Madison Small Cap Fund Q3 2024 Investment Strategy Letter

After lagging the large cap indices for most of the year, small caps outperformed in the third quarter, driven mostly by multiple expansion, as earnings continue to be relatively depressed relative to large caps.

Performance And Positioning

The Madison Small Cap Fund (Class Y) returned 6.3% in the third quarter of 2024. Performance lagged the Russell 2000’s return of 9.3% and Russell 2500’s return of 8.8%. Underperformance was driven by both allocation and selection. Our laggard sectors in the third quarter included: Industrials, driven by stock selection; Healthcare, also driven by stock selection; and Information Technology, primarily driven by allocation effect. Energy outperformed, driven by allocation, and Consumer Discretionary also outperformed, driven by stock selection.

We made very few changes to the fund’s positioning in the third quarter. Our only new investment to the fund was Workiva (WK), a cloud-based software provider of compliance and regulatory reporting solutions, whose platform is used by thousands of companies to publish SEC and other regulatory documents.

More than 75% of the Fortune 500 use at least one of the solutions. The Workiva platform offers customers collaboration, data integration, and process management controls, which result in greater visibility and insights into their financial and regulatory management systems and enable efficient regulatory filing and reporting. Workiva is considered a system of record for compliance and regulatory reporting, a relatively non-discretionary category.

The company has a new CEO focused on profitable growth by building a partner channel with the influential Big 5 consulting firms. The competitive moats are wide and deep, as Workiva continues to press where it sees its greatest competitive advantage: being the only provider selling a single platform for financial and non-financial reporting with assurance.

Furthermore, the company has a significant installed base of existing customers (~6,000) ripe for harvesting. Our base case is that the installed software is very “sticky” with low turnover rates and durables growth runways. The current stock price represents a material discount relative to our conservative intrinsic value assessment of $100 per share. We’ve opportunistically used the combination of new management resetting expectations, broadly weak sentiment for software companies, and recent market volatility to establish this new position.

From a sector perspective, our overweights are in Consumer, Industrials, and Information Technology, which has been consistent for a few years. Long-time investors will know that we don’t make sector bets, these happen to be the areas where we’ve found the highest quality business at discounts to intrinsic value. Although our Industrial stocks represent the biggest drag to our performance in the third quarter, we are very optimistic as we look ahead. Many of our Industrial stocks are tied to the housing sector, which has been depressed for a few years. The housing market has been in a structural undersupply for several years (see the chart from Realtor.com). Residential construction has been pressured by high costs and a tight mortgage market. However, as we potentially begin a central bank rate easing cycle, the combination of undersupply vs strong secular demand and lower rates may result in a significant residential construction cycle lasting several years.

Although we continue to be underweight Healthcare, stock selection year-to-date has been generally strong. Our largest overweight remains Information Technology, where we have outperformed the Russell 2000 Index by about 1,000 basis points year to date, almost all driven by stock selection. Many of these investments occurred during 2022, when the sector was extremely out of favor, and we identified attractively growing, profitable technology companies trading at large discounts to their intrinsic value.

While there is some macro uncertainty in the market, specifically around the strength and durability of the labor market, consumer spending remains resilient, buoyed by higher wages and a halo of wealth effect from the strong market and higher housing prices. Many of our investments tied to the construction industry await signs that the industry has bottomed, and project starts could accelerate in early 2025, driven by nascent interest rate easing cycle and a potentially soft economic landing. We are closely watching the Architectural Billing Index for signs of an inflection. Thus far, it remains in slightly contraction territory.

One Final Note

As we reflect on our five years with Madison Investments, we’re reminded of the strong alignment between our investment philosophy and that of our teammates on the broader Madison U.S. Equity Department. When we joined the firm in the third quarter of 2019, the shared commitment to bottom-up, research-driven, high-conviction investing and a focus on risk management was immediately clear. Embracing the Participate and Protect approach that Madison Investments is known for came naturally. Our core investment principles remain unchanged. We continue to enhance our collaboration with our U.S. Equity colleagues in an effort to deliver the best risk-adjusted investment returns possible.

As always, we appreciate the opportunity to serve our clients.

Sincerely,

Faraz Farzam | Aaron Garcia

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