Podcast: Quality-first approach to large-cap growth investing

00:00:00 - 00:00:33

Nate Geraci

I am now joined in studio by Brad Klapmeyer, Senior Portfolio Manager at Macquarie. Of course, Macquarie is a global financial services firm. They currently manage over $600 billion in assets, but they entered the ETF space in November of last year, and they now offer four ETFs all together, including the Macquarie Focus Large Growth ETF (ticker: LRGG), which just launched in May. 

Brad, it is so great to have you here in person. Welcome to the podcast!

00:00:35 - 00:00:38

Brad Klapmeyer

Yeah, Nate, thanks. It's really my pleasure to be here, and I love the show. Thanks for having me on. 

00:00:39 - 00:00:42

Nate Geraci 

You know it's funny, Kansas City really isn't that big. I'm surprised we haven't crossed paths before.

00:00:45 - 00:00:46

Brad Klapmeyer

Yeah, same with me. I'm sure we will now that we know each other's faces. 

00:00:48 - 00:00:53

Nate Geraci 

You're right, I'm going to see you every day in the grocery store or around town.

So, look, tell us a little bit about your background in Macquarie Asset Management. 

00:00:57 - 00:01:39

Brad Klapmeyer 

Sure. Just to start off with my background, I joined the industry in March of 2000. So I've been doing this for a wonderful 23 years, 24 years. They've been full of obviously ups and downs, but a lot of learning and a lot of fun.

I've been doing equity research that entire time, so multisector research. Any industry you want to know about, we can definitely have a conversation about. 

I joined the Large Cap Growth franchise at what was Ivy, and now is Macquarie, in 2011 as the associate PM and took over PM role in 2016. So, I have full ownership of large-cap growth investing. I love it, and I think it just fits what I do.

00:01:40 - 00:01:59

Nate Geraci

Alright. So, let's do this. Let’s briefly spotlight this Focus Large Growth ETF. And then I have several topics for us to dive into. I definitely want to hear your views on the current market environment and this rotation that looks underway out of mega-cap tech stocks. First, walk us through the investment process behind LRGG. 

00:02:00 - 00:02:51

Brad Klapmeyer 

Sure. Yeah, I did bring my crystal ball, so happy to hit on the market environment. Obviously, that's someplace where we focus. It's always impactful to what we do, so love to get to it. In terms of the high-level investment process for LRGG, we think we have several unique attributes or things that we do with that.

The first is quality. And not surprisingly, quality is something that comes out of a lot of investors’ minds, but we think quality characteristics are proving to be more persistent than growth and – this is the key, the “and” is key – have the ability to generate more frequent excess returns. So not only is it a wonderful characteristic, but you also get excess returns of that. So, for us, quality is foundation. Quality is a non-negotiable, if you will. 

The second thing we do with LRGG that is unique is our definition of quality.

00:02:52 - 00:04:05

Brad Klapmeyer

We focus on business model quality, not on growth rates. Growth rates comes second to business quality. So only the best companies with the deepest, widest competitive moats out there will be in consideration for what we do. We analyze that quality from a unique perspective. We look at it through both a qualitative and quantitative lens. Believe it or not, we'll maybe talk about human behaviors and behavioral tendencies today. We believe that two-sided quality analysis helps really break through those human tendencies and really get to the bottom line of the business. And then the third aspect that's unique is concentration. We wholeheartedly believe in deep concentration. LRGG is a 15- to 25-stock portfolio. We’re right at 22 securities right now. 

We believe that you can run a very risk-aware portfolio that provides those exposures to those names. So, the output that we have generated over time is participating, if not outperforming, in strong market environments, and we’ve had a lot of them. And then the business quality really helping investors weather those bouts of volatility in those drawdowns.

00:04:05 - 00:04:42

Nate Geraci

I want to come back to quality, and we'll certainly talk about investor behavior and how that fits in here in a moment. But to that last point you mentioned on concentration, I was looking at the holdings for this ETF, and without question this portfolio is highly concentrated – I think, what, 22 holdings last I checked? But if I look at the top holdings, it does look somewhat similar to the S&P 500, at least at the very top, right? You have Microsoft, NVIDIA, Apple, Alphabet, Amazon, Visa, etc. So, how different are you seeking to be from, say, that benchmark, or just how do you think about this overall in terms of concentration? 

00:04:43 - 00:08:01

Brad Klapmeyer 

Sure. Yeah. So there's two points. One is concentration and the merits of concentration, and, you know, we believe that skilled managers have valuable information. Active managers actually have valuable information. There is skill, there is edge, and you know, fortunately, history says we are one of them. So, we're happy to be put in that camp and we try to earn that every day. But the empirical evidence to us is very clear. Let skillful stock pickers do just that. Let them concentrate. Don’t let a skillful stock picker diversify away that skill. And we see that a lot, whether it's on our side of the table, where we miss not participating in a name, like this run on Tesla, then you had problems with Tesla. Or career risk. You've generated a bunch of AUM, now you want to protect it, so you derisk the portfolio. These are all unreasonable things, and it happens from

the other side of the table, where investors want to own all the names that are in the news, or they want to derisk the portfolio. And we would say don't allow that to dilute the returns. If you have a bunch of managers that each own 75 to 100 names, all of a sudden you own every market out there that exists. That's not really getting what you're paying for. 

And so, the evidence is clear to us, that skillful managers can really, really add significant value. The second point that I think is a fair observation is that we do own a lot of names that mirror the index, and we receive this question quite often, and it goes beyond just looking at those top 10 weights, though. We have to really get down into the active weights. So not only what we own, but how do we differentiate ourselves versus this concentrated benchmark? And I think what you'll find when you go down that extra layer is a different set of names. And these are the names where we really have conviction, and we really believe these are exceptional businesses.

You’ll find a company like Waste Connections. So yeah, they don't do a lot of AI, but the waste industry is gold. The landfills in the United States are a scarce resource. They generate a lot of pricing power. We own Motorola Solutions as a top active weight, significant weight. They do walkie-talkies for first responders, command center software. We owned Intuit, CoStar. These are all a different group of weights. There’s a commonality here. No, it's not that they have huge AI data centers, or they got the largest language models that exist out there. What the commonality is is these are companies with massive leadership positions and competitive moats. 

At the same time, we're underweight some of those biggest names in the index. We don't own Tesla. We don't own Meta. These names haven't passed our rigorous definition for quality. So while we may miss some squiggles and some runs in those names, we believe over the long term that quality is the best starting place. That is what ultimately matters to long-term outperformance. Short term, it may be growth rate, but long term, it's always the business quality first.

00:08:02 - 00:08:15 

Nate Geraci

OK, so, let's pull the thread on quality then. I was looking at some of the materials on the website for this ETF, and I came across a short paragraph that I would love to read here and then have you elaborate. So, quote, “Quality first investing is easy to say but difficult to do. The allure of high growth rates can cloud investor judgment. High growth rates are enticing but are often not sustainable.” 

So, comment on that, because that does get into investor behavior.

00:08:35

Brad Klapmeyer 

Yeah, we like that comment: “Easy to say, but difficult to do.” So, you know, this whole concept of quality over growth, we're just stealing from mathematical terminology,

when we say we're trying to change the order of operations, or what is the right order of operations here. Within growth investing, we think the best path to outperformance is not growth but quality. Obviously, we select for growth, but we put quality ahead of growth. Again, order of operations, we think, is very important. And the reason why is that the evidence, to us, is very clear. Growth rates have a high failure rate. That’s why we're skeptical of growth, that's our starting place. While quality tends to improve the odds of growth being durable. So, start with quality and then you shift that durable growth curve higher. 

So, you'll hear us talk about changing the order of operations often in growth investing. Yeah, you can do growth, but make sure you put that quality ahead of it. So the “easy to say, difficult to do” part – there are lots of quality investors out there. When we walk into a meeting with a consultant, trust me, we get the eye rolls, as you would expect. “Here comes another quality investor. Who isn't quality?”

But the evidence that we show is that, while most investors say they’re quality, what actually happens is they get lost on their way to quality. And to us, it's not terribly surprising because we know the root cause of why quality outperforms, and it's because of this allure to growth, as you put it. And that creates this unique situation where, while everyone is saying they're doing quality, quality actually generates more frequent excess returns than growth. And it's because of these behavioral tendencies, these human tendencies, that exist in our life (we won't go there today), that exist in the market, that exist in stock selection, that exist in risk management, that exist in being honest with ourselves when we think about performance. You know, how we think about risk attribution. 

We can spend another show on this whole topic. What is the root cause of this whole thing? It's FOMO (fear of missing out). It’s extrapolation hypothesis. It’s prospect theory. It's these things that permeate every aspect of investing. We know all this, and we can't get lost because the clients are depending on us to get it right. And so we've developed an investment process that tries to minimize those mistakes that we know we’ll make. That’s the two-sided quality analysis. That’s just risk controls. That's concentration, where we really focus on only the best businesses. We don't have room in the portfolio for questionable quality when we're concentrating.

We do believe a lot of managers get lost on their way to quality with good intentions. We observe this root cause, which is human nature, so we can do something different. We can stay on track, which is what we think we do with the Macquarie Focused Large Growth ETF. And all these – first, second, third – non-negotiable. 

00:11:38 - 00:12:20

Nate Geraci 

So let me ask you this. And listeners know I always like to play devil's advocate on this podcast. It’s what I do. And you just mentioned having an investment process to

minimize mistakes. I think one of the ways that some investors attempt to overcome behavioral mistakes is to just put their money in low-cost index funds, right? 

Let it ride, buy and hold. Just let it work for you. And you also mentioned earlier why you think active management may be a better option right now. We can talk about that in the context of the current environment. But what do you think about my comments regarding indexing and minimizing behavioral mistakes?

00:12:21 - 00:15:09 

Brad Klapmeyer

Yeah, I mean, the starting place is important. And looking back over the last decade, passive has really done well, and it's been wise to really look for low-cost options. Large-cap growth managers have struggled with outperforming the benchmark. The problem that I see from this point on is those returns aren't available anymore to you, to me, to anyone. They aren't available. Those easy returns are in the rearview mirror. And as I mentioned, I started my career in March of 2000, which was the peak month of the .com bubble. And I was investing when I was young and through my college career in the mid to late 90s. And honestly, I thought this is so easy. Why wouldn't everybody do this? Like this just makes sense for us all to do it. And what I said to myself over the next decade was: oh, this is much more challenging than I first thought. 

So, starting point is critical if you look at the current market environment. This is not the time to put our heads in the sand and think passive investing will continue to provide returns like it has for the past decade. Twelve, thirteen, fourteen years ago the market was priced for very attractive forward returns. If we look at equity risk premium, we think, that was set up really well for forward returns. The capital environment provided easy money. We were going through globalization.

Now we're in a much different place than that point. If I can get on my soapbox for a minute, something I see, from a passive perspective, is investors want cheap exposure to market-level returns. I think that's justified, But the question we've been asking ourselves more and more is, do they realize that some of these passive options create significant exposure to risk that were really unintended by those? We can talk about what's going on in the market. But a passive indexing strategy with a highly risk index is not necessarily what I think is the right path. I call this blind concentration versus active concentration. With us, at least through active concentration we're using discretion, we're picking those most exceptional quality businesses. Whereas, if you're in a very highly concentrated index strategy, maybe the investor isn't aware of that, and they're taking on more risk than they ever assume they were taking on. 

00:15:10 - 00:16:14

Nate Geraci 

Well, we have just a few minutes left here, so let's talk more about that in the context of the current market environment. And you mentioned that the current starting point we’re at, if you look through the first half of the year, we saw historically low market breadth, right? It was really large mega-cap names driving returns. The NVIDIAs of the world. And then, sector-wise, it was really just tech and communication services.

But over the past few weeks, we have started to see some deterioration in a lot of those names and there's been this rotation into smaller-cap stocks. I pulled some return data this morning. If you look year-to-date, the S&P 500 is up about 15%. If you look at small-caps, on an ETF like IWM, they're up now 11%. If we go back just to July 10, so about three weeks ago, it was S&P 500 up 19% and small-caps up about 2%. So, you can see that spread collapsing this year. 

So, how are you viewing things right now?

00:16:15 - 00:19:44

Brad Klapmeyer

Yeah, we share some of the same observations, and we think this rotation, at least to broaden out the market, is justified. Coming into the third quarter, we made several observations. I guess the first one was this idea of market concentration. And just to give a sense of what it looks like for our benchmark, which is the Russell 1000 Growth, after the Russell reconstitution at the end of June, the top seven names, these “Mag 7” names, constituted about 52% of our benchmark. If you throw in the next three names and get to the top 10, you're easily talking about 62% of the benchmark. 

Back in 2015, the top seven were 15% of the benchmark. So, if you went from 15% in the top seven to 52%. Now, a lot of them have the merits to be there. You get revenue and earnings performance. But it feels dangerous. It just feels that way. It doesn't feel right that that small subset of companies should account for that much of the benchmark.

The second thing that we would observe is this whole idea of market breadth. So, we've been concentrating. This concentration shows up in a few names, but it also shows up in the percent of companies each year outperforming the benchmark, and that's been narrowing, as you mentioned. In the most recent period ending June, the market breadth in the Russell 1000 Growth was lower than it has been over the last several decades, including during the speculative periods during the .com bubble. So, in our benchmark, 91 out of the 440 names through mid-year were outperforming the benchmark – so, yeah, blind concentration here a little bit, right? And then, just looking at another data point, we look at cap-weighted versus equal-weighted performance – so, basically, the difference of owning a cap-weighted index versus equal weighting all the positions in the benchmark. And through mid-year, that was very similar for the Russell 1000 Growth, where the cap-weighted benchmark was up 20.7%. And we're going to have to listen carefully on the equal-weighted one: up 4.5%. Over a 16% differential. The last time this happened was also back into the late 90s period. And we all know what happened. Equal-weighted outperformed cap-weighted for almost a decade after that.

So, we're seeing a lot of things that are kind of breaking loose, as you mentioned. We think the valuations are extremely unattractive for equities versus a risk-free asset – let's be clear on that, versus a risk-free asset. And within that we think quality looks more attractive. So, if we had to make some market conclusions, it would be that equity valuations appear stretched – when and if that matters is anyone's guess. And we think with inside that, quality looks more attractive. The market is in a very unique place, when we look through the breadth, the equal-weight performance versus the cap-weighted performance – in the concentration, we think that should be concerning. And then of course, as I mentioned, we think the focus of Macquarie Focused Large Growth ETF on quality will really help ride through any sort of volatility, good or bad, that we expect over the next three to five years. 

00:19:45 - 00:19:59

Nate Geraci 

on that last point, you are obviously running a large-cap growth ETF. The message here isn't telling investors they need to get out of large-cap growth, it’s that they need to be much more selective in how they allocate here. Does it really boil down to that?

00:20:00 - 00:20:19 

Brad Klapmeyer

Yeah, I think that's right. I think that's always true. I think we've been in a very unique period over the last decade, where quality has been keeping up with the market returns because we've been in this unique environment. But I think discretion in this environment for the next three to five years should be a requirement. 

00:20:20 - 00:20:24

Nate Geraci 

Well, Brad, I'm so glad we could do this in person. Very nice to meet you.

00:20:24

Brad Klapmeyer

Yes, same, nice seeing you. 

00:20:26 - 00:20:27

Nate Geraci 

And we'll have to do this again down the road. Thank you for joining me.

00:20:28

Brad Klapmeyer

Absolutely. Thank you. 

00:20:29 - 00:20:35

Nate Geraci 

That was Brad Klapmeyer, Senior Portfolio Manager at Macquarie Asset Management.