Commentary - December 2023Greenspring Mid Cap Fund

Portfolio Managers Chip Carlson, CFA and Michael Goodman, CFA emphasize the attractiveness of mid-cap companies in today’s environment, the importance of free cash flow and strong balance sheets, and a new position that exemplifies the team’s approach to finding “All-Weather” companies.

Market performance in 2023 was driven by large-cap technology companies. What could drive mid-caps to outperform their larger peers in 2024?

A few powerful macroeconomic drivers are potentially in play for mid-cap companies. If the U.S. economy experiences a “soft landing,” investors’ appetite for small- and mid-cap stocks should increase. The Federal Reserve has indicated that it may cut interest rates in 2024, which should improve investor sentiment toward smaller companies. In general, lower interest rates reduce borrowing costs for smaller companies, making it easier and less expensive to finance projects.

There is currently a large disconnect in the price-to-earnings (P/E) multiple between mid- and large-cap stocks. As of December 2023, the average 2024 P/E of the Russell Midcap Index was approximately 20% lower than the S&P 500 Index’s—the largest disparity in a decade.

The Cromwell Greenspring Mid Cap Fund focuses on finding “All-Weather” mid-cap companies that have strong balance sheets, significant free cash flow generation, experienced management teams, and company-specific catalysts and/or secular tailwinds.

Why do you emphasize free cash flow and strong balance sheets in your investment process?

We believe companies with these qualities, combined with strong management teams and a secular tailwind, can create long-term shareholder value even in a difficult economic environment. Possessing higher free cash flow can be viewed as a defensive posture to help minimize declines during difficult periods. Simply put, companies generating higher levels of cash flow have more financial flexibility. This financial strength allows these companies to pursue value-creating acquisitions, reinvest in their business, or repurchase stock.

Finally, while the Fund’s holdings may not fully participate in strong markets when lower-quality companies are leading the pack, we believe the Fund’s emphasis on more defensive companies can limit the losses in down markets, leading to superior long-term risk-adjusted returns.

Would you please discuss a new position that exemplifies your investment approach?

We purchased Kenvue, which was spun-out from Johnson & Johnson in May 2023. It is a global consumer health company with market-leading brands such as Tylenol, Neutrogena, Listerine and Zyrtec. Operating as an independent company, Kenvue should benefit in several ways:

  • Its experienced management team can accelerate growth by maximizing investments in product innovation and promotion, while regaining market share as supply chain issues recede.
  • With a strong balance sheet and significant free cash flow generation, management is well-positioned to create value by growing dividends, repurchasing shares, and/or making complementary acquisitions.

Spin-offs often trade at attractive prices due to a lack of investor awareness and a stand-alone track record. Kenvue is no exception, trading at an attractive price relative to its free cash flow generation and at a significant discount to its peers. Over time, we expect this valuation gap to narrow as the management team establishes its ability to grow shareholder value.

Why are spin-off companies attractive places to invest?

Over the years, we have found spin-offs to be a unique opportunity to find underfollowed, but solid businesses selling at temporary discounts. When a larger company divests a particular business unit, the results can be a more focused and streamlined operation, allowing the new business to concentrate on its core competencies. This increased focus can lead to improved efficiency and better management of resources. The spin-off could unlock hidden or undervalued assets, leading to a reevaluation of the spinoff’s true worth, potentially creating an investment opportunity as the market may not have fully appreciated the value of the spun-off entity.

The management of a spinoff company is often given greater autonomy and a more direct stake in the success of the business, which can incentivize them to make strategic decisions and implement changes to enhance the company’s performance and shareholder value.

Finally, spin-off companies are typically smaller and more nimble compared to their parent companies, which can allow them to adapt more quickly to changes in the market, pursue growth opportunities, and respond to industry trends with greater agility.

Price-to-earnings values a company’s share price relative to its earnings per share.