After a strong year for large cap stocks in a narrow market, where do mid caps fit, and what role do they play in the portfolio?
Mid cap stocks should be viewed differently than large cap stocks. Unlike the S&P 500 Index, there isn't a concentration driving returns in the mid cap space; rather, there is a wider breadth of companies in different industries that are driving returns, thus more diversification. Mid caps represent a sweet spot in the equity market, where you have established businesses with longer track records than the riskier small caps, but often there is a greater runway for growth compared to large caps. A lot of the large and mega cap stocks today were mid caps at one point. Mid cap stocks have worked incredibly well on a risk-adjusted basis over full market cycles yet remain a somewhat overlooked area, so we think it is a nice core addition to any portfolio.
How do you view valuations in mid caps?
If you compare the consensus price to earnings (P/E) estimates of mid caps and large caps, there is a pretty wide gap, yet if you look at the estimated growth for both the S&P 500 and Russell Mid Cap indices, it is similar, at 14-15% over the next couple of years. So, you’re getting similar growth for a lower starting P/E, and that starting point matters. History shows a clear negative correlation between the starting P/E ratio and historical returns. I think that's substantiated by our bottom-up process. We don't make big macro or top-down calls; we really dig in at an individual security level. And as we look at our pipeline of new ideas, we are finding more ideas at the lower end of the mid cap market cap spectrum, which jives with what we’re seeing from a relative valuation perspective.
Artificial Intelligence continues to dominate headlines, with recent developments—such as the Chinese company DeepSeek's AI advancements—raising questions about the economics of established players in the space. Given the uncertainty surrounding valuations in this rapidly evolving landscape, how does your team assess core fundamentals like moats and earnings stability when evaluating companies in this sector?
What occurred with DeepSeek is an excellent reminder that there are always risks, and the market doesn't always price in risk. It gets to market psychology of fear and greed cycles and FOMO. At Madison, we're always focused on risk. When analyzing businesses, we’re intently focused on their moats or competitive advantages, and we're looking at the sustainability of their growth. When we're researching an industry like AI, which has great promise for tremendous growth and has already seen a lot of growth, what we're looking at isn't any different. Is that growth sustainable, not just over the next year or two, but long term? It's easy to be allured by the prospect of tremendous growth in the next couple of years, which could impact the stock price in the short term. However, the real driver of a business’s intrinsic value is its ability to generate free cash flow five, seven, and ten years down the road. A company with a durable, sustainable competitive advantage (or "wide moat") is more likely to achieve higher returns on invested capital, maintain strong margins, and steady cash flow growth over an extended period. Ultimately, this has a lasting impact on the company’s intrinsic value and the long-term return on investment.
Yes, we may need to be more rigorous when dealing with rapidly evolving information, as we've seen with AI. However, the core principle remains the same: assessing a business's true earnings potential over the long term, with a focus on its sustainable competitive advantage.
How does the team think about interest rates, and what do you look at to assess a company’s ability to withstand a higher cost of debt if rates stay higher for longer?
As a long-term investor, where our typical holding period is eight or nine years, we think about interest rates—or any macro factor—on a normalized level. We anticipate a normalized level of interest rates over time. So, we don't typically see big changes in our assessment of our companies based on the latest Fed news or unexpected interest rate movements. When it comes to debt, specifically, the nature of the businesses we're looking for tend to have less debt, so they're more immune than average to changes in interest rates. Not to mention, these tend to be all-weather businesses that are well-positioned to take the ups and downs in an industry or an economic cycle and are more than capable of paying the debt they do have.
As a result, we’ve typically seen that, over time, our portfolios are not drastically sensitive to interest rate movements. Rate movements, either positive or negative, do not have much of an impact on our portfolio.
Are there sectors in the market that you are excited about going into 2025, whether it be from potential policy changes from the new administration or where we are in the economic cycle?
There are quite a few, and the common theme is that these areas are out of favor. They might be out of favor because investors are anticipating certain policy moves that could be negative for these sectors, or they might be in a weaker part of their economic cycle. But where there's concern, where there's fear, we see opportunity.
Some areas that look interesting to us include higher quality industrials, where we think there are pockets with great, diversified businesses that can handle broad weakness in the sector. We are seeing some intriguing valuations within Consumer Staples, which have lagged the market for a while. Macro factors, like the impact of GLP-1 drugs, are real, but investors may be overreacting to the perceived risks. Additionally, interest rate volatility has caused some great businesses to get caught up in the market’s sell-off of interest rate sensitive companies, and we’re seeing some opportunities there.
We remain anchored on the individual merits of the business and its earnings ability. When the market reacts to headlines or focuses on near-term stock price movements, we’re thinking about the long-term value of the business. And when there is a big disconnect there, that excites us.