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Key Themes for the Small-Cap Space

Greg Carlson

Greg Carlson: Hi, I'm Greg Carlson, and I'm a mutual fund analyst with Morningstar. I'm joined today by Chris Colarik, manager of Glenmede Small Cap Equity.

Chris, thanks for being here today.

Chris Colarik: Thanks for having me.

Carlson: Now, Chris you have been a comanager on this fund since 2001, is that correct?

Colarik: That is.

Carlson: And you work with Bob Mancuso, who has been a leader on the strategy for even longer than that.

Colarik: That's correct. He took over the lead role in 1993. So, he and I have been working together a little over 12 years now.

Carlson: Right. And you have got a process that you have used for the entire duration of that tenure?

Colarik: Yes, that's correct. The process begins with a quantitative model where we are looking to identify stocks that are inexpensive, beginning to have positive estimate changes that are high-quality in nature and are beginning to be recognized for those qualities by the market. And with that then we do a fundamental overlay, both from a macro perspective looking at sector allocation and industry groups, and then also within the individual securities.

Carlson: And you mentioned your overlay, it's somewhat of a theme-driven process?

Colarik: Yes, it is. When we are doing our analysis, whether it'd be from a macro perspective or looking at the fundamentals of securities, a lot of times what we find out during our conversations again whether it be Wall Street or whether it be with their internal analysts or just reading strategy pieces, themes tend to be identified to float to the top, that become obvious that we want to begin to look for names to participate in.

Those particular groups might be experiencing a growth cycle, longer-term secular trends that we are going to try to latch on to and try to benefit the portfolio from.

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Carlson: And those themes tend to be more at the industry level perhaps than the broad sector?

Colarik: Yes, exactly. One of them that we've had for probably about 18-24 months now is the auto industry. That's a play that, again, doing this analysis what we found is a lot of people in 2008, that's easy to reconcile, put off the purchase of a new vehicle. We had low consumer confidence; we had high unemployment. And more recently as we fast forward to today, and over the last year or two, we had an improvement in the consumer-confidence levels. We've had improvement in job growth; we've had improvement here in the U.S.; we have low interest rates; and we have incentives coming from auto manufacturers.

So, we try to figure out again utilizing our model and our fundamental overlay, what names could we identify that would participate from this replacement cycle.

Now again, these cars on the road traditionally have been eight years old; now they're 11. So, we identified a couple of retailers like a Sonic Automotive or Lithia Motors that sell, both, domestic and foreign cars, both new and used. And then we found some companies that supply into the manufacturers like an American Axle or a Tenneco. And they supply things such as chassis and springs and struts. And even a Littelfuse is a company that we identified about a third of their revenues are generated from the little fuses that are used in the fuse boxes of vehicles.

Carlson: Since this is a small-cap fund, as you say, you are focusing more on the suppliers rather than the manufacturers?

Colarik: Correct. [The manufactures would] be a little bit too big.

Carlson: And the same seems to be true in another theme that we discussed earlier, the aerospace theme?

Colarik:  Yes. Aerospace is another one similar to the auto manufacturer. The air fleet in the country is a little bit dated, and so they are going to a refresh cycle currently where they are replacing seats, the galley equipment and the carpet, and those things inside the plane.

Also what's happening is there are some capacity strains that are going on. There is an increase in flight travel both here domestically and internationally. So what we have there is obviously a lot of conversation about the Boeing Dreamliner 787 these days, and then also you have the A380, the Airbus plane that was built a few years ago when the first one rolled out, another large jumbo jet. And these are off to facilitate that need.

And we are trying to find ways to identify names that are participating in what would be a longer-term secular play. And so, again those are names like a Triumph Group and Moog, a couple of names that are again supplying into whether it’s the fluid-handling system in these planes or rudder boards in the plane, those sort of things, and the various platforms that there are across the board.

Carlson: Now in terms of performance, the fund had a solid 2012. Can you touch a little bit on the areas that helped you most?

Colarik: Yeah, I did lead into it a little bit there. The basics and consumer names were the largest contributors to our overall outperformance. Then again within that a lot of it had to do with our theme plays, whether it be aerospace, which was very accretive to our relative performance. And also in the consumer, the auto industry was very positive as we had throughout the year, the number of vehicles being produced in the country continued to ramp up. It was very profitable for the dealers. And so it was a very good benefit for the consumer sector. So, those were the two biggest contributors for the fund for the year.

Carlson: And then on the flip side technology was the biggest detractor?

Colarik:  Yes, technology was. That was a little bit of a drag. Unfortunately, it seems as if there is a lot of postponement of capital enhancements in the IT departments of a lot of companies despite being flush with cash, most companies.

I think some of the politics put a little bit of a hold on some spending. We had the fiscal cliff. We dealt with the debt ceiling a year or so ago; we are dealing again currently with it. We had the European debt crisis and a lot of those things. IT is one of the easier capital expenditures that a CEO can put a hold on. And I think a lot of that happened toward the end of the year until we got some resolutions to these things. Hopefully, we are going to get that resolution here shortly, and we will start to see a better 2013 for some of those companies.

Carlson: Finally, in what types of environments do you expect to fund to fare better or worse?

Colarik: In environments where low-quality, high-beta, high-valuation stocks are working, we tend to lag a little bit. Fortunately over the course of a market cycle that is the shorter period of time. The periods of time that we are going to do well is when valuations are relative or meaningful, when earnings mean something,  and when profitability means something. When investors focus on those characteristics and management, we expect to do really well. That's right our wheelhouse, and of course during the downturns we tend to hold up better because of our emphasis on quality and valuation. Just by nature, they tend to hold up better than the overall market.

Carlson: Well, thanks very much for your time, Chris. I appreciate it.

Colarik: Thank you. I appreciate it.