Madison Small Cap Fund Q2 2024 Investment Strategy Letter

The small cap market was weak in the second quarter, with the Russell 2000 Index declining 3.28% and the Russell 2500 Index declining 4.27%. The Madison Small Cap Fund (Class Y) outperformed each benchmark on a relative basis, declining 1.06%, representing +222 basis points (bps) and +321 bps of outperformance, respectively. Strong stock selection was the main driver. We had two takeovers in the portfolio, which we’ll discuss later.

Small caps continue to lag versus large caps. While the S&P 500 makes all-time highs, the small cap index (Russell 2000) has barely budged from a YTD return perspective and has yet to recapture its previous highs from 2021.

The predominant market narrative continues to be an ever-narrower stock market driven by the “Magnificent 7” and the relentless AI frenzy. The most overheated area of the market, in our opinion, is just about anything related to the Nvidia-charged AI data center buildout, which is quite significant (see the chart below). This isn’t isolated in the technology sector. Select industrial stocks, such as HVAC companies, are benefiting from increased demand despite the broader industrial sector showing signs of weakness. In fact, within information technology, the only companies benefiting directly from the AI bonanza are hardware and select semiconductor and semiconductor capital equipment vendors. Interestingly, there’s been a broad selloff in the software subsector as several high-growth darlings reported weak results and blamed a general macro slowdown. Although the broader economy appears to be in good shape, there is some evidence of a slowdown in capital spending; and industry insiders speculate that the build out in AI is sucking budget dollars away from software budgets.

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Performance Review

Our top performing sector was Information Technology, followed by Consumer Discretionary and Consumer Staples. Strong stock selection drove our outperformance in Information Technology and Consumer Discretionary. In Consumer Staples, contribution was more balanced between selection and allocation. Our best stocks in these respective sectors were Form Factor (FORM), OneSpaWorld (OSW), and Primo Water Corp (PRMW).

Form Factor is a semiconductor test equipment company with a clean, cash-rich balance sheet and very little competition. The moat in this business is very high as they integrate tightly with their customers, which are other test and semiconductor companies, and over many generations of products, making new entrants highly unlikely and market share shifts marginal. FORM’s business is driven by a simple equation: new designs plus an increase in test intensity drive revenue growth. Test intensity is defined as how much more testing a new chip design requires over prior generations. The AI DC buildout is driving demand for a new kind of memory chip called High Bandwidth Memory or HBM. Nvidia’s graphic processing units require HBM chips alongside them, and FORM has dominant market share at the current leading HBM maker SK Hynix. Test intensity for HBMs is estimated to be 25% higher than traditional memory. We continue to be optimistic about FORM’s fundamentals, with the understanding that quite a lot of optimism may already be reflected in the stock price.

Our worst performing sectors for the quarter were Industrials and Materials, both very cyclically sensitive areas. During the second quarter, several bellwether industrial companies reported disappointing results driven by macroeconomic weakness. The Industrial sector has seen some of the strongest fundamentals since the COVID lows as distributors built buffer inventory stock during the days of tight supply chains and strong stimulus demand. And so we were not surprised to see a natural slowdown after several years of growth. However, we are uncertain regarding the magnitude and duration and are watching fundamentals closely. Our worst performing stocks here were Legal Zoom, Summit Materials, and WillScot Mobile Mini.

Legal Zoom (LZ) delivered a challenging first quarter result. During the earnings conference call, management openly discussed losing market share in the all-important first quarter, which has historically been the seasonally strongest quarter for new business formations – the locomotive of LZ’s business. This is troubling for several reasons. Our thesis has been that LZ solutions offer automation for new business formation with arguably the easiest, most comprehensive, and cost-effective solution, competitively speaking. New business formations historically have grown at a 5% compound annual growth rate (CAGR) and growth above that must come from market share gains. So, losing market share is quite possibly a thesis breaker, which is why we have not opportunistically added to this investment. So, why are we holding on? Legal Zoom has a debt free, cash rich balance sheet. Following the poor results and stock sell off, the board announced a material expansion of their stock buyback program, a signal, we believe, in their confidence regarding the long-term opportunity for the company. Furthermore, there were several company specific reasons why the company viewed the share losses as temporary. Most importantly, a deliberate pullback in marketing spending as they reorganized and streamlined their salesforce. Although this investment is on a short leash, if the company can display share stability in the next few quarters, we would consider adding to our position. Legal Zoom is quite profitable, with solid operating margins and, we believe, a very attractively valued stock.

Summit Materials is suffering from a wetter than average spring, which pushes out demand for its building materials. We view this issue as temporary. The start of infrastructure projects and Merger & Acquisition synergies are the company’s larger opportunities in the coming years. We continue to be quite enthused about Summit’s future prospects and opportunistically added to the stock in the second quarter.

Portfolio Activity

Portfolio activity was de minimis in the second quarter. We initiated positions in Inspire Medical Systems (INSP) and Option Care Health (OPCH). The INSP purchase was based on our work suggesting the total addressable market for INSP’s hypoglossal nerve stimulation (HGNS) device for moderate to severe sleep apnea was quite large, and further refinements to the device would increase the utilization of patients looking for an alternative to CPAP. CPAP, while a very successful form of therapy, has a high non-compliance rate of 35%. The business has great gross margins and significant operating leverage as revenue scales. Revenue growth has been exceptionally strong, averaging 65% per annum over the last five years. The barriers to entry for its product are bolstered by strong clinical data and its head start in the HGNS market. Our work suggests that competitors will be at a significant technological disadvantage when they launch. We forecast $17/share earnings power by 2030. The stock had pulled back significantly following their fiscal Q2 due to unrealistically high expectations for increased guidance. We believed this was an opportunistic entry point. However, recent clinical data around the impact of GLP-1s on moderate to severe sleep apnea were more constructive than expected. While we think the impact on INSP’s market is minor, we believe it prudent to step away from the investment currently. We will continue to monitor the investment and will revisit the name once the current volatility recedes.

Option Care is the leading provider of in-home infusion and alternative site infusion services in the U.S., with a dominant 22% share. The market is heavily fragmented with CVS and Optum as the only other players with scale. In-home infusion is gaining share over infusion centers and clinicians and patients value in-home care due to patient convenience and better outcomes. We expect the penetration of the infusion market to continue along historical trends. As a business, Option Care is a prodigious free cash flow generator and it returns capital to its shareholders in the form of buybacks. We admire the company’s recurring revenue profile and its long growth runway. Our intrinsic value for the company is $42/share, which is derived from discounted cash flow analysis.

The only other sales in the quarter were two software companies that were taken over. Model N (MODN) and Hashi Corp (HCP). MODN was taken private by Vista Equity Partners for $30 a share, representing a 23% premium over the 30 day volume weighted average. HCP was acquired by IBM for $35, representing a 50% premium to the unaffected stock price. We decided to sell both stocks prior to the deal closures to fund adds to existing portfolio positions that offered greater upside potential.

Outlook

We continue to believe that small caps represent significantly better value relative to large caps. Historically, small caps have traded at a premium, which has not just disappeared but is now at a possibly historic discount. Although this does not guarantee outperformance, the long-term risk reward for small caps vs large is significantly more favorable, in our opinion. As mentioned earlier, the weakness in industrial and heavy machinery is concerning and we are carefully monitoring risks to our investments. Also, there are significant opportunities in the software sector as investors sell software to buy “Anything AI” (hardware and semiconductor). Since two of our software investments have been acquired, we do have an appetite for a new investment here and the opportunity set is rich. The forthcoming election and actions of the Federal Reserve represent the two biggest macro factors going into the second half. As always, while we are cognizant of the bigger picture, our process has always been bottoms-up and company by company. We will be on the hunt for high quality, enduring businesses that can grow through a cycle, but we will only pay a deep discount to intrinsic value.

Sincerely,

Faraz Farzam & Aaron Garcia

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