Madison Mid Cap Fund Q3 2024 Investment Strategy Letter

The Madison Mid Cap Fund (Class Y) returned 7.17% in the third quarter of 2024, compared to the 9.21% increase in the Russell Midcap Index. In the year-to-date nine-month period, the Fund returned 12.44%, compared to the Russell Midcap’s return of 14.63%.

Portfolio Performance

The top five contributors for the quarter were Liberty Broadband (LBRDA), Floor & Décor (FND), Moelis (MC), Brown & Brown (BRO), and Waters (WAT). Liberty Broadband shares advanced meaningfully upon disclosures that the company was in negotiations with Charter Communications (CHTR) regarding a possible acquisition of Liberty Broadband. We’ve long held that this is the most likely outcome for Liberty Broadband shares, and thus are encouraged by these discussions. While this news has helped to close a large portion of the valuation discount between Liberty Broadband shares and the market value of the company’s ownership in Charter shares, there is still a significant gap, suggesting plenty of value remains. Floor & Décor continues to face a challenged sales environment, given a weakening consumer and housing market. However, potentially positive implications from lower interest rates and market share gains from a large competitor closing stores has investors more optimistic that results will improve. Boutique investment bank Moelis has witnessed a nice rebound in sales, as merger and acquisition activity has picked up off cyclical lows. The prospects for more deal-making in a lower interest rate environment, combined with the prudent organic investments that management has been making throughout the downcycle position the business well to take advantage of improving market conditions.

Shares of insurance broker Brown & Brown are hitting new highs as organic revenue growth continues at a rapid pace and margins are expanding after a few stagnant years. Finally, shares in Waters advanced following signs of a recovery in instrument sales.

The bottom five detractors for the quarter were Dollar Tree (DLTR), MKS Instruments (MKSI), PACCAR (PCAR), Copart (CPRT), and Amphenol (APH). Dollar Tree underperformed following disappointing sales at the core Dollar Tree banner and reduced full year earnings guidance. The company, as well as its closest peers, is facing headwinds from a weak low-end consumer, less ‘trade-down’ benefit from middle-income consumers, and a tough competitive environment. Despite these headwinds, we are encouraged by the long-term prospects of the multi-price initiatives at the Dollar Tree banner, with the latest iteration of updated stores showing a strong up-lift in sales. As management more aggressively rolls out these updates, the impact on the company will be more meaningful, and, we believe, result in much higher earnings power. Shares in MKS Instruments, a maker of high-precision instruments and systems largely used by semiconductor manufacturers, have been volatile over the past year as investors try to forecast the bottoming of the semiconductor cycle. Optimism for a strong rebound early in the quarter quickly changed to pessimism as the hoped-for improvement didn’t materialize.

After initially holding up well against declining freight rates and a softening economic backdrop, sales at truck manufacturer PACCAR have begun to weaken. We think the company’s high-margin, stable aftermarket parts division will offer some support through the current cyclical downturn. Copart’s steady earnings growth took a pause this quarter as margins were hit by elevated growth in expenses. While some of the costs will prove to be more one-off in nature, management is investing behind growth and efficiency initiatives, which we believe will prove to be capital well spent. Amphenol’s business continues to produce strong earnings growth. However, its shares retreated slightly this quarter as investor expectations have started to catch up with business results.

Portfolio Activity

During the quarter we added three new holdings: Graco (GGG), Lithia Motors (LAD), and Asbury Automotive (ABG). Graco is the leading manufacturer of fluid handling equipment designed for difficult-to-handle materials with high viscosities, abrasive and corrosive properties, or precise ratio control. While the company has customers across several cyclical end-markets, around 40% of revenue is from parts and accessories, which have a more stable demand profile.

Graco’s premium products provide a strong return on investment (ROI) for its customers, helping to reduce their use of labor, material, and energy as well as improve quality and environmental performance. The company’s products also represent a small portion of an end users’ total expense. As a result, Graco has strong pricing power and best-in-class margins, including gross margin above 50% and earnings before interest and taxes (EBIT) margin approaching 30%. We’ve long admired this business and their exceptional management team. With the stock underperforming on general economic weakness, valuation in the shares appeared reasonable, providing a good entry point.

We purchased shares in Lithia Motors and Asbury Automotive, two of the largest auto franchise dealer groups in the country, owning a diversified portfolio of dealerships ranging from Toyota to Ford to Mercedes. Investors tend to pay a lot of attention to the level of new car sales, but dealers actually earn more in profits from parts and service than they do from selling new cars, and this steady business provides a nice ballast throughout the economic cycle. In addition, we believe these businesses have a long runway to create value via consolidation of this fragmented industry, as the advantages of scale are increasing.

We also made two adds and two trims during the quarter. We added to Microchip Technology (MCHIP) and Dollar Tree, both at appealing valuations. Microchip’s stock is witnessing pressure given an elongated semiconductor cycle, which is testing investors’ patience. We took advantage of the attractive valuation and increased our position, given the still strong long-term outlook. The headwinds outlined above impacting Dollar Tree’s business has resulted in the stock trading at depressed levels. Given our confidence in the core strength of the Dollar Tree franchise and its potential long-term earnings power, we added to our holding.

We trimmed our positions in Moelis and CarMax (KMX). Moelis’ stock has appreciated nicely this year on improving results from the company. Given the resulting increased position size and higher valuation, we trimmed our holding to a smaller weight. Finally, we reduced our position in CarMax coincident with our addition of the two automotive retailers. While we are positive on CarMax’s prospects, we want to ensure we manage our portfolio’s overall exposure to the new and used car markets.

Respectfully,

Rich Eisinger | Haruki Toyama | Andy Romanowich

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