Portfolio Manager Q&A - Andy Romanowich

With the stock market up double digits in 2023, mostly on price-to-earnings multiple expansion, how do you view current valuations across the market caps?

In general, we’re seeing more attractive valuations the lower you go down the market cap spectrum. It shouldn’t be a real surprise, coming out of last year, where we had really strong returns on a mega cap stocks, and even large cap stocks tended to materially outperform mid cap and small cap stocks. The S&P 500 is near its all-time high, whereas the Russell Mid Cap index is still off about 10% from its all-time high.

When we think about valuation at the stock level, we tend to approach it the same way a business owner would approach valuing their business. We’re focused on the business’s future cash flow producing ability and discounting that to today. So, ultimately, we think in terms of intrinsic value. We do not try to predict short-term movements in stock prices; in fact, we try to take advantage of short-term changes in stock prices by anchoring on intrinsic value. Where we see a divergence of stock price versus our intrinsic value estimate is where we see the opportunities to invest.

How does the team factor in the cost of debt, especially with many years of cheap financing starting to roll off balance sheets?

Financial strength is a very important part of our process, and we don’t purchase too many stocks with elevated levels of debt or aggressive capital structures. When evaluating debt, we tend to look at the normalized cost of debt or normalized interest expense. We recognize that the low interest rate environment of the last five to ten years was not normal. So, by modeling future cash flows based on a normal environment, our portfolio can be better prepared for higher rates.

We think long-term. In our Mid Cap portfolio, the average stock has been held for eight or nine years. We come into these investments thinking like long-term business owners, which means we need to be prepared for any interest rate environment. For this reason, rising interest rates tend to hurt competitors more than our businesses, and we’re seeing that start to play out in the market. Some competitors are going out of business or pulling back on spending to save costs to meet their interest payments. Meanwhile, our businesses are investing; they continue to invest in the company, widen their competitive advantages, and become stronger over time.

Where are you finding opportunities in the mid cap space?

In general, we tend to find opportunities in areas where there’s fear. Fear drives aggressive selling, and when you combine that with the market’s tendency to be very short-sighted, that’s what excites us. That’s where you see wonderful business trading at cheap valuations – or using the framework I discussed earlier, where you see a big gap between our estimate of intrinsic value and where the stock is trading. Right now, one area that’s catching our attention is consumer staples. This sector was one of the weakest performers in the Russell Mid Cap last year. You can point to a lot of investor concerns that have driven stock prices lower – whether it be the impact on demand from GLP-1 weight loss drugs or pricing in a more disinflationary, potentially deflationary environment. These question marks have driven fear, creating a fertile ground for us to search for quality companies that are being overlooked.

We’re also seeing opportunities in technology within the semiconductor value chain. This area has endured headwinds lately, whether it be because of end market demand or just supply in the channel, and revenues haven’t come through as investors had initially expected. What we see from a long-term perspective within some of these companies is tremendous competitive positioning with great earnings power in the long-term. Short-term, their stocks are down because investors are focused on trying to predict when this cycle inflects and when sales growth will inflect higher. We are more patient. We see long-term earnings power and account for it in our valuation of the business.

“Madison” and/or “Madison Investments” is the unifying tradename of Madison Investment Holdings, Inc., Madison Asset Management, LLC (“MAM”), and Madison Investment Advisors, LLC (“MIA”). MAM and MIA are registered as investment advisers with the U.S. Securities and Exchange Commission. Madison Funds are distributed by MFD Distributor, LLC. MFD Distributor, LLC is registered with the U.S. Securities and Exchange Commission as a broker-dealer and is a member firm of the Financial Industry Regulatory Authority. The home office for each firm listed above is 550 Science Drive, Madison, WI 53711. Madison’s toll-free number is 800-767-0300.

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