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Top performing managers

Small-cap equity strategies end the year on strong footing

Blake Harper
Blake Harper

Small-cap equity managers continued to rule Morningstar Inc.'s domestic equity separate account/collective investment trust database, claiming six of the top 10 spots for the year ended Dec. 31.

Of the six, five were value managers.

In the previous quarter, small-cap managers occupied five of the top 10 spots for the year ended Sept. 30 and three were value managers. Four of the managers on the current ranking also were on the previous one.

The remaining four strategies in this quarter's top 10 were precious metals, energy and natural resources strategies.

Last year marked a return to the “sort of historical norm” of small-cap stocks outperforming large-cap and value outperforming growth, said Andrew Daniels, manager research analyst, equity strategies, at Morningstar in Chicago.

In 2016, the Russell 2000 index returned 21.31% and the S&P 500, 11.96%, making it the first year since 2013 the small-cap index outperformed the S&P 500.

During the same period, the Russell 2000 Value index returned 28.92%, surpassing the Russell 2000 Growth index, which returned 11.32%.

Morningstar's overall domestic equity universe returned a median 12.52% in 2016. Domestic small-cap strategies in Morningstar's equity database, meanwhile, returned a median 20.77%; domestic large-cap, 10.49%; domestic small-cap value 27.82%; and domestic small-cap growth, 13.35%.

On the reasons for small-cap value managers' outperformance, Mr. Daniels said financials, an area of focus for those managers, had a strong 2016 on the back of rising interest rates and optimism for reduced regulations with the new administration.

Some of the universe's top performing value managers also benefited from an emphasis on companies reliant on commodity prices, Mr. Daniels said. Commodities rebounded in 2016 helped by recovering oil prices, U.S. tariffs on Chinese imports and President Donald Trump's campaign promise of increased infrastructure spending, he said.

On the flip side, growth managers were hampered by their appetite for health-care stocks, which was the worst performing sector in the Russell 3000 for the year, Mr. Daniels said.

Claiming the top spot on the one-year list was Towle & Co.'s deep value small-cap equity strategy with a gross return of 57.2%. It also ranked eighth on the five-year list with an annualized gross return of 21.62%. All five-year returns are annualized.

Mr. Daniels said the strategy benefited from being overweight industrials, which posted a strong 2016 with the commodities rebound. Top performers there included industrial product firm Ryerson Holding Corp., airlines Hawaiian Holdings Inc. and truck manufacturer Navistar Inc., he said. Officials at Towle & Co. declined to comment.

Behind Towle & Co. was Orchard Capital Management LLC's select small-cap value strategy with a gross return of 47.73%, up six places from the previous quarter.

“In a nutshell, we are a research-driven, intrinsic value manager,” said Blake Harper, Orchard's Chicago-based chief investment officer. “(We) have a relatively focused set of positions where we do proprietary research to identify small companies, primarily, that are at a significant discount to their intrinsic value.”

The portfolio held between 31 and 35 names in 2016, with U.S. Silica, Spartan Motors Inc. and Meta Financial Group Inc. among the top performers.

U.S. Silica, a producer of sand proppants and industrial silica, was added to the portfolio in the middle of 2015 and has been the portfolio's only energy holding since that time.

“We saw (U.S. Silica) as competitively advantaged (with) good logistics and cost structure, and in talking to their management, we thought that they had a well-articulatedand winning strategy to survive the worst of the (energy) downturn,” Mr. Harper said.

Regarding the success of Meta Financial, Mr. Harper said the bank and payment systems provider has been growing its base and financial partnerships and benefited from the fourth quarter rise in interest rates.

Speaking on the dominance of small cap in general over the year, Mr. Harper said the stocks' largely domestic focus played to investors' advantage.

In 2016, “U.S. domestically focused manufacturers and domestically focused businesses had a healthy economy and fewer global risks to trade, or European or Asian malaise,” Mr. Harper said.

Rounding out the top five on the one-year list were GAMCO Investor Inc.'s gold strategy in third with a gross return of 47.38%, followed by Wells Capital Management's precious metals strategy, 46.98%; and DePrince, Race & Zollo Inc.'s microcap value strategy, 46.43%. GAMCO and Wells Capital were also holdovers from last quarter.

Gregory Ramsby, managing partner and microcap portfolio manager at DePrince, Race & Zollo, Winter Park, Fla., also identified auto parts supplier Spartan Motors as a top performer in his firm's microcap value strategy.

A new CEO arrived in February 2015 who improved profitability through internal restructuring, Mr. Ramsby said. “That led to significant outperformance in the stock price in 2016 as earnings improvement materialized,” Mr. Ramsby said.

Other top performers Mr. Ramsby cited for the year were DMC Global Inc. and Middleburg Financial Corp. Like Spartan Motors, DMC Global benefited from internal improvements made by a new CEO who arrived in 2013, along with the recovery in the oil market, Mr. Ramsby said. DMC's products include explosive devices used to open oil and gas wells.

Middleburg Financial exemplifies another theme that was successful for the strategy in 2016 — high-quality, overcapitalized little banks and thrifts that experienced some sort of merger and acquisition activity, Mr. Ramsby said. “Middleburg was acquired in 2016 by Access National Corp. at a price that was double what we paid for the stock,” he said.

Small-cap equity strategies also dominated the rankings for the five years ended Dec. 31, occupying seven of the top 10 spots, with a lean toward microcap strategies. Of the seven, all but one were value strategies and six were carryovers from the previous ranking.

Mr. Andrews said small-cap's strong performance in 2016 and 2013 propelled those strategies to the top of the five-year list.

The median return for the overall domestic equity universe for the period was 14.24%. The small-cap median was an annualized 15.58% and the large cap, 13.94%.

Ranked first on the five-year list with an annualized gross return of 28.12% was ZPR Investment Management Inc.'s volume value strategy. The strategy also ranked seventh on the one-year ranking with a gross return of 44.67%.

Mark Zavanelli, president and main portfolio manager at the Orange City, Fla.-based firm, said the portfolio team looks for microcap stocks with good value and low trading volume relative to the number of shares outstanding.

“The theory behind this is if (these stocks) had better institutional sponsorship or more interest in them, they might trade at better valuation multiples,” Mr. Zavanelli said.

Driving the strategy's one-year performance was its strong weighting to financials (70%), small banks in particular, Mr. Zavanelli said.

With their domestic focus and sensitivity to interest margins, 2016 was the “perfect positive storm” for small banks, Mr. Zavanelli said.

However, conditions were not so perfect over the five years. Mr. Zavanelli attributed the success there to the strategy's focus on neglected stocks, which are a little less subject to market swings than heavily traded stocks, and on the portfolio companies' solid fundamentals.

Rounding out the top five on the five-year list were Naylor & Co. Investments LLC's core composite midcap growth strategy with a gross return of 27.38%, followed by BMO Global Asset Management's microcap equity strategy, 23.7%; Donald Smith & Co.'s microcap value equity strategy, 23.52%; and Northpointe Capital LLC's microcap value strategy, 22.75%. All were also on last quarter's five-year list.

Among domestic collective investment trusts, Brandywine Global Investment Management LLC's diversified small-cap trust ranked first on the one-year list with a net return of 32.34%, followed by Edge Asset Management Inc.'s smidcap value equity fund, 30.25%; Artisan Partners (APAM) Asset Management Inc.'s value equity trust, 29.57%; DePrince, Race & Zollo's large-cap value equity CIT, 28.78%; and Victory Capital Management Inc.'s small-cap value collective fund, 28.75%.

The median return for domestic collective investment trusts in 2016 was 12.74%.

On the five-year CIT list, BNY Mellon Investment Management's EB DV dynamic U.S. equity fund ranked first with a net return of 17.85%, followed by Amalgamated Bank's Longview quantitative midcap fund, 17.68%; J.P. Morgan Asset Management (JPM)'s JPMCB U.S. active value fund, 17.62%, Brandywine's diversified small-cap fund, 17.48%, and Quantitative Management Associates LLC's U.S. midcap core equity fund, 17.24%.

The median return for domestic collective investment trusts over the five years ended Dec. 31. was 14.64%.

All data for Pensions & Investments top-performing managers report are provided from Morningstar's global separate account/ collective investment trust database. The data for the rankings on which this story is based were pulled Feb. 1.