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Special report

Small cap continues to ride high for year, but market changing

F. Thomas O’Halloran said limited exposure to emerging markets helped returns.

(updated with correction)

Small-cap growth stocks dominated the list of best-performing domestic equity strategies for the year ended March 31, according to Morningstar Inc.'s separate account/collective investment trust database.

Seven of the top 10 equity strategies for the year were small-cap growth, which has been on a winning streak since the year ended Sep. 30, 2013. In fact, the small-cap growth strategies of Essex Investment Management Co. LLC, Falcon Point Capital LLC, Lord Abbett & Co. LLC and Oberweis Asset Management Inc. were among the top 10 in the Morningstar database for the second consecutive quarter.

“The overall domestic growth categories, they've had very strong quarters,” said Nicholas Sundberg, Chicago-based data analyst at Morningstar. “Last quarter, the small-growth managers were also pretty visible in the top 10.”

Overall growth strategies had the highest median return for the year ended March 31 at 25.29%. Overall value strategies returned 24.1% for the year, while the blended strategy returned 23.38%. The median return for all equity strategies was 24.12%, slightly higher than the Russell 3000 benchmark of 22.61% but below the median return of 35.33% for all equity strategies for the year ended Dec. 31.

Executives at Essex Investment Management seem to agree that 2014 will be a more challenging year for stocks. “We do think that — and it's been true so far — calendar 2014 won't be as smooth as calendar 2013,” said Nancy Prial, Evanston, Ill.-based portfolio manager and managing principal at Essex. “We think the market is more fairly valued.”

Morningstar's Mr. Sundberg also noticed a trend of lower returns for the quarter ended March 31 vs. the previous two quarters. “Across the board, everybody dropped pretty significantly,” he said, adding that most portfolios were “looking for returns in the 1% to 2% range, as opposed to returns of 8% to 10%.”

Still, he did note that recent equity returns remain relatively high. “I think it's pretty interesting to note how large the median one-year return was, 24.12% ... as opposed to the three-year number, 14.33%.”

Exciting times

Executives at Zevenbergen Capital Investments LLC like the current investment environment. “It's very exciting, and it's a great time to be an investor,” said Brooke de Boutray, managing director and portfolio manager of the Zevenbergen Z/Tech strategy, which took the top spot for the year ended March 31 with a gross return of 73.16%.

Seattle-based Zevenbergen's technology portfolio topped the one-year list for the third consecutive quarter. “It's a team approach so it's not one person that makes the performance,” Ms. De Boutray said. “It's the collective ideas of an experienced and knowledgeable and effective team.” She went on to say the portfolio team is effective because “we work very well together.”

Ms. de Boutray said the firm's fundamental research leads the team to invest in companies that are actively changing existing markets, like Google Inc.'s self-driving car and Amazon.com Inc.'s developing grocery business.

“We own disruptive companies. Tesla (Motors Inc.) is disruptive to the traditional automotive industry. Because of their visionary leadership, these types of companies are willing to take risks and invest in the next decade of growth,”said Ms. de Boutray.

She also identified Netflix Inc., another holding, as a market-changing company that is “disruptive to the entrenched cable industry.”

Christopher Meredith, principal, senior portfolio manager and director of research and portfolio management at O'Shaughnessy Asset Management LLC in Stamford, Conn., sees institutional investors moving into his firm's microcap strategy as an alternative to private equity. “Even though it is not a typical allocation space for a lot of plans, we are seeing a lot of interest in this strategy right now. They're looking for more flexibility and liquidity,” said Mr. Meredith. “We're seeing a lot of interest in this from the institutional space.”

Mr. Meredith sees O'Shaughnessy's strategy of investing based on long-term potential, measured in three- to five-year rolling periods, as particularly compatible with the long-term philosophy of institutional investors. “We like to preach long-term investing,” said Mr. Meredith. “Our research shows that there can be volatility in the (microcap) space, but if you're disciplined, the long-term opportunity is higher.”

O'Shaughnessy's microcap strategy — with a one-year gross return of 52.67% for the year ended March 31 — invests in companies that the portfolio managers believe are likely to be overlooked by other investors. “We're focused on companies that get less attention in the marketplace. A lot of companies don't even have analysts attached,” said Mr. Meredith.Essex Investment portfolio managers also look for companies that receive less attention from the marketplace. “These are not household names. We look for companies early in their growth process, a point in time when the future growth prospects are not fully reflected in the price,” said Ms. Prial. “We do that by using a screen at the front end of the process. I think it is something that differentiates us.”

2 microcap strategies

Essex Investment Management had two microcap strategies on the top 10 — the Essex Micro Cap Growth Strategy had a one-year gross return of 49.96%, while the Essex Small/Micro Cap Growth Strategy had a one-year gross return of 48.71%.

“We're very agnostic at the beginning of the process as to where the growth will be coming from,” said Ms. Prial. Although she attributes the microcap strategy's one-year performance largely to the health-care and biotech sectors, she said the screening process makes sector concentration less important than the firm's evaluation of individual potential. “We identify improving growth wherever that growth comes from.”

F. Thomas O'Halloran, Jersey City, N.J.-based partner and lead portfolio manager of Lord Abbett's Micro Cap Growth strategy, which was second for the year with a one-year gross return of 60.17%, said some areas need to be cautiously managed. “We have (had) very low exposure to emerging nations over the past couple of years because China has had a slowdown in its industrialization boom and the troubles in Russia are another factor that led us to minimize, if not eliminate, our exposure at the current time.”

Although the Lord Abbett strategy has limited its exposure to emerging markets, Mr. Halloran said the strategy's high-growth approach finds new markets by investing in emerging companies. “I'm always excited about new companies coming to market through IPOs. That is the window all winners come through.”

Although small-cap growth strategies dominated the one-year period, only one growth strategy appeared on the top 10 list for five-year returns. Value strategies made up five of the top 10 for that period.

But the top strategy for the five years ended March 31 was Memphis, Tenn.-based Chickasaw Capital Management LLC's MLP energy strategy, with a gross return of 43.13%. In second place was the U.S. Ultra Microcap strategy of Allianz Global Investors, Munich, Germany, with a gross return of 39.62%. Boston-based Ironwood Investment Management LLC's small-cap blend strategy was third with a gross return of 39.08%.

The Russell 3000 returned an annualized 21.93%, while the five-year median return for Morningstar's separate account database was an annualized 22.73%.

In the collective investment trust universe, Wellington Management Co., Boston, had the top two spots, with its Wellington CIF II Small Cap Opportunities strategy showing a gross one-year net return of 38.2%, and its Wellington CIF II Mid Cap Growth S1 returning a net 33.96%. The median for collective investment trusts for the year was 22.41%.

All of the data for Pensions & Investments' quarterly “Top Performing Managers” report are provided from Morningstar Inc.'s global separate account/collective investment trust database. For information on the database, please contact separateaccounts@morningstar.com or call 312-384-4087.

This article originally appeared in the May 12, 2014 print issue as, "Small cap continues to ride high for year, but market changing".