Castleton: Hello and thank you for joining this episode of Global Perspectives, a podcast created to share insights from our investment professionals and implications they have for investors. I’m your host for the day, Lara Castleton, and today we’re digging back into equities.

In our conversations, we often hear two questions: One, when will the dominance of U.S. mega-cap names falter. And two, when will historically cheap small caps poise their comeback? Well, there’s a lot of conversation on either end of the spectrum, large and small caps. We think an equally important question is what’s happening in the middle.

Mid-caps tend to represent a larger portion of portfolios while still offering diversification benefits from the mega-cap names. So, to dive into all things mid-caps, I’m excited to be here with Brian Domain, mid-cap Portfolio Manager on our U.S. Small and Mid-Cap Growth team and 25-year veteran of Janus Henderson. So, Brian, welcome.

Brian Demain: Thanks Lara. Nice to be here.

Castleton: So, to just start, let’s set up the macro environment, so the Goldilocks scenario of soft economic landing, easing inflation, strong growth. It did hit a little bit of a speed bump in April. What’s your overall outlook for the economy as it stands today?

Demain: So, I would say, ultimately, we’re long-term investors, so we’re not going to let a few weeks or a month or two of data points really sway what we think is kind of the overarching long-term story. And to us, the key there is that we’re in a very different economic backdrop than we were for the 2010s. And then through the 2010s, we had the 10-year [Treasury] yields at a 2% to 3% range, kind of bouncing around there, went even lower during the COVID period. For the last 18 months or so, we’ve been in this 4% to 5% range, and I think as long-term fundamental investors, the level of interest rates is really the most important driver, and we think the 4% to 5% is probably the right longer-term ballpark.

A lot has changed versus the 2010s. We have what we would call the four D’s – deglobalization, decarbonization, demographics, and deficits – all kind of driving higher interest rates. And why that matters so much for equity investors is simply, if you’re discounting cash flows, to discount an equity, you take the risk-free rate and you add an equity risk premium. And if the risk-free rate is 2% or 3% higher, it’s going to lead to a much higher discount rate, which is going to have meaningful impacts on the valuations of growth companies. And I kind of go into that diatribe a bit because we can get a little lost in the shorter-term macro data points. But the bigger picture thing here is that the economic backdrop that so many of us got used to in the 2010s is definitively over.

Castleton: OK. So, to focus on the longer term, maybe not as important, but are you still feeling OK? No impending recession looming from a base case?

Demain: You know, we obviously think about that as it impacts our companies’ earnings. Company balance sheets are relatively healthy; the economy has held on reasonably well. I wouldn’t say that there’s definitely no recession, but I think there’s a case to be made that even if we had a recession, there’s a very high likelihood it wouldn’t be as dramatic as some of the recessions we’ve seen recently. I mean what we saw during COVID or during the Global Financial Crisis, those really aren’t emblematic of what a recession might look like in a normal business slowdown and an asset-light economy. So, it’s not something that keeps us up at night.

Castleton: OK. No, that’s great. And I think it is very difficult to know exactly what’s going to happen. So, if we think about the economic cycle, are we late? Are we early? It just … it’s harder to tell. Mid-caps tend to do a little bit better in that potentially early-cycle environment. But just maybe, why mid-caps now? And you already touched on it, but would love to have you dive a little bit more into that higher cost of capital and how it affects mid-caps.

Demain: I guess first and foremost in terms of why mid-caps now, one important point to make is why mid-caps. And you know, despite the really strong performance we’ve seen out of large caps over the last five or seven years or so, if you look at longer periods of history, mid-caps have really outperformed both small and large caps over time. So, you know, let’s start there, that this is a really fruitful asset class. We think that’s a function of the fact that these tend to still be companies earlier in their lifecycles than large caps, but that are more established than small caps such that you don’t have as many fallen angels as you may have in the small-cap universe. That creates a really nice backdrop for capital appreciation.

Now, what I would say around cost of capital is, you might intrinsically think [with] higher cost of capital is that it’s tougher for companies down in the cap spectrum, and there’s some rationale to that. But what I would say is that, in some ways, the higher cost of capital is actually constructive for a lot of profitable mid-cap companies. Because, you know, a lot of these companies were facing competitive upstarts that may have been funded by a venture capital ecosystem that wasn’t focused on unit economics the way they are now. And so if the disruptor is now being held accountable to a profit model in a way that maybe it wasn’t before, that allows for the established players to be able to respond and defend their competitive position better. So, we think that’s an important point about a higher cost of capital world.

I guess another point I would make about mid-caps is, we really benefit from a diverse set of companies and economic drivers in a way that, given some of the concentration up cap in the benchmark, large cap may not have as much of a diversity of growth drivers.

Castleton: OK, great. So, I want to follow up on that. When you speak about the large caps, there’s obviously been a story about the valuations in that space and the earnings from the mega-cap names. What is the dynamic in the mid-cap universe from a forward earnings and valuation perspective?

Demain: Yeah. So, starting with the concentration in the large-cap universe, I don’t want to … I wouldn’t argue that there aren’t powerful growth drivers in large cap. The Magnificent 7 and the growth drivers they have are some of the most powerful, businesses we’ve seen in the history of capitalism, and these are very big growth drivers. But it is kind of a couple of growth drivers, and all of those companies kind of play into that ecosystem. I think what we do see in mid-cap is a broader set of growth drivers. But I think when you when you unpack the Midcap Growth Index and the Russell Midcap Growth, [which] is the benchmark for the strategy that I manage, the benchmark as a whole trades at about 35 times earnings. And it’s important to sort of just let that number sink in, particularly against the backdrop of a 4.5% to 5% 10-Year yield.

Historically, the Russell Midcap Growth traded at more of a mid-20s earnings multiple. We think that that is more reflective of the growth opportunities within most of the companies in the benchmark. And what I would point out though is that this is not a function of all of the companies trading at 35 times earnings; there’s a subset of companies trading at 50, 60, 70, 80 times earnings, and then companies trading at more prosaic reasonable valuation multiples, about a third of the benchmark, the Russell Midcap Growth Benchmark, trades at over 10 times enterprise value to sales. When we unpack that number and we use discounted cash flows to value our companies, when we sort of reverse engineer how a company would need to grow such that a discounted cash flow would allow you to pay where these companies are trading and still make, call it 10% a year in the equity. If a company trades at 10 or more times sales, our math shows that it needs to compound its sales at 19% a year for the next 10 years if it’s going to exit with a 30% operating margin to make 10% a year in the stock.

That’s a little wonky, but what I’ll unpack with that is, to think about growing 19% a year for a decade – and this would be organically because the discounted cash flow (DCF) doesn’t assume any acquisitions – only 6% of public companies historically have grown their sales at 19% annually. The vast majority of those have done it with acquisitions. And so, over a third of our benchmark is trading at a valuation that only 6% of companies historically – and really lower if you take out acquisitions – have been able to achieve. And so we do think there is a lot of danger in the more highly valued names in the mid-cap universe.

I think against that backdrop, we think if we stay true to valuation discipline, we can find opportunities. As I said, there are still a lot of companies trading at very reasonable valuations. So, we want to find companies where we can buy the stocks at reasonable valuations, participate in their earnings growth …. these are still growth companies, but have a little bit more downside protection if the story doesn’t play out kind of the way folks may think.

Castleton: Wow, so that’s actually quite staggering. So, a third of the benchmark is priced at a level that only 6% of companies have historically been able to achieve, all the while in a 4% to 5% interest rate environment, whereas for the past 10 years it was zero.

Demain: You summarized it better than I.

Castleton: No, it’s just that I hadn’t heard that. So, thank you. That is really staggering. So, important to be very disciplined on your valuations.

I just want to touch on one more theme that is in the mid-cap space, or in general, I just haven’t heard that much about stock-based compensation, but something that is worth noting within the mid-cap universe, or maybe just broadly, can you speak to that?

Demain: Yeah, I mean obviously stock-based compensation isn’t uniquely a mid-cap issue, but it is quite important for us in the mid-cap growth space because we, in our benchmark, we tend to have a lot of faster-growing companies that tend to be heavy users of stock-based compensation. We are certainly not against the use of stock-based compensation; it is a powerful way to incentivize employees. But we strongly believe that stock-based compensation is an expense; even though it’s not a cash outlay for the business, it’s effectively substituting cash with share dilution for your shareholders. It is an expense of the business, and many companies have gotten in the habit of excluding stock-based compensation in their adjusted earnings numbers. You know, it’s particularly prevalent in certain sectors, technology most notably. A stat that we’ve run, if we look at the operating cash flow for the benchmark as a whole, 36% of the operating cash flow in the benchmark comes from stock-based compensation. In other words, if that compensation were paid in cash instead of stock, the cash generation of the benchmark would be about a third lower.

And for our strategy, the percentage of cash flow going to stock-based compensation is much lower. You know, but we think that, effectively, we’re getting a meaningful overstatement of the profitability of these companies by the way they’re adding back stock-based compensation, and certain companies are more aggressive in that regard than others. And so it’s something that, I think as these companies, as their growth rates kind of slow down, as we think about a higher cost of capital world where profitability is emphasized more, I do think this will increasingly come on to investors’ radar screens, and there could be a bit of a reckoning for some of the companies that are more aggressive with stock-based compensation.

Castleton: So in the mid-cap space in general, and probably in a lot of the equity environment today, there’s a lot of room to be really discerning in terms of the winners and the losers within the space. So, I love that you teed up that mid-caps, relative to the large cap universe, which has similar earnings drivers for their index, mid-caps have a lot more of a diverse opportunity set.

So, I want to dig into a couple of the big themes that you’re looking at and focusing on, starting with one of the most topical, which is AI. So, it’s obviously featured a lot in the mega-cap names, but what’s some of the trends within AI that you’re actually witnessing in the mid-cap universe?

Demain: So, obviously we don’t have the opportunity of investing behind some of the hyperscale cloud players or the biggest GPU providers and the like. But there are opportunities, and so I would emphasize a couple of areas.

One would be AI infrastructure, that can be areas like power semiconductors, other areas of the tech hardware ecosystem where they’re benefiting from the increase in CapEx (capital expenditures) kind of being driven through the data center industry as a function of AI spend. And so we’ve found opportunities there. Another area we’re thinking about is software, and there it’s really kind of nuanced. And the question we have to ask each of our companies and our analysts as we study the spaces is whether AI is going to be a benefit or a risk to the business model.

There are certain software businesses where we think they will be able to embrace AI tools and fortify their competitive advantages and bring a lot of value to their customers. There are other software businesses where AI may prove to be more disruptive because it will lower the barrier of switching costs or barriers to entry for other software competitors. And so, on a company-by-company level, we are finding opportunities in the software space as well.

Castleton: OK, very interesting. And then can you help explain the whole electrification theme? What are some of the growth drivers that you’re finding investors could take opportunity of?

Demain: Yeah. So, I think this is really interesting. If you look at electricity consumption in the United States, it’s effectively been flat over the last 20 years. And yeah, that’s a function of our economy just becoming a little less energy intensive and various areas of efficiency gains. And we think what we’re left with now is kind of a utility infrastructure that supports, you know, a flat energy. It’s decades old. It supports flat electricity consumption, but we see a number of drivers coming in that will drive sustained growth in electricity demand.

EVs (electric vehicles) are a big one. So, if you move from filling your car at the gas station to filling it overnight, that’s going to put more demand on the electricity grid. And we think we’ll see a shift over from gas stoves and furnaces to induction stoves and heat pumps and the like that will drive greater electricity demand.

Solar and wind as forms of electricity generation are going to require a fair amount of transmission investment around them to connect them to. You know, where the sun shines or the wind blows may not be where people live. And then on top of all of that is this turbocharger of AI and AI data centers that are about six times as electricity-intensive as a traditional data center. It’s going to stack all of these on top of each other. And we have this backdrop of, electricity’s demand has been flat for 20 years, but now we’re going to inflect higher, and we think this will last for a long time.

And so that presents a number of different investment opportunities. It would point to electrical componentry, which, there’ll be a lot of demand in the data center [space] and in the utility grid as a whole. We point to power semiconductors that help up convert or down convert voltages and the like. And I think maybe less discussed by growth investors are regulated utilities. Those are historically not really thought of as a growth sector, but increased electricity demand is going to lead to those companies needing to spend more capital. And because they earn a return, a regulated return, on their capital spend, they should deliver solid earnings growth as well.

Castleton: That’s what I was going to actually bring up, is that you wouldn’t necessarily think of utilities as a growth sector, but all of those points that you laid up, they lead to very big growth opportunities within that space. And from a utilities perspective within portfolios, they’re just broadly not represented in the S&P [500^® Index] to any significant margin. So just maybe another reason and attraction to go down in cap and look for some of these opportunities outside of just the large cap universe. So very interesting there.

I want to turn to healthcare as well. Actually, we did a podcast with Andy Acker and Jonathan Coleman – check that out, shameless plug – a couple of months ago on just small/mid-cap healthcare opportunities. I’d love for you to just reiterate a little bit within the healthcare space, what innovation opportunities are you finding there?

Demain: Sure. Healthcare as a whole is just a very powerful theme because you really get the marriage of the innovation you referenced as well as the demographic trends, just as people get older in the amount of healthcare they’ll consume. And there’s so many different areas to invest, so many different opportunities kind of across the healthcare sector. But I would highlight an area we’ve found increasingly attractive of late, which is life science tools. So think of these companies as the companies that are effectively selling the pickaxes to the miners of pharma and biotech companies, and that can be equipment and reagents for research and development, or it could be for pharmaceutical production.

The sector has been out of favor because a lot of companies stocked up on a lot of these goods kind of early on in COVID and there was a bit of a windfall in R&D spend at that time. And so, we’ve gone through a digestion period where these companies have had stagnant top lines. We think we’re emerging from that, and these companies should see solid growth going forward.

One of the really powerful trends as we move from small molecule pharmaceuticals to large molecule biologics, the complexity of production goes up dramatically. When you’re creating a protein that’s incredibly complex, with tons of amino acids [that] need to be linked exactly the right way, that’s actually a very cost-intensive production process, and these are the companies that are effectively the cost of goods sold into those production processes. So there really are some very powerful underpinnings of growth. And that, married with the fact they’ve been out of favor of late, I think sets up a unique opportunity for us.

Castleton: So great opportunities across a variety of sectors and growth innovations – AI, utilities, electrification, healthcare … maybe just bring us back again as a theme, 5% interest rates, very different cost of capital than the past regime. So, are there any themes or trends that you’re looking at in terms of just how companies are allocating their cost of capital?

Demain: Capital allocation does become meaningfully more important in a higher cost of capital world. It’s easy to make the math work on acquisitions. When you can borrow money at 3%, it’s a different story; when the 10-Year is at 4% to 5% and you’re borrowing money at 7% to 8%, getting that capital allocation right is increasingly important.

Also, because of the higher cost of capital, some of the competition in the M&A arena is kind of fading away and can’t afford to pay as much. So, if you think about financial sponsors that need to go borrow five or six turns of leverage against their purchase price, well now that leverage is coming much more expensive. So, we think companies that have the opportunity to consolidate their industry have really good operating models where they can acquire assets and improve margins and really just sort of have developed that muscle memory of executing M&A at high returns on capital, that becomes increasingly valuable in a world of higher cost of capital. And so, we’ve always cared about how our management teams allocate the capital that their business generates, which, ultimately, we think belongs to our clients. But we’re increasingly scrutinizing that and realizing the power of competitively advantaged capital allocators in the current backdrop.

Castleton: All that makes sense and leads into just a little bit more on your process. We’ve touched a lot on valuations. I mean, you mentioned there’s some pretty extreme ones within the mid-cap space. Maybe for listeners, it’d be helpful to just hear how your process is in terms of approaching valuations. Is it just, we eliminate the most expensive, or how do you think about valuations within your space and where you’re going to allocate your capital?

Demain: Before we even look at valuation, we’re looking for companies that meet a few key criteria. So, the first is, we want sustainable growth companies, companies that are growth companies today, but that will still be growth companies five, seven, 10 years from now. They’re growing in a fashion that will allow their growth to sustain. We want companies with strong competitive positions; they have a moat, if you will, that allows them to earn healthy returns on invested capital. And then we want strong management teams that we think are good leaders of the business and good allocators of capital. So, you know, when we’re analyzing businesses, those are things that are requirements for us to invest in a company.

Once those boxes are checked, we’ll then consider valuation, and we’re certainly not saying any stock over 10, you know, any stock over 10 times sales is uninvestible, or any stock over the 35 times earnings of the benchmark is uninvestible. We’re looking at each company on an individual basis, but what we don’t do is use relative valuation and say, well, this stock trades at 35 times earnings, but this other competitor in the industry trades at 40 times earnings, therefore, the stock is undervalued. It’s really much more of a, what do we think this business is fundamentally worth. When we build a discounted cash flow for the company, we’ll build in our projection of cash flow streams, and then we will look at the implied IRR (internal rate of return) that we can earn over the next 10 years in the stock and use that as kind of our valuation benchmark. And so that’ll allow us to pay up for some really special growth companies, but it will keep us disciplined from paying up for any company trading at a higher valuation. Ultimately, we’re growth investors; we want to buy companies with earnings growth. But we think if we were to ignore valuation discipline, we could potentially expose our clients to certain difficult periods when the market may come to realize that some of these valuations are extended by historic standards.

Castleton: Okay, so then just to wrap this up here, again, knowing we don’t really know exactly what might happen, how do you think about just managing portfolio risk for, what if the Goldilocks scenario does happen, or what if there is a recession, just how do you think about that holistically?

Demain: I think it’s just important to realize that portfolio construction is a really powerful tool to think about that risk. And the portfolio is going to include some companies that would grow in most economic environments, and then it will include other companies that will feel an economic cycle but hopefully will gain share through the economic cycle. And portfolio construction is really a tool that allows you to balance those in an appropriate way to participate in the upside while protecting some of the downside. There’s no magic bullet to sort of solve that, but balance I think is kind of the keyword there.

Demain: OK. Well, thank you, Brian. That was great. Walking through all things mid-caps, it sounds like there’s some really interesting growth opportunities to drive a lot of innovation and just the economy going forward. However, the index in particular has some challenges that require some careful navigation. So, before I let you go, I did just want to say and get one more thought from you.

You write one of the most popular commentaries year-end at the firm, in which you detail several book and podcast recommendations that are all wonderful. The whole distribution team here just really values that. So, I do want to end seeing if there is any book or podcast that you think would be particularly interesting for our listeners.

Demain: I would say probably the book that’s caused me to think the most that I read over the last year or so has been The Rise and Fall of the Neoliberal Order by Gary Gerstle, who’s a historian in the UK. And effectively what it does is explore how did we go from Ronald Reagan’s “tear down this wall” to Donald’s Donald Trump’s “build this wall.” And really just the bigger picture question there is, what’s the political realignment we’re going through. It’s a big-picture book, it’s not going to help on an individual stock level, but it does help frame the very different political backdrop we are in today than we’ve been in over the last 30 or 40 years, which in some ways does go back to informing some of the interest rate dynamics and the like. I mean, he just he lays it out in a really crisp fashion with some interesting history along the way.

Castleton: Interesting, not what I would have expected. Well, thank you for that. And thank you for tuning into this conversation. We hope you found it valuable and that you came away with the takeaway that while mid-caps may not dominate the headlines as much as their small- and large-cap counterparts, they can offer that potential sweet spot within your equity portfolio.

For more insights from Janus Henderson, you can download other episodes of Global Perspectives wherever you get your podcasts. Or visit janushenderson.com. I’ve been your host for the day, Laura Castleton. Thank you. See you next time.

10-Year Treasury Yield is the interest rate on U.S. Treasury bonds that will mature 10 years from the date of purchase.

Discounted Cash Flow (DCF) analysis is a valuation method used to estimate the attractiveness of an investment opportunity. DCF analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.

Russell Midcap^® Growth Index reflects the performance of U.S. mid-cap equities with higher price-to-book ratios and higher forecasted growth values.

S&P 500^® is a registered trademark of Standard & Poor’s Financial Services LLC.