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Advisor select

Todd Vingers joined LMCG in June 2002 as the head of the Value team and Lead Portfolio Manager. In October 2014, Mr. Vingers became Co-Portfolio Manager on the Mid Cap Val +

Touchstone Mid Cap Value Fund
TCVAX (A Shares)
TMFCX (C Shares)
TCVYX (Y Shares)
TCVIX (Inst Shares)
Fund Family
Touchstone Funds
Fund Advisor
Touchstone Advisors Inc
Sub Advisor
LMCG Investments LLC
CONTACT

303 Broadway Street, Suite 1100
Cincinnati, OH 45202

T: 800-638-8194

High Quality Companies with Transitory Issues
Touchstone Mid Cap Value Fund
Ticker.com
Jul 19, 2017

Q: What is the history of the fund?

The Touchstone Mid Cap Value Fund, which was launched in September 2009, seeks long-term capital growth by investing in strong, mid-cap companies that dominate their niche, but trade at a discount to fair value due to a temporary issue.

On the value continuum, we fall somewhere between deep value and growth at a reasonable price. Although not a low-volatility product by any means, the fund does tend to be less volatile than its peers and its benchmark. Our lower beta and downside capture help to deliver better risk-adjusted returns over time. 

Through a classic value investment approach, we focus on strong companies which are temporarily out of favor in the market. We believe that these businesses which are selling at a discount to fair value have the potential to generate excess returns.

Sub-advised by LMCG Investments, LLC, the fund currently has approximately $700 million in assets under management. 

Q: What are the core tenets of your investment philosophy?

We seek to deliver superior risk-adjusted returns to our investors, both versus our peers and our benchmark. We utilize a classic value investment strategy which focuses on solid companies whose stock is temporarily out-of-favor in the market. We believe that leading businesses which are selling at a discount to fair value have the potential to generate excess returns. We focus on stocks that offer a high probability of modest outperformance rather than a low probability of high outperformance.

We consider ourselves a high-quality manager. To us, high-quality companies are those with good and sustainable returns on capital. Usually they dominate their market niche and have a competitive moat or barrier to entry that perpetuates their high returns. 

However, because good companies like these are expensive when they are performing well, we look for those undergoing temporary negative events. Our time is then spent figuring out whether these developments are transitory or the beginning of a negative secular trend. If it’s transitory, we’re likely to be interested in buying the stock.  If it’s a negative secular trend, we’re unlikely to buy these companies regardless of how cheap they are. This difference between transitory and secular trends is where most of the fund’s alpha or competitive edge comes from.

Q: As a mid-cap value fund, how do you define mid cap and value?

Companies in our benchmark, the Russell Midcap Value Index, generally have capitalizations between $2 billion and $30 billion. The weighted average market capitalization of the Index falls in the range of $7 billion to $8 billion.

By definition, value stocks are companies which are statistically inexpensive – but we don’t buy companies simply because they are cheap. Our focus is on identifying high-quality businesses that dominate a market niche but are temporarily out of favor and trading at a discount to fair value. Though the market cannot wait for a quarter or two, we’d rather not wait for things to get better and then start chasing.

Although the front-end screens we use can vary based on and sector or industry, they typically include traditional value metrics like price-to-earnings, price-to-book, and price-to-cash-flow ratios as well as dividend yield. For many sectors, the most important screen is enterprise value-to-EBITDA; in high-growth sectors, a Risk Evaluation and Mitigation Strategy (REMS) is employed. 

Q: What is your investment strategy?

We look for catalysts. Many of our peers try to determine not only what a catalyst is, but also its timing, which we believe is difficult to do consistently. Our interest hinges on the probability of a catalyst occurring versus its timing, and is a key differentiating factor for us. 

This doesn’t mean we don’t care about the timing – if we could perfectly understand it, we would invest immediately before a catalyst. But because it’s so difficult to predict, we would rather be earlier and get the lowest risk part of the move when expectations aren’t as high than to be chasing the stock once the catalyst becomes evident. 
Generally, when looking at situations with transitory issues, we aren’t looking for a large turnaround in long term prospects. Those types of situations can be binary where the stock either goes to zero or increases greatly. 

We do not like binary situations. Our preference is for more modest bets having a lower range of outcomes skewed to the upside – for instance, outcomes with the potential for 20% to 40% relative upside and perhaps 10% downside. 

Q: Would you describe your research process?

Our quantitative front-end screens define the statistically inexpensive part of the mid-cap market, generating an investable universe of value stocks for the fund. 

Whittling down this universe uses a combination of quantitative screens and a pre-approved list of companies that we’re biased toward because of their high returns on capital and other high-quality factors. Our wish list isn’t static, but generally contains about 250 companies. When one of them breaks down in the screens, it becomes eligible for us to research. 

Ideas that make sense and meet our biases and process are then modeled by an analyst. A unique part of our research is that it examines a company’s historical data. Obviously, the past doesn’t determine stock price. However, we can often see discernable cycles in a business’s margins, its return on capital, its industry, or the economy. Examining this historical data enables us to make projections which are more directional in nature than simply trying to out-model the Street for a given quarter

  • Inception: September 30, 2009
  • AUM: $660 million

Concurrent with the modeling, the primary analyst speaks with their industry contacts and leads a conversation between our team and someone from the company’s management team – typically the chief financial officer. 

We start by trying to gain an understanding of the firm’s longer-term fundamentals, not just what’s happened last quarter. We ask questions about its competitive dynamics, whether barriers to entry are going up or coming down, or if the company’s product is becoming commoditized. 

Only then do we talk about the issue the company is experiencing. More often than not, a problem is company-specific – for instance, a hiccup related to manufacturing or a merger. At some point, we make a judgment about whether the problem is transitory and can be fixed by management, or is evidence of a negative secular trend.

After speaking with the management team, the analyst will finish working on the stock, tweak the model, then present a research report to the rest of the team. We read it beforehand, and after digesting the information, we the team meets and discusses how good the business is, the barriers to entry, and whether the problem transitory or secular. 

Equally as important in our minds as whether or not to buy a stock is how much of it to buy. First, we look at how far below fair value it is; the further below fair value, the greater our interest is in owning it.  Other factors affecting weight are returns on capital and downside protection.

Q: How do you define fair value?

To determine fair value, we first normalize a company’s earning power. For instance, if a business has a 15% operating margin when things are going well but a 5% operating margin when things aren’t, we’d say it’s a 10%-margin business on average. 

On that 10% margin, we might look at a number of metrics related to earnings power: gross or free cash flow, earnings per share, and EBITDA or operating earnings; for non-financials, we tend to lean more towards EBITDA. 

To determine fair value, we then apply a normalized relative multiple.  These normalized earnings levels and normalized multiples assume there isn’t secular occurring.

Our bias is toward companies with better balance sheets, which we define using net debt-to-EBITDA more so than debt-to-cap. We look for businesses with good cash flow coverage and nice profitability because they help limit our downside and tend to be a bit less volatile than our peers and benchmark. 

Q: Can you give some examples that highlight your research process?

One of the portfolio’s top weights is a private-label food company called TreeHouse Foods Inc. In the U.S., private-label packaged foods represent 20% of the grocery business; they help stores increase profitability and the perceived value of their brands. 

Generally, the packaged food space in grocery stores is extremely sluggish right now with growth of zero to 1%. But TreeHouse is growing more quickly. 

We thought this was a good secular backdrop for TreeHouse, and found its story even more interesting. TreeHouse purchased private-label cookie and cracker business from ConAgra Foods, Inc., and frankly, ConAgra had mismanaged the business and sales of its brands were dropping. TreeHouse is in the process of turning this around. We think the Wall Street has yet to appreciate it.

TreeHouse has tremendous cost synergies which will benefit margins and earnings per share. Before ConAgra’s issues, margins for the business were 13% but had dropped down to 8%. We think TreeHouse can get them back up to at least 10% if not in the lower teens – in addition to the cost savings it will realize. 

To us, this was good company with the expertise to increase the core margins of the business it purchased. Further, the stock was extremely inexpensive due to a company-specific event and it was in a sector underappreciated by the market – so we were especially excited.

Another example that illustrates our research process is Valvoline Inc, which we had been watching for a while and purchased earlier this year. Valvoline basically has two businesses; one is consumer automotive oil products, and the other is rapid automotive oil-change stores.

For some time, Valvoline had been owned by the specialty chemicals company, Ashland Global Holdings Inc., which in 2016 spun Valvoline off. When companies first spin off, we are wary because it often takes them several quarters to get their legs under them and learn how to deal with the Street. 

Sure enough, Valvoline’s first earnings call was something of a disaster, creating a stock dislocation and a short-term opportunity which we took advantage of. 

The great long-term story, though, is that Ashland had been sucking all the excess capital from Valvoline to use for its own purposes. As a result, Valvoline didn’t grow as fast as it should have. But now the company can keep the cash flow it generates, so it can reinvest in real estate to grow its oil change locations more rapidly and focus on its bottom line. 

Another longer-term improvement for Valvoline comes with the move to synthetic oils. Despite the much longer intervals between oil changes required by cars today, the dollar margin and profitability per vehicle over a year has increased. 

Ultimately, a number of short-term opportunities came together along with a longer-term backdrop of improvement. Since we purchased the stock last year, the market has shot up. Because the company is slightly more defensively oriented, we’re pleased that it’s held in there so far and anticipate more outperformance going forward.

Q: How do you construct your portfolio?

Individual position sizes are limited to 5%, but it’s unusual for anything to be over 3%. We are definitely benchmark aware, but not benchmark driven: the fund’s sector weights must be within 10 percentage points, or 1000 basis points, versus the sector weights of the Russell Midcap Value Index at all times. As a result, it will always be broadly diversified – but we won’t become a sector product.

This diversification results from our bottom-up process rather than a top-down strategy. After buying individual stocks, we look at these broad constraints to make sure we aren’t creeping up against them. Although we don’t try to position the fund according to what we think about the market, economy, interest rates, and tail risk, we do want to be aware of macro risks and their potential impact on the fund.

When a stock no longer meets our price screens or hits its fair value, we sell it. Also, if we feel we have made a mistake – for instance, if an issue we believed was transitory turns out to be secular – we sell the stock and move on.

Q: What does risk mean to you and how do you control it?

We carefully monitor risk in the portfolio, and every stock placed in the portfolio must have a favorable risk/reward profile.  Risk management is embedded through every stage of our entire process, and generally, our focus is on the downside protection of individual stocks. We look at individual companies and what their risk parameters are, considering their upside/downside, volatility, balance sheets, and so on. 

When viewing a company in isolation, we examine how it will protect the rest of the portfolio and confirm that it won’t dial up a risk factor to too great a degree. Any new stocks we buy are assessed as to whether they will add more or less of a risk factor. 

We also utilize risk management tools within our portfolio accounting and trading software systems. Because we do deviate significantly from our benchmark and want to ensure the fund doesn’t get too far away from it, we measure things like Barra factors to see statistically significant exposures and risks we didn’t anticipate. One characteristic of our style that consistently pops up is that we tend to correlate negatively with momentum. 

 

Please consider the investment objectives, risks, charges and expenses of a Fund carefully before investing. The prospectus and the summary prospectus contain this and other information about the Fund. To obtain a prospectus or a summary prospectus, contact your financial advisor or download and/or request one at TouchstoneInvestments.com/literature-center or call Touchstone at 800.638.8194. Please read the prospectus and/or summary prospectus carefully before investing.


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