At KAR, we believe, and have always believed, in quality-based investing. We think the best way of achieving excess returns over time is to purchase businesses with strong fundamental characteristics at attractive valuations. We especially seek out companies whose products or services exhibit significant differentiation that we expect to build and maintain a competitive advantage over time.
Our Mid Cap Sustainable Growth Strategy (MCGS) shares this investment philosophy and has more similarities than differences with our other strategies. However, mid caps have characteristics that differ from both large caps and small caps, and our MCSG strategy is tailored to address these differences in ways that can drive positive results.
Here are four key differences and characteristics of this mid cap stock strategy.
Criteria tailored to a more competitive benchmark
The Russell Midcap Growth Index is a much higher quality and less volatile benchmark than the Russell 2000 Growth Index. It contains far fewer unprofitable companies, which translates into a deeper pool of quality businesses. Since mid-cap growth is a more efficient asset class than comparable small caps, it’s necessary to dive deep and set strict criteria to find companies with the potential to outperform the index.
Search for discrepancies between Wall Street consensus and our researched estimates
Many names in our MCSG universe are more heavily covered by Wall Street analysts than our small caps. It is not uncommon for these mid cap companies to be covered by 20+ analysts, whose published estimates are largely dictated by corporate guidance. Therefore, in addition to our typical evaluation of company quality and valuation, we look for companies we believe have the capability to exceed these Wall Street estimates consistently.
Vigilant attention to innovation and disruption cycles
Disruption is a significant factor in evaluating mid cap companies. At times of heightened innovation and disruption, such as today’s technology-fueled wave, companies can rapidly increase in value, leading to multi-year outperformance.
However, disruption generally involves a business strategy of heavy upfront investing, which can initially obscure long-term profitability. Combined with the fact that today, many disruptive companies are staying private longer and may implement their IPO as a mid cap or larger company, it requires extra focus on identifying the start of such cycles to take advantage of opportunities.
Smaller initial positions in emerging businesses to mitigate risk.
The upside in finding companies in the early stages of competitive disruption can be significant. We recognize that opportunity with a willingness to take smaller initial positions (1%-3%) in emerging businesses in early-stage, heavy-investment, high-growth periods to mitigate the elevated risk. Although these companies tend to have much higher P/E ratios and earnings volatility than more mature businesses, we choose our selections based on indications that they are on a path to developing strong fundamentals. Many of these disruptive companies will likely move into the large cap universe.