Spotlight on Trillium’s Small/Mid Cap Portfolio

Trillium’s Small/Mid Cap (SMID) portfolio was launched in 2001 and invests in small and mid-capitalization companies across economic sectors that also meet Trillium’s sustainability criteria. As of March 31, 2014, the strategy has over $100 million in assets.

The SMID investment strategy team, led by Laura McGonagle, CFA, seeks to find stocks with superior earnings growth prospects that are available at a reasonable price. Prior to joining Trillium in 2001, Laura was a sell-side equity analyst focusing on consumers’ growing awareness of the impact of nutrition, environment, and lifestyle choices on their well-being.

Investing For a Better World’s editor, Randy Rice, recently sat down with Laura and Jonas Kron, Trillium’s Director of Shareholder Advocacy, to talk about the strategy and how it approaches Environmental, Social and Governance (ESG) issues:

Randy Rice: What are the qualities in a Small / Mid Cap (SMID) portfolio that might be attractive to investors?

Laura McGonagle: A SMID portfolio may be interesting for investors who are looking for exposure to equities down the market capitalization spectrum. Some investors look for pure small capitalization (cap) exposure, but Trillium’s product is a blend of small and mid cap companies.

Our SMID product is benchmarked to the S&P 1000. In this portfolio, we will only initiate positions in companies with a market capitalization below $10 billion.

RR: Is there a particular time when investors should look for SMID exposure?

LM: While there are times when SMID companies can over or under perform versus large cap companies, historically, over the past 10 years, the S&P 1000 has performed significantly better than the S&P 500. I believe there is room for small/mid cap exposure in a client’s asset allocation at any time; the magnitude of that exposure will depend on a client’s financial needs and risk tolerance.

There is a tendency for SMID names to do better during more stable economic times. Investors are more willing to take risks when they are feeling better about the economic environment. Smaller companies tend to have less diversified product lines, customer base, and end markets, so they can have a more volatile performance. When investors are more cautious, they tend to gravitate toward bigger, more stable companies, especially consumer staples or healthcare names, which sell more needs-based products and services. Over the long term, however, SMID companies on average have done better than large cap companies.

Given that our investment process is fairly low turnover, we occasionally allow holdings to run up above this level if we continue to like the company’s story.

Trillium has held Whole Foods (NASDAQ: WFM) off and on in the SMID portfolio since the early days of the strategy. Whole Foods has benefited from the increased attention in the natural and organic foods space, especially recently as there has been much more everyday awareness about what is in foods, including artificial flavors, colors, chemicals, and preservatives. This awareness is increasing across the income spectrum. Whole Foods is a good example of buying a stock while a company is a small/mid cap and holding it as the market cap grows, trimming the position back over the years, but remaining involved as healthy eating remains a solid, secular trend. However, as the company’s market cap held steady in the high teens (billions) we could no longer justify holding it in the portfolio. We exited the position in mid-2013 and are playing the healthy living trend in other ways (i.e., United Natural Foods—a natural/organic food distributor).

Middleby (NASDAQ: MIDD) is a stock we have owned for close to a decade. They are a smaller player in the food service and equipment market. Management has done a great job working with both independent restaurants and chains, creating innovative products that save its customers time, labor, and energy. Middleby’s first product was a pizza oven that was quicker than those then on the market and more energy efficient. Over the years, the company has become a serial acquirer, buying smaller industry peers. Middleby recently purchased Viking Range, which gives them an entrance into the residential market. The company is known for being a strong partner with their customers, helping clients expand their menus and offerings while working within the restaurant’s existing footprint. The company has dozens of Energy Star products, and it has good employee relations, with a 98% employee retention rate. They also produce a sustainability report, which is currently more qualitative than quantitative as compared to its larger competitors, but it is an important step. At a $5.8 billion market cap, Middleby is now a solidly mid-cap stock.

RR: How does the SMID portfolio vary from Trillium’s other core equity strategies? How do you feel about the current economic environment for your product?

LM: Aside from having a lower average market cap, the SMID product has a narrower universe of stocks to choose from than our other strategies. While there are more small/mid cap public companies in existence than large cap companies, Trillium is working from an internal buy list of stocks that has been vetted by our analysts on both a fundamental and ESG basis. As such, of the roughly 200 names on our list, only about half will be eligible for the SMID product. And Trillium’s SMID portfolio tends to hold fewer positions so it is slightly more concentrated.

SMID stocks also tend to have more of a domestic (U.S.) business focus, which at times such as now, when there is fiscal uncertainty in many of the global markets, can be positioned to outperform. Many large cap companies have international revenue exposure—even if they are based in the U.S. and in a domestic benchmark. SMID companies are also attractive because currently there is a lot of cash that it sitting on the sidelines, increasing the possibility for acquisition for these companies. As we continue through 2014, we expect the SMID portfolio to remain well positioned for a continuing U.S. economic recovery, and will look to continue to take profits from positions that have worked and reinvest in attractively priced companies with superior growth characteristics.

RR: Jonas, how does Trillium integrate shareholder advocacy into the investment process?

Jonas Kron: Internally, our advocacy and research teams meet on a weekly basis to share information and analysis. Advocacy information sharing is a standard part of all the stages in Trillium’s research process. Whether it’s conducting a sector review, exploring a potential new company for portfolios, or assessing macro-trends, insights brought by the shareholder advocacy team are integrated into the investment process.

RR: Are ESG issues different in a small company?

JK: When engaging with smaller companies, investor expectations need to be a bit different, as these companies may not have the internal resources to produce sustainability reports or provide good and complete information to share with investors on the impact of their ESG practices. That doesn’t mean that they shouldn’t be responsible to provide that information, but that we may have to move more slowly. That said, many small companies are able to provide a purer focus on ESG issues in the products they produce, such as Annie’s (a natural food company) or Cree (a maker of LED bulbs).

RR: Does corporate engagement with SMID companies differ from engagement with larger companies?

JK: In a smaller company, there is a greater chance that investors will meet with senior management or a member of the board of directors and bring our concerns directly to the decision-makers.

RR: Is there a “typical” corporate engagement for a small cap company?

JK: The short answer is “no.” Each company has its own particular characteristics and issues, so the engagements must take that into consideration. Our communications can range from asking simple questions to clarify our understanding of policies, to engaging in long- term, in-depth dialogue involving multiple stakeholders. Over the course of any given year, Trillium will host companies in our corporate offices to discuss their ESG performance records. We will also attend annual stockholder meetings,; participate in stock analysts’ days, or visit company headquarters or facilities.

RR: Can you talk about some recent engagements Trillium has had with companies in our SMID portfolio?

JK: We recently had meetings and discussions with Cree (NASDAQ: CREE) about board diversity issues because the company’s board was all men. There is strong evidence that diversity is an important factor in a well-run company that performs better financially. Our engagement began with a shareholder proposal asking the company to make a commitment to diversity on the board level. We were able to share these concerns directly with the lead independent director of Cree, who was also the chair of the board’s nominating committee, and he agreed with us. Subsequently, the company made changes to its governance structure to ensure that women would be considered in board nominations, and just weeks later, the company announced that they were bringing its first woman onto its board.

Last year, Trillium also had a series of discussions with Valmont Industries (NYSE: VMI), which manufactures efficient irrigation equipment for farmers. Even though we like the company’s environmental story, the company didn’t have any meaningful sustainability reporting, or any information about its greenhouse gas emissions related to their manufacturing. Trillium filed a shareholder proposal that resulted in the company making a commitment to set baseline data for its metal coating division, which is the most greenhouse gas intensive part of its business. Doing so is a good first step for the company to begin to manage their greenhouse gas emissions. Once a company establishes a baseline, they can begin to set targets to reduce their emissions in a meaningful way.

RR: For individual investors is there an easy first step to begin this type of engagement?

JK: The very minimum shareholder engagement that all investors should participate in is voting proxy ballots. Proxy issues range from the approval of boards of directors to shareholder proposals on social and environmental issues like those we file every year. Sadly, too many investment managers and traditional mutual funds have failed to thoughtfully vote their clients’ proxies, either by not voting at all or always voting exclusively with managements’ recommended positions. Trillium not only votes proxies on our clients’ behalf, we publish those votes on our website.

Editor’s Note: This article originally appeared in the Spring 2014 issue of Trillium’s newsletter, Investing For a Better World.

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Investments in smaller companies generally carry greater risk than is customarily associated with larger companies for various reasons, such as narrower markets, limited financial resources, and less liquid stock.

The views expressed are those of the authors and Trillium Asset Management, LLC as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be a forecast of future events or a guarantee of future results. These views may not be relied upon as investment advice. The information provided in this material should not be considered a recommendation to buy or sell any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the authors on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold, or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is for informational purposes and should not be construed as a research report.