Michael Malseed: Ned Bell, thanks for coming in today to Morningstar to speak to us.

Ned Bell: Thanks Michael. Thanks for having me.

Malseed: As we know, you're the portfolio manager of Bell Global Equities and Bell Emerging Companies with a global equities specialization based in Melbourne. Perhaps we could start with defining the area of the market that you play in in Global Equities because it's quite unique relative to the broader market.

Bell: Yeah, sure. So, the global small and mid-cap space is a little different to how you think about small and mid-caps in Australia. So, for example, Woolworths will be classified as a global SMID. So, if we think about the MSCI definition, it's the bottom 28% of (aid) markets. What we do is we apply that to the MSCI World Index and what that does, it gives us a range, a market cap range of about $1 billion to about $44 billion. So, it is a little different. But the benefits are that it means that we can own stocks when they're really in that most exciting growth curve of their trajectory and tilt away from the stocks where liquidity is quite problematic. So, it is quite advantageous, and it also means we can own stocks a bit longer than you otherwise would.

Malseed: Yeah. So, if we think about that category universe of global small caps, which is increasing in popularity at the moment, you're not playing in that really small micro-cap illiquid space. You're in the more liquid, more developed company in the psyche of Australian investors.

Bell: Exactly. So, the thinking behind it is – there's a real sweet spot there. And so, we want to avoid companies that are essentially going – still going through what we call their adolescent period where they're burning cash, they're still raising capital, they don't have great balance sheets. You don't need to generate alpha in this space in that area. You can focus on the companies where they've been through all of that, but they're just starting to generate a bit more scale. They've still got a good growth trajectory of call it 10%-plus revenue growth, 15% earnings growth at a nice runway of earnings compounding. That's really the sweet spot.

Malseed: So, if we look at global equity market returns in the last 12 to 18 months, they've been strong, but everyone is talking about them being dominated by very small cohort of tech mega cap stocks, the Magnificent Seven as they're called. So, how has SMID performed in that market?

Bell: So, SMID has lagged for the best part of the last four years really. But I think the important thing is it's not necessarily for fundamental reasons. So, the earnings performance has actually been extremely good over the last 10 years but also since COVID. So, you've seen really strong earnings growth. But again, the asset class has lagged. It now trades on, I think, its sub-14 times earnings. And if you look at how that compares to the Magnificent Seven, it's literally trading on a third of the valuation of the Magnificent Seven, which are trading on about 41 times earnings. So, they have lagged, but the fundamentals are strong.

One other issue is that we've seen companies in that space, they've paid down a lot of debt, and they've actually taken a lot of structural cost out of their business since COVID. So, arguably, they're more match fit now for what could be more volatile economic times than what they have been in the past.

Malseed: Could you give us a couple of examples of stocks that fit into this space well?

Bell: Yeah. So, a couple would be Amadeus IT. So, it's a software company. They globally essentially dominate the travel software space. So, their customers are basically the major airlines. So, it's the booking systems. They've consolidated their position. It's a high return on capital business, 25%-plus. They will benefit from the ongoing increase in demand for travel. And that's still got a ways to play out the expectation around Chinese travelers hasn't really picked up yet. That's still to play out. But we'd expect them to grow their earnings by 15% to 20% a year for the next two years.

I think another one is Edwards Lifesciences, which is in that mid-cap space. So, they're the global leader in tethered surgery. So, heart replacement valve surgery. Interestingly, the stock has been quite weak on the basis that the hysteria around these weight loss GLP-1 drugs. Ironically, they will actually benefit from that because more patients will become eligible for that surgery. So, that's an example of, again, it's a growth company that will generate probably 12% to 15% earnings growth at least. That's been quite conservative. And again, it's come down to a multiple that's about 22, 23 times earnings. So, in terms of the valuation metrics versus the growth, it's actually pretty good value. And I would argue much better value than a lot of other names in the mega cap space, which have become very, very crowded.

Malseed: So, what do you think the catalyst is going to be for these small and mid-cap stocks to re-rate positively and catch up with what we've seen with the mega caps?

Bell: Yeah. So, I think there's a couple of catalysts, the first one being is that – so, first, from an earnings growth perspective, small and mid-cap stocks as a whole, they should grow their earnings by about 13% next year. MSCI World, the earnings growth will be more like 5% or 6%. So, that growth premium I think is an important catalyst. That will be the first time in several years where SMIDs will outgrow the larger-cap peer group.

The larger-cap peer group arguably has downside risk to the earnings by virtue of their China exposure – the revenue exposure, which the SMIDs generally don't have. So, that's number one. Number two is where we are in the inflation and the interest rate cycle. So, while we've been in the camp of higher inflation and higher interest rates for longer, we are seeing signs of inflation moderating. And there's more and more discussion that the U.S. might actually land the soft landing, which is a huge positive in our view. So, if we see some interest relief between now and the presidential election next year, which is what we think will happen, that will most likely start getting priced in three to six months in advance of it actually happening. That we think will create – will be a huge catalyst for the most inexpensive, mispriced parts of the market to really catch fire and see some good multiple expansion. So, those are two big catalysts.

And probably the third one being is just the presidential election itself. So, irrespective of who wins, both candidates will promise they're going to spend anything that's left in the tin. And like what we saw when Trump was elected, you saw a lot of the mispriced parts of the market really run quite hard into the election.

Malseed: Okay. One of the other characteristics of your investment style is investing in really high-quality companies. Quality as a factor has been quite synonymous with growth because you have to pay up for quality and quality companies usually grow strongly. And we've seen this big growth derating cycle, which has hurt quality over the last couple years as well, tied with interest rates. So, what are your thoughts of quality as a style and the outlook for that going forward?

Bell: Yeah, it's an interesting one, because we've seen quite big divergence in what I call quality performance this year. And again, the MSI definition of quality includes growth as one of the three predominant factors. And so, as a result, you've seen these mega-cap stocks have driven that factor quite a bit higher. The way we tend to think about quality is more on the basis of consistently high profit margins, return on capital, balance sheet strength. Now, that factor, for one of better phrase, hasn't done that well this year. That's actually lagged. So, you've seen things like healthcare and consumer staples have actually been relatively weak this year and are actually very inexpensive. So, I think it depends on how you think about quality. But if you if you differentiate between quality and growth, because they're not the same thing, we would argue that quality is actually pretty good value for where it is now.

And the other point I'd make is that history shows that quality as a factor does tend to outperform well during periods of high inflation. And so, we did some work that showed that over the last 40 years, every year when U.S. CPI has been above 4%, the quality factor has actually outperformed by an average of 7.4% with two exceptions. The first exception being the period starting last year to now. So, quality has lagged by 400 basis points last year. 80% of quality stocks have lagged this year. And the only other period where that that relationship didn't hold was 1988 when quality lagged by 3.3%. But in the subsequent three years, quality outperformed by more than 10% in each year. So, we feel like quality is actually quite well spring loaded for a strong period of outperformance in the next couple of years.

Malseed: Okay. So, it sounds like you're quite positive about the outlook, the potential to generate alpha through pure stock picking that will play into your style?

Bell: Absolutely. I mean, we honestly feel very spoiled for choice in terms of like where to allocate capital now. Our biggest problem is actually finding capital in the portfolio. And we are finding we're having to move stocks out where the fundamentals haven't materially changed, but there might be 10% upside. But we're finding other names where there's 25%, 30% upside. So, we feel very spoiled for choice. The dislocations in the market are everywhere. And the only time I can think where there's been more dislocations was back in the back half of 2016 when Mr. Trump was elected, and you'd remember it was a terrible year for quality. The Brexit vote was also in that year in Q2. So, there were a lot of top-down drivers that resulted in a lot of dislocations. And that's where we feel really optimistic. We feel the most optimistic when we see the most disconnects, and that is absolutely now.