Pursuing Consistent
SMID Growth Returns

Did You Know? 

SMID GROWTH AND SMALL CAP GROWTH RETURNS ARE HIGHLY CORRELATED

Investing in SMID growth companies can provide exposure to the small cap growth universe, where access can be limited because of manager capacity. The Russell 2500^TM Growth Index includes the 1,074 names of the Russell 2000® Growth Index, as well as an additional 194 mid cap names.ⁱ As a result, the correlation between the total return of the two indices is almost perfect at 0.99.ⁱⁱ Despite highly correlated returns, the Russell 2500 Growth Index is slightly less volatile; its standard deviation is 19.51% versus 20.68% for its smaller counterpart.ⁱⁱⁱ 

Our Philosophy and Approach to SMID Growth Investing

Our investment philosophy has been carefully designed to pursue strong risk-adjusted returns over full market cycles with a low-volatility approach to high-growth investing. The main tenets of our philosophy are:

• Companies with high-quality business models and secular growth opportunities tend to generate more consistent returns.
• High-quality companies that are under-recognized by the market tend to generate outsized returns consistently over time and present opportunities for bottom-up fundamental research to be rewarded.
• Inherent volatility of small and mid cap stocks requires a comprehensive, active approach to risk management to help preserve consistent excess returns generated from stock selection.

In the following sections, we explore how these beliefs inform the process by which we seek to identify high-quality, high-growth businesses with positive fundamentals that market participants have not fully recognized. 

Why Quality Matters

We believe high-quality companies offer investors opportunities to compound consistent returns over time. We define a quality business as a small or mid cap company with strong potential to grow into a successful large cap company. To substantiate this belief, we constructed an analysis with the objective of creating a hypothetical investing environment to determine if the combination of stronger return on assets (ROA and a proxy for quality) and superior sales growth (a proxy for growth) could
result in a better investment opportunity set. Specifically, each year we divided the constituents of the Russell 2500 Growth Index into thirds based on that year’s ROA. Within each ROA bucket, we further grouped the securities into thirds based on that year’s sales growth. We calculated various statistics annually for the nine buckets and then averaged the results over the 10-year study period. We observed higher ROA and sales growth companies had stronger returns and information ratios^iv than their lower ROA and sales growth counterparts, as shown in the table below.

This analysis supports our philosophy of seeking to identify high-quality businesses with above-average growth. So, how do we approach identifying the quality companies of tomorrow? In reality, quality has no perfect predictors. We view quality holistically because we believe quality is about a company’s ability to grow into a larger entity in a way that creates value for shareholders, and no one metric reveals this business attribute. We have found quality companies often have differentiated,
secular growth stories and business models that can generate cash. Our integrated process profiles businesses according to hard metrics and softer qualitative characteristics. The qualitative and quantitative aspects of our work converge in the development of our thorough company-specific quality profiles. To illustrate, we review our approach to two important analytical characteristics—revenue and earnings.

Ten-Year Analysis of the Russell 2500 Growth Index for Quality &
Growth Characteristics

Source: S&P Capital IQ, Loomis Sayles analysis from 31 December 2013 to 31 December 2023. The underlying universe was the Russell 2500 Growth Index. Returns are annualized and include reinvestment of capital gains and dividends but do not reflect any fees or expenses. The analysis assumed a one-year holding and rebalancing period. Please see the Endnotes for a more detailed description of the
methodology. This is for illustrative purposes and does not represent any Loomis Sayles investment product.

Past performance is no guarantee of future results.

For obvious reasons, revenue is an important aspect of a company’s growth profile. We seek businesses with visible revenue growth and sustainable revenue streams, such as subscription services or backlog-driven business models. Predictable revenues help drive the magnitude and sustainability of growth by enhancing a company’s ability to generate cash to reinvest in its business. While revenue numbers tell a quantitative story, the qualitative aspects driving them illuminate a company’s long-term potential.

When assessing a company’s earnings, we do not use a static earnings hurdle. Rather, we look for a company’s ability to generate relatively steady earnings growth. Earnings stability can provide insight into other aspects of business quality. Consistent earnings may indicate increasing cash flow, which management must efficiently allocate to grow the firm. Relatively durable earnings growth often points to business model effectiveness and favorable competitive positioning. Both are key drivers of a company’s long-term prospects. Assessing a company’s earnings profile, coupled with these more qualitative aspects, furthers our understanding of a company’s long-term prospects. 

Our Investment Process 

1. IDEA GENERATION 

We use a proprietary growth screen and traditional fundamental analysis to source investment ideas. Roughly half of our ideas are sourced through the growth screen, which is informed by our investment philosophy. We also leverage our experience in
fundamental research and network of industry and company contacts.

2. FUNDAMENTAL ANALYSIS

Regardless of the source, we research each investment idea using rigorous fundamental analysis. Given our focus on quality, we seek companies with visible and predictable growth drivers, strong competitive advantages, business model strength and management teams with vision and experience.

3. DISCOUNTED CASH FLOW (DCF) VALUATION ANALYSIS

To better understand and compare the reward-to-risk in high-growth businesses across sectors and industries, our primary valuation tool is DCF modeling. Critical model inputs are developed during our in-depth fundamental analysis.

4. BUY DISCIPLINE

We seek to initiate positions at a valuation offering a minimum 25% upside potential with a return-to-risk profile of two to one, upside to downside. We target at least a one-year holding period, although we prefer a multi-year holding period.

5. PORTFOLIO CONSTRUCTION

The portfolio is a diversified, style-pure SMID growth strategy with approximately 65 to 85 names. Position sizes are typically 0.75% to 3.0%, based on our level of conviction.

6. SELL DISCIPLINE

We actively monitor all holdings in the portfolio. A position can be sold or trimmed for several reasons: a stock attains our price target, the position grows to a portfolio weight that is beyond our fundamental level of conviction, the investment thesis deteriorates or we identify a better risk-to-reward opportunity. We follow a stop-loss discipline based on both absolute and relative price action, under normal market conditions.

7. INTEGRATED RISK MANAGEMENT

We believe a high-conviction active management process requires disciplined risk awareness. Our risk management is integrated into our investment process from the stock level to the portfolio level and from the buy discipline to the sell discipline.

Our Focus on Unrecognized Companies

We not only seek to invest in quality businesses but also those that have yet to be recognized by many investors. Market inefficiencies create an information gap between a company’s stock price and our longer-term valuation expectations, a differential that is often more pronounced the less visible a company is in the market. SMID growth companies outnumber
large cap growth companies by almost 4.3 to 1,^v but large cap growth managers outnumber SMID growth managers by 2.5 to 1,^vi resulting in far fewer investment professionals to cover a much larger investable universe. Our ability to efficiently identify
quality companies where valuation disconnects exist is essential to achieving our long-term performance objectives. To discover these underexploited investment opportunities, we utilize a proprietary tool with the objective of identifying emerging winners early in their growth cycles. We concentrate our analysis on top-tier growth companies with favorable price and volume trends.

Once we identify portfolio candidates through this targeted screening process, we focus our fundamental research on valuation to determine if disconnects exist. Finding opportunities that others may overlook is integral to our process. Similar to developing a company-specific quality profile, our proprietary research results in a company-specific valuation model using discounted cash flow (DCF) analysis. DCF modeling’s emphasis on future cash flows supports our belief that efficient capital use in high-growth businesses can lead to superior cash flow growth and create shareholder value over time. Companies may have different growth drivers, but a business’ future success will often be seen in its cash-generating ability. We also favor
DCF analysis because it tends to reward businesses and managements that allocate capital effectively; this analytical tendency supports our quality bias in the portfolio. Finally, cash flow is fairly universal, allowing for effective comparison across companies and industries. We believe using DCF models to value high-growth businesses differentiates our approach from many in the SMID growth space.

Our philosophy and focus on fundamental bottom-up research among underexploited companies results in a portfolio with returns that are typically driven by stock selection. Since the strategy’s inception, a majority of our returns have come from stock selection rather than sector allocation, market timing or other factors. We believe this is important to sustaining performance over the long run. 

Integrated, Holistic Risk Management

A high-conviction active management process requires disciplined risk awareness, since the majority of risk we assume is stock-specific, not factor risk. As a result, disciplined risk management—from the stock level to the portfolio level and from the buy decision to the sell decision—is integral to our investment approach.

• BUY DISCIPLINE: We match position sizes to our fundamental level of conviction and our estimate of business model risk. While the portfolio is built from the bottom up on a company-by-company basis, diversification is also built into our buy discipline through limited sector weights and position sizes. Combining relatively tight constraints with an active bottom-up stock selection process supports our objective of generating alpha through stock picking, not sector bets or other factors.
• ONGOING MONITORING: We actively adjust positions as needed to manage risk in the portfolio. We also manage risk on the security and portfolio level using several customized processes. To monitor the most appropriate risk metrics for our strategy, we utilize a proprietary risk management tool developed by our Quantitative Research and Risk Analysis (QRRA) group and tailored to our strategy objectives. Additionally, daily reports provide real-time risk information, including portfolio factor exposure, beta and individual security contribution-to-risk factors.
• SELL DISCIPLINE: We actively monitor all portfolio holdings, and sell decisions are typically a function of price target attainment or deterioration in the fundamentals of our investment thesis. However, we also have a clearly defined stop-loss discipline to highlight where our view is significantly at odds with the market. Material price deterioration over the trailing month can lead to further review and, most likely, a sale. This tool helps remove emotion from the decision-making process and supports capital preservation.