Interview with Cortina Small Cap Value's Alex Yaggy

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Q&As and Interviews

Interview with Cortina Small Cap Value's Alex Yaggy

Shauna O'Brien Nov 11, 2014

Alex Yaggy is the lead manager of the Cortina Small Cap Value strategy, which was launched in 2011 and has $54 million in assets as of September 30, 2014. Previously, Yaggy was co-manager of the Morgan Stanley / Van Kampen Small Value Strategies and an analyst at Neuberger Berman.

Insights from Alex Yaggy First off, congratulations on how the Cortina Small Cap Value Fund (CRSVX) has been performing since its inception three years ago. Besides the markets performing well over that same period, what in particular would you point to as causing the outperformance of small cap stocks?

Alex Yaggy: Thank you. We are very pleased with the results to date and now that we’ve crossed the three year mark we’re attracting a lot more investor interest.

I think there is a misperception about smaller companies – while perceived as risky, in a lackluster economy, smaller companies actually have an advantage over larger companies. They have a nimbleness and an urgency to either grow revenues or repair their operations, and oftentimes both, whereas larger companies tend to have more institutional inertia and scale that extends their willingness to endure the consequences of bad decisions.

Small companies don’t have that luxury, so for us, at the start of every investment idea discussion the first topic is always how the business is evolving for the better. That improvement could be accelerating growth, improving cash flows, restructuring, or all of the above. I think that explains why smaller caps have done well over the past few years – whereas the bigger companies are slower to both recognize their issues and implement the fixes, smaller companies, including new ones, are able to improve and grow rapidly.

When we launched this strategy, our goal was not to recreate the typical value fund that just has a collection of low P/E companies. We looked at what has worked over the past years, and recognized that evolution is the key. Thus was born our approach of ‘We Believe in Evolution.’ It is the cornerstone of our philosophy, which, in practice, means that we only invest in companies that are changing for the better.

Often the bull case for an investment idea is predicated on an equity’s valuation rather than the fundamentals of a business. That’s crazy. You don’t buy a car or a house just because it’s the cheapest, you buy the one that offers the best value. In our view, cheap doesn’t equal value; value is created through the transformation of an underperforming company into a better one. Identifying those companies before the quantitative screens do is our advantage. Candidly, how small caps in general are performing versus other asset classes just becomes noise over time so we just focus on what we know, which is how to analyze companies. One would imagine that along with that outperformance comes the challenge for small cap fund managers maintaining positions in some of the better performing names. How do you navigate through these challenges as far as your fund’s holdings are concerned?

Alex Yaggy: That should not be a problem for portfolio managers and it isn’t for us. As companies get to the upper end of what we consider our market cap bounds, we’re generally headed for the exits in the near future. Reducing and eliminating positions is a crucial part of risk control. In fact, we probably spend more time on when to sell than when to buy. First, our investors are with us to be invested in small cap companies so you are not going to see us morph into a mid-cap fund simply because we refuse to part with our favorite positions that have grown. Second, the portfolio is always in flux and while low turnover is sometimes ideal, a certain amount is necessary.

Our philosophy is very much of a qualitative look at a company supported by a very rigorous and quantitative portfolio construction and risk control process. We sit down at the start of every quarter and revisit the thesis, estimates, and price target for every company in the portfolio with the goal of always having a fresh perspective. We track those targets and how close our positions are to them in real time. When companies hit their targets, unless we can justify a higher target we move on. That is particularly true for positions that have been disappointing for whatever reason.

Inventing a new thesis to justify an existing position is a cardinal sin in this business. Even for companies we really like, fair value is fair value, so once achieved by a company we begin our exit. I’ve been doing this for long enough to know that getting too attached is a risky proposition. What are some of your favorite sectors currently and are there areas that you are becoming less bullish on?

Alex Yaggy: We are fairly sector agnostic, but usually we have a large weighting in financials, industrials and technology. We actually believe Financials are an underfollowed sector, at least in the small cap world, simply due to the large number of companies. It’s not unusual to find really interesting changes occurring at financial services companies that are still below everyone’s radar.

Technology, too, is always interesting. There is so much change in that sector that it’s hard to keep track of, but certainly there are companies we can find that are undergoing structural transformations that will be materially additive to their bottom lines and all the while they tend to have very cash rich balance sheets that protect on the downside.

Today I am most concerned about energy simply due to the massive amount of capital that has flooded that industry. Almost independent of what commodity prices do, it seems likely there is some excess capacity on both the production and services side and, in certain cases, accompanied by high debt loads. I will be very surprised if oil around $80 or below doesn’t result in a few bankruptcies of weaker and indebted companies. That doesn’t mean we don’t have any exposure to energy, it’s just the companies we own have unique characteristics that should weather the current downturn well. Of late I have also been looking at more consumer companies. The internet has created such disruption for that sector and managements are finally getting their arms around how to compete so their companies evolve, so they are becoming more attractive to us than they have been over the past few years. During the recent sell-offs in the markets, we have noticed small caps have been particularly vulnerable. Have you noticed that similar phenomenon and are you considering raising your cash allocation if that persists?

Alex Yaggy: Our mission is to be fully-invested and we have always found that when it is hard to find good ideas, look harder. We think it is a mistake to over commit to a bullish or bearish view on the market because you really just can’t know what the future will bring and your own biases can obscure the true facts. I think small caps appear vulnerable mostly because they tend to be early to reflect changing economic dynamics, both for good and bad. This is nothing new, so it’s not a reason to change our portfolio construction.

Cash for us is really a function of positions growing and shrinking. We’d like it to be 3-5% at any given period, but at times it can be above those levels for brief periods. We would much rather sell a position that is either fully-valued or we have quickly become concerned about than remain invested just to stay within somewhat arbitrary cash ranges. Conversely, as the market has declined recently, we are finding more ideas to execute upon while adding to existing positions, and we could find our cash below 3% fairly quickly. Again, sometimes the best ideas are found in markets where everyone else is lamenting overall high valuations. Many who watch the market contend that Federal Reserve policy is the biggest deciding factor in how markets will perform. Do you tend to put that same sort of emphasis in your investment strategy

Alex Yaggy: I certainly hope not. We are caught in a perverse Fed-speak loop. I don’t want to discount what the extended low rates have done to the economy and the market. It has created many distortions that will eventually be washed away to someone’s great discomfort. Their press releases make easy headlines for the media and easy explanations for portfolio managers to explain their recent performance, or lack thereof, but while the Federal Reserve policy is very important, it is not the only factor. There is an entire economy out there filled with billions of participants that is far more meaningful. I think it’s amazing how much time is spent on the Fed’s words when the impacts tend to be very short-term on the markets. And they are not infallible nor omnipotent.

The biggest factor for our companies is always their individual performance. So the first part of the answer is that while moves at the Fed can create a lot of short-term momentum one way or another, if an Industrial company has a great new product that is taking market share, what the Fed is doing is a lot less relevant to our thesis than how well that product is selling. The second part is to recognize where it is important.

Financials represent roughly one-third of our portfolio where we own banks, insurance companies, a few specialty REITs and other financial services companies. Although that weighting is below the benchmark’s weighting of roughly 40% Financials in the Russell 2000 Value Index, it is still well above most other indexes and many of our peers’ Financials weighting. What the Fed does for both policy and regulations has a material impact on those companies.

Earlier this year when rates were declining, our underweighting of traditional REITs hurt our relative performance as those equities jumped as their yields became ever more attractive, but in other periods such as 2013, just the opposite occurs. Whether that rate decline was related to the Fed’s gradual wind down of Quantitative Easing or bank capital requirements implemented in Europe is someone else’s zone of expertise. To follow up on my earlier comments, it might be easy to attribute market moves to the Fed’s policies, but that may be confusing correlation with causation.

If we find companies that are changing for the better, we should be rewarded as investors regardless of what the Fed, or the economy, or the markets as a whole are doing. Let the talking heads do their thing with the Fed and we’ll focus on what we do.

The Bottom Line

While many investors steer away from small caps, Alex Yaggy and his firm embrace these companies and focus on their ability to grow. This strategy has been successful for Cortina Small Cap Value Fund (CRSVX) – the fund that Alex is the lead manager of.

DISCLOSURE: The views and opinions expressed in this article are those of the author’s, and do not represent the views of Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions.

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