Among Carillon Scout Mid Cap Fund’s (UMBMX) holdings, such stocks as Abiomed (ABMD), Arista Networks (ANET) and Comerica (CMA) are providing enough lift to keep the fund ahead of its midcap blend fund peers and within shouting distance of the S&P 500.
X The fund is down 0.37% this year as of Feb. 28 vs. a 0.87% decline by its midcap blend peers tracked by Morningstar Direct and a 1.83% gain by the S&P 500.
But it’s the fund’s longer-term performance that catches the eye. It’s outperformed both its peers the S&P 500 in the past one, three, five and 10 years ended Dec. 31. It rose 24.02%, and an average annual 14.17%, 16.35% and 11.13% in the past three, five and 10 years.
Former Air Force B-52 bomber crew member Patrick Dunkerley and his co-managers oversee the top performing mutual fund. In an interview with IBD, Dunkerley credited the strong showing to his investment team, their disciplined investment process that combines fundamental, marco economic and technical analysis, as well as a flexible valuation approach.
IBD: You not only beat peer midcap funds in the past 1, 3, 5 and 10 years, but you also beat the S&P 500 in that period, one of only 16 mid cap funds to do so. What’s behind the strong performance in both short term and long term?
Patrick Dunkerley: We are fortunate to have performed well over many years and different time periods. We seek to generate good risk-adjusted returns as measured against our benchmark, the Russell Midcap Index. I credit our team members, including our team chemistry plus our disciplined investment process for this sustained performance.
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Co-managers Derek Smashey and John Indellicate have been with us since inception in 2006, and co-manager Jason Votruba joined us in 2013, along with senior analysts Craig West following health care and Eric Chenoweth following energy and utilities, who joined us in 2016 and 2017 respectively.
Our investment process is unique because we incorporate both top-down macroeconomic and company specific analysis, with an emphasis on quality stocks, and a flexible valuation approach, which changes depending if market conditions are bullish or bearish.
IBD: The biggest exposure has been to tech, consumer cyclical, financial services and industrials. What do you see the source of performance in the balance of this year? What macro trends are affecting your decisions?
Dunkerley: Healthy leading indicators, good credit availability, adequate money supply growth, and an upward slope to the U.S. Treasury yield curve all support our bullish equity view at the moment, but increased volatility seems likely given the market sentiment is adjusting to higher interest rates. From a sector point of view, we are sticking with investments in cyclical companies for now, with an emphasis on technology, financials — including banks and insurance companies that benefit from higher interest rates, industrials, materials, and energy as strong U.S. and global growth is lifting earnings.
The consumer discretionary sector is enjoying a new tailwind, with retail sales coming in stronger than expected, and more earnings performance likely as the U.S. tax cuts and wage increases stimulate growth. We believe stock selection is important so we own deep discounters such as Ross Stores (ROST), or other retailers than can blunt the effect of online competition. In addition, consumer companies offering unique experiences such as Live Nation Entertainment (LYV) benefit as millennial consumers seek entertainment, such as live concerts.
We believe U.S. inflation will increase and the dollar should continue to be soft if risk-on investor sentiment prevails in 2018.
Our position in gold miner Newmont Mining (NEM) helps to insulate the portfolio from a gradually declining U.S. dollar, and should capture benefits from an improving gold price due to curtailed capital spending in the gold mining industry. The company pays a 1.4% cash dividend yield, and has unhedged exposure to the gold price.
Stronger defense spending funded by the recent federal budget should help companies like Harris (HRS), a leader in military radios. In addition, companies like Hexcel (HXL) and Xylem (XYL) are profiting from global growth in aircraft demand and the need for better water treatment, respectively.
We expect equity markets to rise further, but, if credit conditions turn bearish due to an overly aggressive Federal Reserve, then we would become more defensively positioned. This will eventually happen, but it’s not happening at the moment and we believe bullish conditions for U.S. equities are intact, despite the recent volatility in the markets.
IBD: Where are we in the small cap, mid cap and large cap cycle of outperformance/underperformance?
Dunkerley: We think mid caps are set up for competitive performance with the other capitalization categories. For the trailing 10 years ended Dec. 31, 2017, U.S. midcaps and small caps have outperformed their large-cap cousins, as measured by the various Russell indexes, with midcaps generating the best returns over that time period. This midcap outperformance is consistent with longer-term historical data dating back to 1979, although we would caution that mid caps do not outperform in every time period.
For example, last year, the large caps outperformed. But, given the long-term historical outperformance of U.S. midcaps, they deserve a premium valuation and currently they do trade at a slight premium to large caps, based on forward looking (estimated) price-to-earnings ratios. We believe the recent outperformance of large caps was driven by a valuation discount that was too wide. But that discount has narrowed.
IBD: Do you buy only midcap companies or will you buy large caps and small caps as long as they don’t lift or lower the average market cap above or below midcap?
Dunkerley: We seek to buy stocks within the market capitalization range of our benchmark, the Russell Midcap Index, with particular emphasis on companies with greater than a $2 billion market capitalization as they are often more liquid.
IBD: What’s your process for buying stocks? Do you start with screening for fundamentals?
Dunkerley: We believe an active approach can outperform the benchmark by choosing higher-quality stocks, and by employing both top-down and bottom-up portions of our research process. We follow over 150 economic indicators on a weekly basis, and we employ a toolbox approach to valuation, utilizing different tools during a bull market cycle to measure upside potential of a stock, while paying more attention to downside valuation risk during bear markets.
We believe a good understanding of the macroeconomic picture helps us to more effectively position the portfolio sector weights, which are important.
In addition, our bottom up research checklist helps us to identify the fundamentally strong companies with favorable financial characteristics, undervaluation, good business models, effective management, and that are free from serious litigation risks.
IBD: How big a role does technical analysis play in your selection process?
Dunkerley: We do look at charts, particularly as an aid for timing of trades, or to help better understand the fundamental picture at a company. Some of the “cheapest” stocks in the long run, in other words the best long-term investments from my experience, are found making new highs.
We don’t have to be the first to buy or sell a stock in order to be successful, as significant moves up or down can often be long lasting. So quite often, the market will “discover” a stock as evidenced by strong price action seen in the chart. We just have to do the fundamental work to make sure the investment is sustainable. We also buy stocks that are experiencing price corrections if we think they have the quality characteristics we seek, so we are not exclusively buying stocks near highs.
IBD’s TAKE: Many of the top performing stocks in the past were trading at new price highs and above-average P-Es before they made the biggest gains of their run-ups.
IBD: What are your sell rules?
Dunkerley: Our process is to sell a stock due to a negative change in the fundamentals, problematic valuation, if we find a better investment alternative, or to manage our portfolio characteristics. One advantage of active management is the ability to seek to sell stocks with weakening fundamentals before the bad news is fully reflected in the stock price, so we strive to act decisively when our thesis changes.
IBD: Do you spend much time talking with company management or do balance sheet and earnings report tell you what you need to know?
Dunkerley: We believe the numbers reported by companies are one of the most important clues in securities analysis, determining the quality of the business, spotting trends, and evaluating the effectiveness of management. Good investment practice involves a thorough understanding of the cash flow statement and balance sheet, in addition to the income statement. We believe too many investors ignore the former and emphasize the latter, and this causes problems particularly during bear markets.
However, we also like to invest with good management teams, and our investment team meets with various company managements nearly every week, or sees them at conferences in order to better size up their strategies and abilities.
We also read conference call transcripts to deepen our understanding of the businesses and better understand the strategy of management, in addition to face-to-face meetings.
Finally, competitive dynamics are always important and we seek to own companies we perceive as having a sustainable advantage so they can better protect profits and grow, such as a unique products or strong industry position, new product cycle, or management skill. But we don’t exclude commodity businesses that we think are experiencing an upcycle in fundamentals.
IBD: Do you have a standard size, steps or range for beginning positions?
Dunkerley: We often ramp a new position to at least 50 basis points (half of 1%) of the portfolio fairly quickly.
IBD: Your portfolio is quite diversified with 154 stocks and 18% in the top 10 and no stock account for more than a little above 3%. How do you manage your winners?
Dunkerley: We let winners run when it seems prudent to do so, although we often trim the position if we think the upside move is overdone. Our forward-looking valuation tool, the discounted earnings model helps us to gauge upside potential in a stock, primarily during bull markets.
We build these for each stock we invest in, it’s part of our fundamental analysis. So if we notice a stock discounting too much of its future potential, we will often trim it down or swap into another stock. This is another advantage of active management over passive, when properly executed.
IBD: What strategy do you have for lagging stocks that were put into the portfolio with expectations of superior gains but become a drag on portfolio performance?
Dunkerley: Our sell discipline is well defined, and has helped us to outperform our Russell Midcap benchmark by controlling downside risk. We will sell or trim a stock when we detect fundamental deterioration in the business outlook, or if we determine that high valuation is an outsized risk. Each of our team members covers one or more sectors of the market, and we emphasize looking at the downside risks all of the time, but especially prior to each quarterly earnings report.
So we do a lot of work detecting and analyzing downside risk factors in the stocks we own. It’s an ongoing project, and we seek to avoid complacency regarding the fundamentals or the valuation. Keeping tabs on stocks we already own is the majority of the work we do typically.
IBD: Turning to a few of your top holdings, DXC (DXC) has run up 50% since last April and is trading at all-time highs near 103, with a market cap of $29 billion. What do you like about the Hewlett Packard Enterprise spinoff? Sales are down and it’s expected to post its first profit in five years. And does the stock have more room to run, or is it getting too rich — and its market cap too big?
Dunkerley: A clearer picture of the earnings history can be found under the former ticker CSC. On a GAAP basis, the company was profitable four out of the past five years. The top end of the market capitalization range of the Russell Midcap Index is currently near $40 billion, so a $29 billion market cap company is a midcap company as currently defined by Russell.
We think the stock is cheap at under 7X total enterprise value to EBITDA if you look two years out, and Mike Lawrie, the CEO there has a great track record of delivering earnings progress, and positive shareholder actions such as special dividends and spinoffs. If they successfully spinoff the government technology services business, that will be the second time he has accomplished a spinoff since 2015, back when it was named Computer Sciences and they spun off CSRA, another government services technology business.
They also paid a $10.50 per share special dividend that year, so a repeat in 2018 of a special dividend would be sweet, but we can’t forecast that.
This is not a rapid top-line growth situation, it is more about rationalizing the business and managing it more efficiently, so margins can expand. The recent merger with Hewlett-Packard Enterprise Services gives Lawrie a bigger platform to work with. This is one of the best CEOs in America today, we think. So this is an investment in good management execution in what is a competitive technology services industry. We have owned this stock for many years and it has performed terrifically for shareholders.
IBD: Abiomed has also run up, but it continues to post big earnings increases. What’s the potential for this stock and what are the risks?
Dunkerley: For the long term, we think Abiomed has great prospects. They have a strong competitive position in small heart pumps for cardiac surgeries. We think the available possible total market (TAM) for these pumps could be as much as an estimated 500 thousand units globally over time, although we don’t expect Abiomed to capture all of that market, as few companies ever do that and competition almost always surfaces at some point.
We estimate their unit volumes just passed the 24,000 annualized run rate, so there is a long potential runway to this story. Their products are life savers in the hands of a well-trained cardiac surgeon, and they are expanding overseas.
The risks in a stock like this are usually competition, which is developing slowly, high statistical valuation that can lead to a correction in the stock, or some type of unexpected flaw in the technology, or poor execution. Since their devices are approved and used in the U.S., Japan, and Germany, among others, and they have great sales and profit momentum, we view the latter risk as low. The stock has had a great run so it could be a better one to buy on pullbacks.
IBD: Atmos Energy (ATO) is 12% off its high and looking for a bottom. What’s your thinking on this stock’s prospects at this point?
Dunkerley: This is a quality utility company, serving the lower-risk market of regulated gas utility service, with a service footprint in eight states including a large presence in Texas. Regulated utilities offer a better safety profile in our opinion than many industries, so we have owned them in size from time to time when the cycle is right, such as when we expect interest rates to be stable or falling.
Atmos has an excellent safety record, which helps them to gain favor with state regulators, and that has driven better than average earnings growth. They also maintain a conservative balance sheet, which we like.
Atmos may be one of the few utilities that keeps a chunk of their tax savings from the recent corporate tax cuts, due to potential favorable treatment in Texas, where 70% of their assets are located. However, that is a developing situation and will depend on political outcomes, never a certainty.
The main concern with the stock now is the direction of interest rates, which have moved higher. So Atmos has moved down with the utility sector. Our weighting in utilities is underweight currently vs. the benchmark due to our outlook for higher interest rates.
IBD: What happened to Arista Networks that it’s 22% off its all-time high after beating earnings estimates? How do you handle a stock like this?
Dunkerley: Arista is a share taker in the fast-growing switch market for cloud infrastructure. However after a big run-up, the stock has pulled back, possibly due to what we perceive as conservative guidance by management. We think Arista’s advantages are in their software and management expertise, so we are confident in their long-term outlook. Enterprises are rapidly shifting workloads to the cloud and Arista’s networking software was built for this environment.
IBD: What’s your favorite stock at this point, the one with potential to deliver the strongest performance?
Dunkerley: For the near to intermediate term, I would have to go with DXC Technologies, our largest holding due to its low valuation and potential operating margin improvement, the potential for a spinoff, and or another special dividend. The global macroeconomic background is favorable for technology companies at the moment, with decent economic growth in many areas of the world, a change from a few years back.
Finally, technology spending is a capital expenditure which we think can do well in the middle to late part of an economic cycle, since we believe companies are more likely to spend on technology systems when they feel better about their financial prospects. The recent corporate tax cut in the U.S. helps reinforce our point of view on this, we believe. However, for the long-term, Abiomed may have the greatest upside potential due to reasons previously mentioned.
IBD: Where did you serve in the Air Force, and are there any aspects of serving in the military that translate well to money management?
Dunkerley: I served in B-52 bomber units, and was stationed in Maine and California. Military service is good at fostering teamwork and communications skills, and the ability to perform under stress. I enjoyed my time of service and learned a great deal.
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