is in the mega-caps. But those things change pretty quickly.
Lefkovitz: JB, one of the things that Wasatch is known for is closing its funds to preserve flexibility and not to own too much of the companies and to be able to buy and sell without moving markets. Your funds are all currently open to new money. I’m curious if you’ve looked at your openings and closings over the years and whether they say anything about the asset class.
Taylor: We haven’t really paid attention to the overall asset class when it comes to opening and closing our own funds. Our number one priority is making sure that we have the right amount of assets and not too many assets so that we can perform for our clients. One thing to know about our firm is, we’re privately owned. We own our own firm. We’re broadly owned across our firm. And we want to guide our own destiny, which means we don’t have any outside interest telling us to grow or telling us to continue to grow assets. And so, we close funds well ahead of time in terms of having the right amount of assets to manage so that we can invest in the types of companies we want to invest in—these small-cap companies—and we can hold them for a long period of time. We happen to be open right now. It has been a little tougher relative period for small caps, but we feel very comfortable with the assets that we have to manage. And we have a few funds that may be closer to closing as they’ve attracted more interest and investors invest with us.
Benz: Can you talk about the methodology for closing? I remember I was covering some Wasatch funds back in the day and I remember a fund closing very, very tiny asset level. Maybe you can discuss how you decide to close a fund, and how the complexion of the fund and the focus of the fund might influence when you might close.
Taylor: The number one thing is, we take that fund strategy, which let’s say in small-cap growth, maybe we want to own 40 to 50 names. Our new purchases, we want to be squarely in the small-cap space. So, call it, $3 billion or $4 billion in market cap and under for the companies that we purchase. We’re not afraid to allow our winners to ride and to hold those companies as they get larger. But the number one calculation is, can we reinvest the money that we have when we make trades and sell companies out or need to buy new companies? And can we do that in a way that doesn’t affect performance, doesn’t cause us to drive up stock prices when we make purchases? Every single day we’re monitoring how many days of liquidity we have that we own in each one of our stocks. And we also monitor the percentage of companies that we own. And we typically don’t own more than 10% of a company. We’re not afraid to own that much because when we find a great smaller micro-cap company that we want to own for the next 10 years, we want to own a lot of it. But the vast majority of our companies, we own less than 5% of.
Lefkovitz: JB, there are lots of notions out there about small caps. There’s an idea that small caps are more sensitive to the economy. There’s a notion that small caps have more sensitivity to interest rates. Are these things that you’ve noticed over the years?
Taylor: I don’t think it’s something that could be answered with a simple yes or no. Again, the reason we love small caps is simply because there’s thousands of companies to pick and choose from to find these really special companies, companies that we can buy when they’re $500 million in market cap and watch them grow to become multi-billion-dollar cap companies. And so, certainly, there’s aspects of the index. If you’re looking at small cap, you’re looking at the Russell 2000 Index, there’s value components of that index. Close to 15% of the index is in biotech stocks. And those things are going to behave differently in different types of markets, but don’t really affect how we view the asset class, because again, we’re trying to assemble 40 to 50 for each fund of the very best names we can find.
One of my favorite ways of thinking about the small-cap space is we’ve gone back and looked at every company in the Russell 2000 over the last 30 years. And if you do this on an annual basis just for simplicity. And at any point in time, if you look at the companies that were able to grow over a five-year period, were able to grow their revenues greater than 20%, and you only owned those companies—so you’d have to be perfectly clairvoyant to do that—but if you only own the companies that going forward are going to grow at a 20% compounded clip over the next five years, you absolutely smash the market in every single period. And it doesn’t matter what type of market environment you’re in. It can be high rates, low rates, you can be in a recession, you can be in a go-go growth market, a momentum-oriented market. If you own fundamental growers into the future, even if you overpay a little bit, but if you own that basket of companies, you crush the market. And we’re talking by like you double the market’s returns over every single one of those periods. I call that our “opportunities always exist” slide because it doesn’t matter what type of market environment we’re in, we’re able to go out and find individual companies that are growing their revenues and earnings at better than a 15% clip every year and that are attractively valued in a way that we’re going to get paid when they grow into the future.
Benz: We wanted to ask about small value versus small growth. You mentioned your firm’s founder was an academic and there is a lot of academic research that points to the value of small value, the small-value premium. Yet you’re a growth shop, growth-oriented. Can you talk about your take on the small-value premium, whether you think small value has a long-term edge?
Taylor: I think that’s a great question. I think when you look at academic studies, like the ones that show that small value over periods of time does better than growth. Again, it’s looking at indexes broadly, which means maybe the growth index has some issues that make it a little difficult to invest in it, like that 15% biotech component—that’s going to be extremely volatile and not always performing well. But the bigger point about the studies is a lot of them are done in truly an academic sense. Like if you buy the cheapest companies in the Russell 2000 Value and then you rotate out of those each month and you buy the next cheapest companies and are constantly buying and selling, you can have calculated really good returns over a long period of time.
The one thing that gets overlooked is that value strategies tend to reap all of their rewards in a very short period of time. So, like, nine months or 12 months after a recession, a value strategy, a really deep value strategy, will absolutely crush growth strategies because all of these forgotten companies, highly levered companies, trash companies suddenly have a debt-cap bounce that isn’t small in nature. Sometimes there are up 5, 6, 7x or 10x in a very short amount of time. And it creates the alpha for the next five, 10 years. That’s a very hard thing to do as an investor to adhere to that academic study, if you’re trying to implement that. It still can’t compare to harnessing the growth of real fundamental growers. If you’re investing in companies that are growing 20%-plus and they do that for 10 years, you have monsters of companies that will eclipse any kind of return from a value bounce that may happen in certain companies. So, we have value strategies here at Wasatch. They’re still fundamental-focused strategies focused on great companies that may continue to grow in the future but may have hit a bump in the road and we think are poised to recover their growth going forward and therefore are out of favor and cheap in the market. But it’s quite different than an academic, just pure value for a value-sake fund.
Lefkovitz: You mentioned trash companies, JB. It’s well known that their profitability is an issue in the small-cap space. How do you sort through the thousands of companies out there and avoid the trash?
Taylor: Great question. I’ll give you a couple interesting points. So, the Microcap Index, and we like to go down into the micro-cap space, but the Russell Microcap Index, I think 55% of that index is in unprofitable companies. The Small Cap Index, it’s closer to 30% of the index is in unprofitable companies, about 20% of the weight of the index because they’re small weights, those unprofitable companies. So, our approach to finding companies has pretty much been the same since we founded the firm. Being in Salt Lake City, being kind of off the beaten path, not in one of the big finance centers or finance cities, we’ve had to come up with our own ways to make sense of the investment universe and to allocate our time and resources. So, we have what’s called our DuPont screen, which is a one-page financial resume of a company. And the format that it’s in is proprietary to us, but none of the data is. It’s all data that we get out of FactSet or Bloomberg, publicly available data. But it basically shows us in a very condensed, easy-to-understand format for us, a company’s financial history for the last 10 years. Going back by quarter, we have income statement, balance sheet, cash flow statement, and all the ratios that we find interesting on that page. And we literally go through every single one of those DuPonts in the investment universe several times a year. So, we’re screening, trying to touch every single company, trying to see where the pockets of interesting growth and valuation are.
So, the two things we don’t do when we come in every day is we don’t answer our phone and talk to brokers who are pitching ideas, and we don’t look at the index to see what’s moving or trading up or trading down. We want all of our ideas to be generated here in Salt Lake through our own fundamental process. And basically, we let the numbers lead us to the interesting ideas, and all the great investment ideas at Wasatch have really been found by this Dupont process.
Benz: I wanted to ask about something that we’ve been hearing a lot about over the past several years, which is that companies, promising young companies, are not going public. They’re staying private. I wonder if you have thoughts on that phenomenon and how that influences how you look at the universe of publicly traded small caps? Do you think about their competitors who might be private and so on?
Taylor: That’s something we’ve always done is think about who the competitors are to our companies, whether they’re private or international companies. Just as a quick detour, we started our international effort back in 2002 and roughly about half of our assets today are invested outside the US. Because we were finding competitors or admired companies of our investment companies here in the US, they were mentioning companies overseas and we started to look at those companies and apply our same due diligence and bottom-up research process and found a lot of very interesting companies outside the US. So, we’ve always been doing that.
I would say certainly the cost of being public has gone up. Sarbanes-Oxley and now ESG reporting has made it more costly for small- and micro-cap companies to be public, which has caused, I think, less companies to come to market and also companies are coming to market later and at larger sizes. That’s obviously been fueled by venture capital and private equity investing more and more money.
We haven’t seen that as a challenge. There are a fewer, less interesting companies coming to market in our small-cap space, but our space is so huge. I go back to that chart I referenced before, the opportunities always exist. At any given point—I left that detail out—at any given point, there’s somewhere between, call it, 10% and 15% of the Russell 2000 goes on to grow at that 20% clip over the next five years. Those are your opportunities and that’s a lot of companies. That’s hundreds of companies every year. If you can harness those, you’re going to have great returns. So, certainly, it’s something we think about. We don’t whine about it and there’s plenty of opportunities in our small-cap space.
Lefkovitz: Have you noticed anything different about the types of companies that IPO and list publicly versus staying private? Are there quality differences?
Taylor: No, that’s a great question. With the one big exception being this whole SPAC phenomenon that took place in 2021-22, the SPAC issuances, which basically lowered the hurdle for financial disclosures and requirements and the amount of financial history that a company needs to show before presenting itself to the public—all those things were lowered in terms of the difficulty of doing that. and hundreds and hundreds of crap companies were brought to market just with slide decks and great promises of future growth that had no real underpinning. So, when we talk about searching through a bunch of rocks looking for gems, that SPAC period was like taking a giant bucket of gooey rocks and just throwing it on top. We sorted through those as well. There are very few companies that are interesting, but there are a few that have come out of that. That would be the one thing I’d mention.
But still, we see great companies still come to market. These companies have their own needs in terms of capital needs. Also, sometimes they have employee stock plans that have been in place for a long period of time and being public is a great thing for their employees and building goodwill. We hear all the time that companies that still come public love what it does for their reputation with clients in their industry. So, we still get great companies coming to market. As you mentioned, some of them have been coming a little bit later at a larger size, and there’s definitely some companies that haven’t come because they’d rather stay private.
Benz: I wanted to follow up on micro-caps. You mentioned that you look at micro-caps and you all have a dedicated micro-cap strategy with holdings of just a few hundred million in market cap. Maybe you can talk about that space—what you view as its challenges, how you see that it behaves differently than the broad small-cap universe. Also, I would be curious to hear why there aren’t more micro-cap funds. Is it just tough to field a profitable offering in that space because you’ve got to close it so early? Maybe you can talk about all those things.
Taylor: The challenges with the micro-cap space are certainly these companies are much smaller. The management teams are typically less experienced or maybe if they are experienced, they’re less deep. You have a founder that’s great, but you may not have an organization that’s as developed as a larger-cap company. Certainly, by being tiny and small, there’s potentially more risk there because they’re not as diversified in terms of their businesses. They’re almost certainly not going to be global businesses. They’re going to be focused in one part of the US. But all those things that are potentially negative are really attractive to when you find something that’s special that does have a great management team, that can grow for a long period of time or has found a little niche that is really interesting. If it’s in the micro-cap space, it’s not going to have Wall Street analyst coverage, so your ability to get an edge to go out and visit a company. We still get companies where we go out and visit a company and they say, hey, we’re surprised you’re here. We haven’t had anybody call on us in months or years in terms of being interested in us. That’s very exciting to us.
No one gets into the asset-management business—if their only goal is to make a lot of money, micro-cap is a hard place to start a fund and focus there because the amount of assets that you can manage is fewer because the slugs of positions that you need are smaller, or that you have to invest are smaller, in each one of these companies. It’s hard to manage a lot of money in micro, but that’s why we close funds. We like the space because we’re mostly focused on performance, and we know it’s a great place to get returns that are differentiated and really great investing in these companies where fewer people are looking.
Lefkovitz: JB, you mentioned that half of Wasatch’s assets are in internationally focused strategies, not just Europe and developed markets outside of the US, but also emerging and even frontier like Vietnam. What are the unique challenges of investing globally and how do you do it from Salt Lake City?
Taylor: A great question. We travel a lot and I’m focused on the US side, but my partners who invest internationally, I just have a lot of empathy for them because they’re traveling much more and going on longer trips. But we do the same thing that we do in the US, which is we go out on weeklong trips and visit as many companies as we can and we get to know the management teams, get to know their business prospects, get to know their reputation in a given market.
The challenges are, certainly, the travel is hard, but the insights are the very same. And one of the real benefits—emerging markets is a great example—is we can take themes that have worked in the US over the last 20, 25 years and get to still apply them, even if they’re older themes, we can apply them in emerging markets because those economies are much younger, they’re growing faster. So, an example of that would be in the US, Sherwin Williams is a great company with a great brand selling paint, but it’s not a small-cap growth company. Well, you can go to India and find paint companies that are growing 20% year over year with great returns on capital and huge headroom because there’s still so much development out in front of them. The same can be said for finance companies and small banks, they’re just growing at a much greater rate because the loan activity and the growth there underpinning everything is so much faster. On the challenge side, there’s the language barrier and sometimes the reporting in terms of numbers has historically not been as consistent as it has been in the US, but that certainly has improved dramatically over the last 10 years, and we don’t see as much of a delta there anymore.
Benz: Yeah, it seems like, especially in the small-cap space, there would be smaller companies that wouldn’t have the big IR department that a very large company would and so they’re not able to do the hand-holding in terms of language barriers and so forth. How do you navigate that logistically?
Taylor: Speaking for international investments?
Benz: Yes.
Taylor: We do have foreign speakers here, so we have quite a few languages spoken inside our office here, which helps in certain cases. We do hire translators at times. We definitely use Wall Street brokers a little more internationally than we do in the US in terms of helping us set up appointments and navigating some of those IR functions that we do just ourselves. We reach out to companies directly ourselves here in the US. Outside the US we sometimes use a third party to help set up the meetings. Sometimes translators are provided and most speak English. So that’s the other thing is, we’re at a disadvantage as Americans in terms of the number of languages we speak, but outside the US, that’s not the same.
Lefkovitz: Curious if there are certain markets that you found especially rich in opportunity or markets that you found particularly challenging?
Taylor: Outside the US?
Lefkovitz: Yeah.
Taylor: I would definitely highlight India. We have a phenomenal India-focused mutual fund run by Ajay Krishnan. It’s done great because we’ve been able to invest—India was one of the first companies that we really dove into when we started our ex-US efforts and it was simply, again, it’s from the bottom up. It’s not because we had some big macro take on India, which many people have really constructive views on. It’s more about the fact that when we were going through DuPonts, our financial resumes of companies, we were just finding tons and tons of companies with 15% to 20% growth, not very expensive, good margins, good returns on capital. Capital has never been easy in India. So, those companies that can generate good returns on capital are doing something special and truly figured out cost and efficiencies and great management.
I’ll contrast that with China. China is a really difficult market. A huge important country, obviously and a huge important market, but the return on capital discipline there has never been quite the same. Money has been cheap through certain times, and it’s definitely been a market of grow at all cost as opposed to generate great efficient returns. And so, in China, you get more of those fake growth companies that are showing three or four years of great top-line growth, but it doesn’t have a strong underpinning of cash flow or balance sheet support. So, they’re blowing out their balance sheets to get it. They’re making tons of acquisitions. They’re just upping the risk profile of the company and then all of a sudden you have a company that doesn’t grow and doesn’t have margins and that can be very difficult. So, we’ve definitely had to be more careful and picky in China, whereas a place like India has been really fruitful.
Benz: I wanted to ask about small caps broadly, US and non-US. You may have said this when you were discussing the case for small caps. Efficiency—market efficiency, inefficiency, it stands to reason that the small-cap market would be less efficient than large caps, but I’m wondering if you can share your thoughts on that topic?
Taylor: I think it’s definitely the case that as you go down in cap, the markets are less efficient. I would never say, look, the markets are hard, period. The one great thing about this job—it’s also the really tough thing about this job—is that I’ve been doing it 28 years and there’s never been a year where I’ve said, “Oh, I’ve got this whooped; this is easy now.” But as you go down the cap spectrum, certainly there are less Wall Street analysts covering names and producing less research, and there’s less investors focused on it. Again, $12 trillion is invested in those top seven companies and only $2.5 trillion in all 2,000 companies of the Russell 2000. So, there’s just less minds looking at those companies and trying to figure them out. And at the same time, a company like Amazon is a little more difficult to analyze because of the number of business units and all the different growth factors that they have. Whereas you get down in the small-cap space, there’s less people looking at them, but also, we think from the fundamental standpoint, we can get great insight on them. And so, we think that’s a great combination.
The other thing I’d say about efficiency or inefficiency is, I would say the markets are largely efficient most of the time, and then there’s always inefficient opportunities within those markets. But then you also get periods where things just get out of whack and stock prices really become dislocated from the fundamentals. 2022 was an example of that. 2022 was one of only two periods in the last 30 years where in the Russell 2000, those companies that grew better than 15% at the top-line and exceeded their earnings estimates didn’t generate really positive performance. They generated negative performance, and it’s only happened twice, in 2022 and in 2008. And we expect over the long term, fundamentals to drive stock price. But every once in a while, you get a period where everything is selling off at the same time. You had that post-covid—you had that four-week period where markets were down 30% to 40%, and it was totally indiscriminate. It didn’t matter if companies had great fundamental prospects and growth or if they were just kind of average. In 2022 was kind of a similar period, but we see that as opportunity because by knowing which companies truly have a great fundamental underpinning, we stick to those or invest more in those, and they were really well rewarded in 2023 when the market kind of woke up a little bit.
The reasons for that kind of inefficiency, certainly I believe algorithmic trading and quant trading has actually only made things less efficient because you get more momentum in the market carrying a certain way I call it button-mashing. Everyone starts mashing the same button on certain factors or certain trades, and they all get going the same way and carry momentum for longer than they might if everyone was taking their fundamental analyst hat to it.
Lefkovitz: Well, you’ve talked about the DuPont screens and the quantitative approach that you use to sort through large universe, but I know you do a lot of qualitative work as well, and you look at corporate culture. I’ve seen you write that culture beats strategy every time. So maybe you can talk about how you evaluate a company’s culture from the outside.
Taylor: That definitely wasn’t my quote. I believe that, but I borrowed that for sure. Culture is incredibly important. It could be a great asset for a company and really determine the long-term trajectory of a company, whether something is truly special or just an average company. I think the important thing to point out is every company has a culture. I think the questions are how strong is the culture? Is that culture aligned with what the business wants to do, what its objectives are? And then for us it’s, do we agree with the culture, do we like the culture that they have? We do that in a lot of different ways.
We get out on the road and visit all the companies we own and hundreds of other companies every year on the ground, visiting the management teams, interviewing them, interviewing as many people within a company as we can. You can learn a lot simply by going and doing visits to companies. Some investors don’t believe this is important. We think it’s absolutely vital. We spend way less of our time going to investment conferences and hearing pitches, and we allocate all that time to going out and visiting individual companies and simply being at an office and understanding, noticing how the receptionist responds to the CEO walking a factory floor and to see if people are nodding out of fear or nodding out of respect for the managers that are walking down the hallway. The best thing is when they don’t nod at all because they’re so focused on their work, and they’re not worried about senior management coming down. That would be a great sign. So, we pay attention to all these little details. Certainly, we spend time focused on incentives. How are the people within a company incentivized to perform? How it works in theory? How it works in practice?
And then I’ll tell you something I find very interesting is, so we’re big believers in a collaborative team effort here at Wasatch. So, we never believe in the lone analyst or the lone portfolio manager making individual decisions. We want to build our knowledge based about a company and our insight through this multiple-eyes effort of using our very experienced partners to work together. And one of the places this has shown up the best is in evaluating management teams. And so, we’ve done this practice for about 20 years now where about every year and a half, we take our senior investment team, and we rank all of our management teams from top to bottom. And each analyst and portfolio manager here has to rank a management team as their number one management team and one as their very last. So, you can’t give B-pluses to everybody. And we take those results of each senior professional here and aggregate them, and we come up with a forced rank of our best-to-worst management teams. And we’ve done that every 18 months or two years. And the fascinating thing is that is our best predictor of future outperformance. In other words, the companies that rank the highest in our aggregate view of management teams, which incorporates some culture in it and incorporates competitive advantage of the company.
There’s a lot that can go into someone’s subjective view of how good a management team is. But we just call it here’s our management score. That is our best predictor of future performance. We’ve run studies in the past where we had—we call it the jelly bean exercise where everyone is guessing—it goes back to that that wisdom of the crowds where a group can better assess how many jelly beans are in a jar than one person can if you take the average of all the group guesses. And we’ve done the jelly bean experiment with growth rates, okay, have everyone opine on which company will grow the fastest to which will grow the worst, which stocks will outperform the best to those the worst. But none of those compare to the predictive value for us. They don’t compare to the management ranking. And so, this gets into the culture, but also how we think of using multiple eyes and the wisdom of our team.
Benz: You’re a big fan of learning from mistakes within Wasatch. Is that something you look for in the companies that you own as well, where you look for clues that they have rebounded and learned from mistakes and maybe made themselves better from those mistakes? And maybe you can share an example or two on that front.
Taylor: Absolutely. We’re huge believers in one of our cultural principles is that we’re a learning organization and that with each mistake we make, we should value those because we get better. And the corollary to that is that we don’t fire people for making mistakes here because that would be getting rid of someone who is now more valuable. And so why have someone else benefit from that person’s wisdom for making mistakes? So, we’re big believers in taking a really cold look at our own behavior, our own decisions, the ones that work well, the ones that didn’t work, and how do we continually improve from that.
Certainly, when we look at companies, we want to do the same thing. So, it’s a pretty common question when we’re visiting management teams—tell us the dumbest thing you ever did. Usually there’s mistakes that are more public and open and we dig into those—what happened here? What was the mistake? What’s changing going forward? A great example is one of our four investment holdings here is a company called The Ensign Group, which was a micro-cap that we found about 10 years ago. Of all places, it’s in the skilled nursing business, which we almost had a rule at the time that if you wanted to lose money, invest in skilled nursing. That’s a really difficult, horrible industry. It’s very competitive. There’s a ton of government regulation. You have government reimbursement. Sadly, your census, your population in your nursing home is dying and needs to be replaced. So, there’s a lot of difficult things in managing that business. We found a company in Southern California that just going through the DuPonts that had all these interesting characteristics and they’ve been growing 10% to 15%, had high returns on capital, did not have any debt, which is shocking for a skilled nursing business. I was surprised it was a skilled nursing business when we found it. But basically, what we found is there’s a company with amazing management that had a management approach to the business that was quite different than the industry.
The classic model in the industry is you continue to promote caregivers that are really good at their jobs into positions of management, and they get to a place where they’re not great managers of an entire skilled nursing facility. They were great caregivers, but they’re not a great manager. Ensign goes out and finds really talented people that weren’t even thinking about skilled nursing, and they train them on how to run a very high service, high reputation, skilled nursing facility. The reason they were able to get to the size that they were without any debt is they were able to simply go out and buy assets on the cheap because they were so poorly run, and they could implement their own operations and get them to profitability and do quite well. It’s a tiny company in an enormous industry. So, that’s one of our great themes is, hey, find a company that’s doing something a little different with a great culture, great management team in a huge industry that’s generally poorly run, and you can grow for years and years and years. That company is basically, it’s up 20-fold since we first invested in it. It’s still a relatively small company that we think can grow for years because there’s 15,000-plus skilled nursing homes in the country, mostly run poorly, and they still have 300.
So, a mistake they made—here’s a company that was executing incredibly well. They made a very large acquisition in Texas. They in hindsight would absolutely admit that they made a big mistake because Texas was a hard market. It was a very difficult market for them, and they were seeing results that they weren’t used to in terms of being able to execute in that market versus all the other markets they were in. So, they bought a larger company that was performing quite well and thought that it would help bolster their underperforming facilities in that market. What they found out is that those companies a year and a half later were performing just as poorly, and they had to replace every single one of the facility CEOs within a year-and-a-half or two-year period. The lesson for them was, hey, we have such a great operating model that’s been built on these small ones and two singles and doubles acquisitions. We don’t need to go for a big home run acquisition, and we’re certainly never going to try to help an underperforming asset by acquiring at a higher price, a higher-performing asset.
The reason I tell that story is, we lived through that. It’s a company that we owned when it was really small. They were doing quite well, and then they made this acquisition, and it takes about a year for those results to work into earnings, and the earnings drop, and the estimates drop, and that stock goes completely out of favor. Many people would sell the company because they made a mistake or because it didn’t have the momentum that it had previously. And you have to be patient and long-term thinking. So, we just dug in, tried to understand the nature of the mistake, how the company was responding, what they would do in the future, and we held and bought more, and it took a couple of years, but it bounced out of that and performed incredibly well.
Sorry, there’s a long answer on that, but it’s really important to think about this, the way that returns are generated over time. One of the best-performing stocks in Wasatch’s history is a company called O’Reilly Automotive. I won’t sing the jingle here, but most people know the O’Reilly jingle. We invested in that company in 1998. I think it went public in 1993, and at the time, we found this company that had just a great execution model. They focused a little more on the professional side of the business, which most people never think about when they think about this business. The professional auto repair guys are coming to O’Reilly to buy their parts, and they have to have different types of systems and different types of delivery and logistics to make that work, and they were executing like crazy on that and allowed them to continue to build and grow and grow. The biggest point about that stock is that over the next 25 years, O’Reilly went from three to 300, so it was a 100-fold return, which is just an unbelievable market story and stock story. But the crazy thing is that if you measured it in terms of weeks, O’Reilly spent more time underperforming the Russell 2000 Index than outperforming it. So, how does something go from being worth a dollar to $100 or $100x and spend more time underperforming? It’s because returns are not linear. There are going to be periods and sometimes long periods where stocks underperform, but it would be crazy to get out of them. so, that’s why in small cap, you can really get to understand a company, get to understand the management, get to understand what they’re going through and have the wherewithal and safe to hold through those periods in order to harness these really great returns.
Lefkovitz: It seems to require some real intestinal fortitude to stick with some of these companies through their ups and downs. Let’s turn the mistakes question on you, JB. Have there been times where you’ve sold too early or just gotten the thesis wrong in the first place?
Taylor: Yes, it happens all the time. So, when I’m meeting with a client, a potential client, we tell them, hey, you’re hiring us because of our mistakes. We make mistakes all the time and we learn from them. Then our promise is we try not to make the same mistake twice and we try to learn from those mistakes. But it happens all the time and you can’t be a great growth investor without having stories of companies that you sold too early and didn’t continue to hold because you either thought that they got to a size where they weren’t going to return going forward or you just simply get things wrong.
Well, before talking about an individual security, I’ll talk about learnings that we’ve had in terms of portfolio management where we’ve done things a certain way. Everything we’ve done has been homegrown or organic here at Wasatch and we learn over time by doing back studies and looking at our own behavior and our own data. So, a couple of things we’ve changed over time. One is, we used to have longer lists of names with much smaller weights at the bottom with the idea that, hey, we get to know companies and just enter a small position, maybe 20 basis points, 50 basis points of a company and watch it for a while and see if it turns into something. After doing that for decades, we did backtest studies and realized we have massive amounts of data that’s proprietary to us. We go, hey, we’re not generating alpha for our clients by holding these small weights. We do much better when we wait and have the conviction to buy something at 1% or 2% of the portfolio. And so that’s a change that we’ve made over time.
Another one is, we learned—we used to always leave in small cap that you needed to have kind of 3% to 5% cash to take advantage of less liquid situations when the market would fall out of favor, and you wanted to pounce. And what we found there is that having that extra bit of cash didn’t really help us. We didn’t deploy it the way we thought we did when it was time. And more importantly, it was a drag on performance for the vast majority of the time when the markets are going up, not down. And the other point being is we invest in such high-quality companies that have great cash flow characteristics that when markets do fall out of favor, our funds tend to outperform anyway, so we don’t need that cash buffer. So, we quickly, realizing that over time, we took our cash positions across the funds down to very minimal levels. So those would be examples of learnings that we’ve adopted over time.
Benz: You’ve said that every company is a technology company. I’m wondering if you can talk about what you mean by that?
Taylor: I just think in the last 15, 20 years, software has become so easy to deploy with the cloud, easy to update, easy to change, easy to apply, easier to install, that companies have to be adopting technology. It doesn’t matter what industry you’re in, but if you’re not using the best technology for your company, you’re going to miss out. And so, I think it’s just a notion of, hey, we think of every company in terms of how are they applying tech to gain competitive advantages and do better than their competitors.
One of the best investments we’ve ever had is—we love businesses that are sleepy, a little bit under the radar, not things that everyone thinks of as being a growth business. There’s a company called Copart that’s in the business of—they pick up salvaged vehicles on behalf of insurance companies and then auction them off to buyers who take those cars apart for the parts or they rebuild the cars to make them what they call straight cars, drivable cars again with salvage titles. And this is a company we’ve owned for 20-plus years. It’s been a phenomenal winner in the market in a business of junkyards. Not many people think of being as really a growthy business, but they very early saw the internet as a way to change the business. And so, they – previously, all these auctions were done at a local level where buyers would come and bid on cars, just like you’d see at an auction with an auctioneer and all that. And they were the first to put all these auctions up online, which now seems like an old idea, but at that time, it was revolutionary, and it changed the business forever, and mom and pop junkyards who were in the same business couldn’t compete. And so, they rolled up that industry. And now if you wreck your car, if you salvage it and the insurance company calls it a totaled car, there’s about a 50% chance it’s Copart that comes and picks up that car and takes it to one of their facilities and then it auctions it off to the highest bidder. And they just make a really nice fee every time they do that. And so that’s an example of a company applying technology that’s not a tech company, but it absolutely transformed the business and transformed the industry.
Lefkovitz: Well, JB, we wanted to close by asking you about Wasatch’s independent nature. You recently changed the legal structure of the company. Why is it so important to you that Wasatch stays independent?
Taylor: It’s of vital importance. So, owning your own company is huge because we get to invest exactly the way we think is best to invest. There’s tons and tons of stories in our industry of companies selling out in order to make short-term gains or just selling out, founders leave and want to maximize the value of what they’ve built. And all of a sudden, that company is taken over by a larger firm that has different interests. They have growth interests. They have cutting cost interests. They have different investment objectives. And we want to stay independent because it allows us to invest exactly the way we want. We’re one of the few firms in our industry that has been around as long as we have. We’re coming up on 50 years next year. That has successfully stayed independent the entire time. We’ve never gone outside the firm for debt or capital or any sort. We’ve successfully recycled more than 100% of the equity in the firm from first-generation founders to second- and third-generation founders. And we think it’s absolutely vital for our clients when they come and hire us to say, “We will be independent, we’ll own our own firm, and we’ll make our decisions the way we think it’s best in perpetuity going forward, and you’re not going to wake up one day and find out that we sold to someone else so that we could make a bunch of short-term money.”
Lefkovitz: Well, JB, we’ve really enjoyed talking to you. Thank you so much for joining us on The Long View.
Taylor: I really enjoyed it. Thank you very much for the opportunity.
Benz: Thanks so much, JB.
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