Earnings growth is slowing down, even among the country’s most consistent earnings growers. Over the last five years, the Russell Midcap Growth Index has seen average annual earnings per share growth of 16.4%. This year Ron Zibelli, who manages the Invesco Oppenheimer Discovery Mid Cap Growth Fund, estimates earnings growth will be in the high single digits for the benchmark index, and in the 12% area for his fund’s portfolio.
The anticipated growth for both measures is quite a bit better than what many observers expect for the large-cap S&P 500. At the start of 2019, analysts saw double-digit earnings growth for that benchmark over the previous year. Now, many expect growth for the index to flatline. At the same time, the performance of small-cap stocks has proved disappointing.
Zibelli says a confluence of factors make mid-cap stocks, which he defines as those with $4.5 billion to $40 billion in market capitalization, an attractive place to be. “Mid-caps appear to be a sweet spot among domestic equities,” he says.
Large companies are being buffeted by a number of headwinds. Over a decade into the current economic expansion, GDP growth has slowed to around 2% in the U.S., and the slowdown is even more pronounced in other parts of the world. That restrains revenue growth, particularly for companies that derive a significant portion of their revenue from foreign sources. A stronger U.S. dollar means that overseas profits translate into fewer U.S. dollars. Rising labor costs, tariffs and what Zibelli calls “the widespread influence of disruptive innovators with new business models and technologies” are challenging the profit models of large incumbents. The tailwind from corporate tax cuts has also died down.
While some midsize U.S. companies are also affected by those factors, they usually don’t feel them as sharply as large multinationals because their customers tend to be closer to home. They are also in a better position to be the disruptors, rather than the victims, of older business models. “It doesn’t make sense to buy a Gillette razor when Harry’s [an online seller of shaving supplies] sells them at a discount,” Zibelli says. “And over the years I have come to appreciate how mid-caps can be more insulated from macroeconomic issues. At the same time, they are at a point in their life cycles where they have perfected their business models, are scaling their businesses and have more professional management. It’s a productive phase of a company’s life cycle that lends itself to superior growth.”
Small Caps Grow Up
Like a proud parent, Ron Zibelli gets satisfaction from watching stocks in his portfolio grow from the challenges of their small-cap childhoods into more mature midsize companies with recognizable names. But there was a time when he could only watch that growth from the sidelines. Before joining OppenheimerFunds in 2006 to head up its small-cap growth strategy, he’d been managing small-cap funds at Merrill Lynch. Over the years, small companies climbed out of reach when they became too big for his firm’s small-cap portfolios. “It was frustrating to have to sell them when they became too big, then watch them move into a huge run as mid-caps,” he says.
Since he began leading OppenheimerFunds’ mid-cap growth strategies in 2010, however, he’s been able to keep many of those once-fledgling companies under his supervision in the Invesco Oppenheimer Discovery Mid Cap Growth Fund. He is also the portfolio manager of the firm’s small-cap offering, which allows him to home in on up-and-comers early on. About half the stocks in the mid-cap fund were once holdings in the small-cap fund, or still are. “We think the ability to develop relationships and information networks with companies early on is our secret weapon,” Zibelli says. Most of the 90 or so portfolio holdings aren’t in the benchmark index, and the ones that are usually appear in different proportions than their index weighting.
The mid-cap assets under his wing ballooned when Invesco acquired OppenheimerFunds in 2019 and Zibelli assumed management, along with Justin Livengood, of Invesco’s mid-cap fund as well. The acquisition followed a number of others for Invesco in both the passive and actively managed corners of the investment world, including its deals for PowerShares, Van Kampen and the ETF business of Guggenheim Partners. Zibelli says his two funds, which have a combined $5.2 billion in assets, invest very similarly. “Our capacity is well north of the current asset under management,” he says.
The higher-than-average growth rates of the companies, along with their above-average price-to-earnings multiples, make the portfolio look somewhat aggressive. But Zibelli tempers that profile by investing in what he calls “premier” growth companies that have superior quality characteristics—such as leading market shares, sustainable competitive advantages, superior management and strong products or services.
He also employs a number of risk-control measures in the portfolio, limiting the size of any company position, for instance, to 2.5% of assets, or by limiting the sector allocations to no more than 5% above or below the benchmark. “We want to earn alpha through stock selection rather than sector bets,” he says. On the sell side, Zibelli and his team are constantly on the lookout for signs that a company is vulnerable to disappointing fundamentals, including a slowdown in earnings, that could spark a downturn.
The combination has produced above-average resilience in down markets as well as responsiveness in bull markets. “Zibelli, Livengood, and the rest of the team have done a pretty good job executing this strategy since adopting it for this fund in mid-2010,” notes Morningstar senior analyst David Kathman. “The portfolio has typically had higher average valuations and growth rates than the mid-cap growth Morningstar category and the Russell Midcap Growth Index, thus helping it keep up in bull markets, but the managers’ preference for steady, profitable growers has provided some downside protection when the market goes down.” According to the report, since mid-2010 the fund has beaten the index in quarters with negative returns, and exceeded it about half the time in quarters where the index gained more than 4%.
‘Neutral’ Market Outlook
Going into 2020, Zibelli says he has a “neutral” market outlook. On the one hand, the U.S. economy seems to be growing, albeit slowly. Wages are ticking up, and consumer sentiment is generally positive. Interest rates appear to be in check. On the other hand, corporate profits are flattening out and wild cards such as trade negotiations and election results remain in play.
Companies that are able to grow earnings in an uncertain economy with the help of innovative products or services can be found in a variety of industries, Zibelli says. In the industrial sector, for example, fund holding CoStar Group has grown into the largest provider of commercial real estate data in the U.S. and maintains the most comprehensive database of commercial real estate information in the industry. Its users, who pay a monthly fee for its subscription service, consist of brokers, investors and other professionals in the real estate industry.
“CoStar is like the Bloomberg of the commercial real estate industry,” he says. “It has great leadership, a sustainable competitive advantage, and a vast database that took 15 years to assemble.” Its earnings per share have risen fivefold in the last four years.
RingCentral, another fund holding, is a leading source of affordable software communications systems for businesses, helping them with functions such as cloud phones, online messaging and online faxes. “The software replaces old telecommunications equipment and gives businesses state-of-the-art digital capabilities in a couple of weeks,” Zibelli says. “Instead of requiring a giant install, RingCentral has an easy-to-use subscription model.”
One of the health-care holdings in the Invesco fund, Dexcom, sells devices for managing diabetes. Such devices have traditionally required users to prick their fingers several times a day for blood testing, but the Dexcom offering allows users to simply look at a device attached to the body that constantly monitors glucose levels and issues alerts when numbers go out of the safe range. Zibelli says it’s particularly helpful to parents of young children because they can monitor glucose levels from their phones.
Chipotle, which was added to the fund last year, was once a holding in the small-cap fund. In 2015 and 2016, the company’s stock plunged after hundreds of customers became ill and media reports about salmonella, E. coli and other food safety problems at the company’s restaurants surfaced. The company later implemented a number of comprehensive food safety measures, and Zibelli bought the stock for the mid-cap fund about a year ago after a new chief executive officer joined the company. “He’s been systematically upgrading the company and is off to a great start,” Zibelli says.
