Chiara: Hello and welcome to TDAM Talks ETFs, a podcast where we dive deep into the world of exchange traded fund markets in Canada. We will share the latest trends, insightful analysis and uncover strategies that will help you navigate the complex world of ETF investing. I'm your host, Chiara Carozzi, here at TD Asset Management or TDAM for short. Today's largest and most recognizable stocks were one small and mid-cap companies.
Chiara: On the podcast today, we will be exploring a big opportunity in a small and overlooked place in the market, small and mid-cap markets, otherwise known “SMID” for short. This place can provide a huge opportunity for valuation discounts, strong earnings growth, momentum and most importantly, diversification benefits. Today I'm joined by Trevor Cummings, VP of ETF distribution here at TD Asset Management and a returning guest, Britney Puglia, who is the regional vice president in the advisor distribution channel here at TD Asset Management.
Chiara: Welcome to the podcast.
Trevor: Glad to be here.
Britney: It's a pleasure.
Chiara: So maybe we can begin by discussing and telling our listeners what are small and mid-caps and why SMID in the U.S. versus Canada?
Trevor: Yeah. So I mean, I guess if you if you think about market capitalization, there's a couple of ways to slice and dice the market. You can think about mega caps, which are all the ones you just mentioned, the Magnificent Seven, those sort of names, large cap would be the next step down mid-caps, kind of the middle not by number of businesses, but certainly middle by categorization, then small, then micro and the opportunity I would say in the marketplace really is in that small and mid-cap space because as you mentioned, it's overlooked.
Trevor: It's not an area where investors or investment professionals often allocate to a lot of people building portfolios feel that they're sufficiently allocated to, you know, US equities, for example, by buying large cap. But there is this entire world of opportunity once you go a little bit beyond the names that are the most familiar, I think, you know, everybody and their brother, everyone in their sister these days is talking about Magnificent Seven and is it Magnificent Six?
Trevor: And you know who's next to join the party, etc., etc.. There's a big AI kind of gold rush. But again, under that surface, there's just a ton of well-run businesses that can diversify portfolios and enhance return potential from here. So I'm really happy to be here today to to dive into that a little further.
Britney: I'll add I am just super passionate about this space because being an American coming to Canada, everyone knows those large and mega-cap names and there's just so much more opportunity and so much more to talk about than those names. So I get really excited when I speak with advisors and people on the street. There's more opportunity than what they often talk about, and so I get to do that for them and with them.
Trevor: So I guess the other thing too is we can get technical about the definition of small caps. The small cap is kind of $300 million to $2 billion market cap companies. And maybe depending on who you ask, you know, mid-cap might be $2 to 10 billion. I think one of the index providers has names that are as high as $15-$16 Billion considered to be market cap.
Trevor: These are all U.S. dollar terms. So I think it's important to make the distinction that these are going concerns. These are real businesses. They have revenues. They have earnings in most all cases. Certainly in the case of our ETF, they would be profitable and they're not fly-by-night. These aren't lottery tickets. These aren't binary outcomes where you lose everything or you win the jackpot.
Trevor: It's not kind of a lottery effect. These are real companies. The other interesting aspect to this is; there are Canadian large cap names, large cap to our own market, that would be considered mid-cap names in the United States. So if we think about that sort of dichotomy of crossing the border, a mid-cap U.S. name might be considered a large cap name if it were a Canadian domiciled company.
Trevor: And so, again, you know, as we think about investing beyond large caps into smaller and mid-sized companies in America in particular, what we're here to talk about today, that's actually part of the market that is in some cases as big as our large caps up here.
Chiara: Every investor should have exposure to U.S. equities in their portfolio. There once was a time where putting money into the S&P 500 index was deemed a safe way to invest and diversify. But now we're presented with a situation where the S&P isn't all that diversified anymore. We're seeing one of the highest levels of concentration, a typical professional portfolio might have half of that degree of concentration risk that can currently be seen in the S&P 500.
Chiara: And Trevor, you mentioned the “Mag seven” or I think it's the “Mag Four” now you're seeing sky high valuations. So let's unpack that and let's maybe explore the opportunities that present itself in the small - and mid-cap space as an attractive place to be right now.
Trevor: I mean, I guess if I was to say maybe a couple of things that that are pretty interesting. And again, if we go back to first principles, you can kind of think of why would someone buy small or mid-cap businesses in the first place? And the first reason is usually because these companies are growing much, much faster than large-cap or mid-cap companies where they at least have the potential to grow much faster.
Trevor: If you think about a giant bank versus a small Fintech startup or an online bank, you know, ask yourself which of those companies has the possibility to triple or quadruple earnings in a decade or half a decade? It's probably the smaller company. And if history is any indication, small and mid-cap names grow much faster. They grow their earnings and their revenues at much faster paces than large-caps.
Trevor: Now, historically or traditionally, what that also kind of means is that you would pay a premium for that. I think in the textbook definition of small and mid-cap investing, what that's meant, is that you pay higher multiples for businesses that are growing faster. That's kind of inherent. Something really interesting happened probably about five or six years ago, though, and that is to say that small and mid as a category started to trade at lower earnings multiples than large cap and mega-cap.
Trevor: And maybe the best way to say this is: it's not so much that they started to trade cheaper than large and Mega, it's more like large and mega started to trade richer than small bit. So the valuations if you think about the large cap U.S. indexes, they're all trading at sort of 19/20 times earnings these days. If you looked at small mid, the index itself is trading more like 14 times earnings.
Trevor: So the really interesting opportunity and no one knows how long this will last, but the opportunity these days is you can get faster growing businesses at lower multiples, at lower earnings multiples or sales or book value multiples than you would the large cap space. Some of this is probably because of this love affair that we're having with the Mega-cap names.
Trevor: The expectation is that they'll just continue to do what they do, but nothing lasts forever. And so I think this is a time, the opportunity, if you've got a really healthy return, say, in your U.S. equity space, it's time to start thinking about diversifying, maybe into “SMID”.
Chiara: Can we maybe touch upon the concentration risk that you've seen in the S&P 500 and across all investments?
Britney: It's a really great question because most investors don't realize just how concentrated the S&P 500 index really is. And so if we take a step back and we look at why is diversification so important for our portfolios? And the answer is because portfolios need to be set up to weather all sorts of market conditions.
Britney: When an investor says, I want to invest in the U.S. market, they tend to anchor to the S&P 500 as their index to gain some broad exposure. Now, when you look under the hood and you start to go down the path of what's in the S&P 500, you realize that, wait a minute, there's a lot of technology here.
Britney: So from a weighting standpoint, the S&P 500 is not an equal weight index by nature. And even if you could invest in the S&P 500 on an equal weight basis, you still see so many technology names or sub-sectors of technology. And so when investors see that and they start to say, okay, well, I need to add to my U.S. exposure to get diversification, they start adding to more mega and large cap names.
Britney: They start adding individual names that already exist in the index and so this over concentration issue is perpetuated at that point. What we are proposing is to say, let's look at adding something that truly is different into your portfolio. So by utilizing the TD Q U.S. small mid-cap ETF, investors are able to add diversification to their market cap. They are able to add diversification to their sector allocation.
Chiara: And what they're doing then is building a really more robust allocation to the U.S. market, which will help them weather different market conditions.
Trevor: I would say maybe I'll add, think about all of the stocks in the entire world. There are a few that have $3 trillion market caps, trillion with a T, they're American. Think about the $2 billion market cap companies. There's a new one, one gold star if you know who the recent $2 trillion market cap company is. It's American.
Trevor: Another name just hit $1 Trillion market cap in the U.S. All the trillion dollar market cap companies are American. So if you think about a large-cap index or large/mega sort of index, the top ten holdings represent almost well, actually, it's over a third of your portfolio. And I don't know how much is too much, but if you think about small- mid-caps for example, the top ten holdings might only be 20%, 25% of the portfolio.
Trevor: You have way more names or you have way more candidate names. I think to think about, you know, small/mid sort of approach, but none of them dominate the category the way some of the familiar $2 or $3 trillion market cap stocks just dominate the large cap space right now. So you diversify away if you were to add some small mid to portfolios, but you're also going to even in isolation, be more diversified than if you are buying a large cap benchmark.
Chiara: And we're not discrediting these companies in the top ten. They are high quality companies that generate copious amounts of cash flow. But the point that we're really trying to drive home is that high concentration in one sector is something investors should be concerned about. You know, we're trying to provide a smooth ride for your investments, especially when times are tough.
Britney: I do want to talk a little bit... I do want to make a comment any way that in the mid cap space, like when I was building portfolios for clients or in my experience in the industry, it's, you know, mid-cap companies and those small cap companies, especially the well-run ones, especially the ones that have sound business leadership and growth potential, they may even be ripe in certain markets or economic situations to be bought or M&A activities in that space.
Britney: So there's a lot of ways in which the SMID space has opportunity to compete. And I think we hear about companies - looking at these large companies that are buying up smaller companies, but that's happening in that “SMID” space. And so there is opportunity for growth and competition.
Chiara: What would be some key considerations when investing in small mid-cap space? We often talk about the efficiency frontier when discussing SMID, how it improves on lowering risk and increasing returns.
Chiara: Can one of you provide a little bit of color on that for our listeners?
Britney: Absolutely. I would say, at TDAM, we talk a lot about risk adjusted returns and that total return experience for investors. And in this SMID space you are able to add diversification. True diversification with a negative correlation to some of your other holdings in your portfolio, you're able to be compensated for the risk that you do take on in your portfolio, either the valuations and the opportunity for growth.
Britney: And while we're talking about opportunity for growth, I've always known “SMID” as a space where there's potential opportunity for M&A and there's different ways that these companies can compete and grow and continue on their journey to become a larger company. And often we see that in M&A activity where one company is buying another, they're combining forces, whether it's buying another arm of the business where there is a maybe a differentiated product or service that they're adding to their portfolio, or it's - “let's combine efforts and grow into something bigger.”
Chiara: And maybe those businesses were really well aligned at one point and now they're growing as one big happy family. So you know that “SMID” opportunity is beyond just today's valuations, but you're able to be compensated by adding that to a portfolio. And it does, it does push out that efficient frontier because you're adding a differentiated ... a lot of cases uncorrelated or lower correlated ... asset class.
Britney: And there's a lot of opportunity for growth.
Trevor: I’ve actually got a story maybe to share about one of the one of the names in the portfolio, this is a company that operates gas bars and convenience stores. So it's kind of low tech. It's not cutting edge, Internet 4.0 or anything like that. But about ten years ago, a Canadian company, a very successful Canadian company that does the same thing, offered to buy this $1 billion company for almost $2 billion.
Trevor: And they declined - this American small cap company declined the offer. 7-Eleven out of Japan actually offered to buy them for about $2 billion as well. And they declined. And ten years later, this is a $9 Billion company continuing to operate on their own, continuing to follow in the footsteps of some of the titans in this industry.
Trevor: So you have this sort of multiple ways to earn return. You can invest in great businesses, but the great businesses are the ones that are coveted by the bigger fish, if you will. So there's a couple ways that you can achieve an investment objective or earn a nice return accretive to portfolios. When you think about the small “SMID” space.
Chiara: That's great to hear. Now, I want to pivot to the solution here that we have at TDAM for our investors. Why “SMID” at TDAM?
Trevor: Well, I think what I'd say maybe to start is just I touched on this earlier that the large cap index trades at roughly 18/20 times, the mid-cap trades at about 14 times what we do with our ETF in particular is we employ a quantitative strategy. So we're taking a number of candidate securities and the first thing we do is screen for certain ratios or metrics, and that takes the candidate pool down a little bit further.
Trevor: And then once we put these businesses into sort of our quant process, only the very best names make it out the other side of the of the mathematical sort of process. And so what you end up with is this portfolio: It's several dozen securities, it's very highly diversified, but you end up with this portfolio of names that are trading at more like 12 to 13 times earnings. They’ve being screened for certain favorable factor characteristics.
Trevor: Quality, I think is sort of the factor that endures here. But the quantitative model is a living, breathing thing. We don't just hit the button every quarter and then go away. The quantitative team is always revisiting the model. They're evaluating the factors that we are looking at and whether or not they have good predictive ability on a go forward basis.
Trevor: And so we will change the model itself actively speaking so that maybe when we had sort of a value tilt several quarters ago, maybe we're moving more towards a growth and momentum tilt and things like this. So you get this handpicked portfolio maybe of a variety of different companies in different industries, but they're even more attractive than the benchmark or the small mid-cap index or the category as a whole because of our process.
Britney: I'm just going to highlight something there because when I'm talking about this with portfolio managers on the street, I can never stress enough the importance of quality companies, well-run companies, and certainly quality might be kind of an abstract way of giving everything the same simple brushstroke here. But we at TDAM, really are about quality companies in every way.
Britney: And this mandate, the TQSM mandate, is no different. It still is true to who we are as a as an asset management company.
Chiara: Trevor, maybe you can talk a little bit more about the well-run companies. What does that mean?
Trevor: Yeah, a couple examples may be and I won't name names, but if I think about some of the portfolio that the real fun part about the actual holdings of TQSM, the ETF that we have here at TD, the real fun part is they're more familiar, I think, than most people realize. And maybe the challenge is that some of these businesses don't have names that are completely indicative of what they do.
Trevor: And so there are a few that are easy-peasy. I know what that sports apparel company does because I know their name or I know what that kitchen housewares retailer does because I know their name, they're at the mall, etc., etc.. I think where things get kind of interesting though, is is the stuff that maybe is familiar under the surface, but isn't familiar given the name.
Trevor: So the largest company in America ... for loaves of bread ... I mean, this isn't crypto or A.I., but it's bread sliced bread, literally sliced bread. They own the number one brand in America for white bread. They own the number one brand in America for organic bread, for gluten free bread. It's bread, you know, except that it's an exceptionally well-run business and they dominate their category.
Trevor: Or you think about “HVAC” companies. Our furnace has been on the fritz for a couple of weeks now. Hopefully we're in the home stretch of fixing that. But these machines, these technologies are computer controlled. You need specialized people to install and service and maintain heating ventilation and air conditioning equipment. And there are very, very few names and we've got some of them in our portfolio.
Trevor: Sometimes it's pretty boring - water meters, welding equipment, plumbing companies, retirement homes. Sometimes I guess it's a little bit more interesting. One of the ones that I think is pretty fun is a footwear company, and this company is the parent to UGG, HOKA trail runners and Teva sandals. So, you know, chances are you might have one or multiple pairs in your house or my house of one or all of the above.
Trevor: It's footwear. And again, same sort of story as before with the convenience stores. This company was several hundred million dollars in revenue eight, ten years ago today. It's a multibillion dollar powerhouse. And these again, these are very, very familiar, a growing familiarity with these footwear brands. There are American fashion houses. So I think we when we think of fashion brands, we think of a Europeans dominating, and they do.
Trevor: But there are American fashion companies that are publicly traded. If you go to the mall or go to the outlet mall, you can walk into these stores and find something that's pretty dapper, I guess. And they're part of the portfolio, too. So, you know, this small cap, mid cap space has a lot of really diverse businesses. And again, I think if we go back to the adding to your large cap, I don't know that there's any AI in here.
Trevor: I don't know that there's any computer chips or software. There might be a little bit here and there. But the common thread to the small mid portfolio that that is our ETF is that quality company. It is that they are all very, very exceptionally well-run businesses and we've assembled a portfolio so that you don't have to pick and choose one name or the other.
Trevor: You can buy the category and you can delegate to TD Asset Management with our expertise in that space.
Britney: Trevor, that's where I get really passionate because I think of the retail investor who is thinking, “I want to invest in a company I know!” Oftentimes I'm holding up my coffee cup and I'm saying, you know, I know this company well because I'm there every day. So I get that. I we can all relate to that. And that's why I get fired up about SMID because, again, like you said, these are companies where they're actually using these products and services every day.
Britney: They're consuming that bread. They're wearing those shoes, like you said, someone in their house, if it's not them and little do they know it's owned by a parent company. And, oh, by the way, you can invest in that company and you can hold that in your portfolio. So that's where I get fired up for those retail investors who want to invest in the things that they use and know.
Britney: And there really is a way to do that. And it's not so abstract. We actually pull it together and like you said, we do the management and we make sure that they're quality companies throughout what you hold.
Chiara: Yeah, it's always a lot harder for investors to see the small and mid-cap names, right, and recognize them. So, having this discussion will hopefully open up our investors eyes and see, “Hey, you know what?”
Chiara: “These are actually companies that I can invest in!” like you mentioned. So, you know, we've gotten a lot of interest in two our ticker or our solution TQSM given where valuations are and how little exposure Canadian investors and advisors have in the “SMID” space. How does TQSM fit in a client’s portfolio? How are investors using the strategy? What are you seeing with your clients?
Britney: Yeah, so what I see on the street is there is an appetite for something different in their portfolio. Advisors and retail investors really just want to know what is that “different” and where do I get some bang for my buck? And that's where I say: “I've got the perfect idea for you!” As far as building out a portfolio.
Britney: Like anything, there's a core allocation that you might want and then maybe you say, Well, right now I see the value, I see the opportunities, maybe I want to go a little higher. So I like to give a range. You're not like a “one percentage fits all” when advisors know their clients best and know their risk tolerance best.
Britney: But anywhere in that 5 to 10% allocation sweet spot tends to do well. Again, on that efficient frontier standpoint, it tends to be an interesting line item in their statements. And so if there is a little bit of volatility, 5 to 10% allocation typically tends to be a sweet spot where it's comfortable for for a lot of investors, again, speak to your financial advisor.
Chiara: So investors have several options, right? They can invest in “SMID” through mutual funds ETFs. They can select a passive or index strategy smaller mid maybe Walker listeners how to navigate that. Well I'll say when you look maybe from a 30,000 foot view, “TQSM” has competed against other ... both funds and ETFs on the street. So from a performance standpoint, over the long run, we certainly hold our own for those investors who are fee conscious, we definitely compete as being a low cost solution.
Britney: But at the end of the day, it's everything Trevor was saying with that quantitative formula - there is an active eye on what's in here. So while we take the universe and pare it down a bit, there's still a real active eye on what is held in the portfolio. So it's well-diversified across sectors, across names and fortunately for U.S. exposure, you have a lot of opportunity to look across different sectors, whether it's bread or footwear.
Chiara: We keep leaning into those examples here, but you don't necessarily have that breadth of diversification in sectors when you look across the Canadian market. So maybe a reason to look into the U.S. in the first place and even further look into that “SMID” space.
Trevor: I think what I would add maybe about TD's ETF efforts or TDAMs ETF efforts is that we've always had this really, really strong menu of mutual fund options available to investors and investment professionals. And what we've tried very carefully to do, having launched four dozen ETFs now, is we want to add one more page to the back of that menu.
Trevor: We do have small cap mutual funds, we do have mid-cap mutual funds, we have a small cap, mid-cap ETF and the idea here is that they're not exactly the same. There are some features and benefits that, depending on the investor or the client, one solution might be best for the other. So I think our role as manufacturers of really great solutions for Canadians is - we want to give you that choice in that optionality where you get to say, you know, for this family that I'm working with or given my investment outlook and my philosophy and my tolerance for risk, this is the better solution for me.
Trevor: So it's all about providing Canadians with a little bit more choice than we had maybe several years ago. And I think time has proven so far that this is a really, really great strategy for us because we're growing very quickly on both sides of the ledger.
Chiara: Comparing TQSM to other options available for investors, you will either find small or mid-cap strategies you rarely find a combined strategy TQSM solves for having to choose between a small or mid-cap exposure. And the beauty of being active is that we take care of finding the right mix between small and mid, and we can be overweight or underweight, smaller, mid depending on market conditions.
Chiara: And lastly, we avoid the headache of rebalancing manually. Since inception, we have outperformed the benchmark and most passive strategies with less risk. We are within the top ten percentile on all time frames.
Trevor: Absolutely.
Chiara: So thank you guys. This was awesome. So happy to have you here in the studio. Thank you for your time and thank you for allowing us to dive deep into the “SMID” space.
Britney: Thanks for allowing me to talk about something that I really care about.
Trevor: Cheers.
Chiara: As a reminder to our listeners, we have a suite of “Quant-based” ETFs for investors in our lineup. We offer Canadian, U.S. and international solutions, which continue to do exceptionally well on a relative basis. Our dividend strategies, both TQCD and TQGD, which have won a “Fundgrade A+ 2023 award” have performed exceptionally well, providing an income stream for our investors.
Chiara: If you're interested in hearing more about how we add alpha using quantitative methods, please go check out our previous podcast titled Navigating an Ocean of Data and our quarterly market commentary located on our website. Before we end things off, I'm thrilled to announce that we have reached $14 billion in assets under management in our ETF lineup. Truly, we can not have done this without your support, our listeners and our investors.
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