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Special report

Small-cap managers keep tight grip on equity rankings

Drew Beja, Granahan Investment Management
Drew Beja, partner and portfolio manager at Granahan Investment Management, says two of its small-cap strategies benefited from the firm’s long-term approach.

Small-cap equity managers once again claimed six of the top 10 spots in Morningstar Inc.'s domestic equity separate account/collective investment trust database for the year ended March 31.

Of those six small-cap strategies, four were growth managers and two were value managers. In the previous quarter, for the year ended Dec. 31, five of the six were value managers.

Andrew Daniels, analyst for equity strategies for Morningstar, Chicago, said in a telephone interview that the shift in advantage to growth from value is a tale of two time periods.

“If you remember going back to 2016, … (after the election) the value-oriented stocks did very well, and small-cap stocks did very well compared to their larger-cap counterparts and that's what drove a lot of value funds to that (prior quarter) list,” said Mr. Daniels.

“Small caps did really well after the election. I think that's partly due to the fact that small-cap stocks theoretically may benefit more from some policy changes in Washington,” he said, adding smaller-cap companies are generally more U.S.-centric than larger-cap multinational companies and would thus benefit more from those policy changes.

“There's been a reversal of that trend in 2017,” Mr. Daniels said. “Not only has growth dominated value, but large-cap stocks have done really well relative to smaller-cap counterparts. It's more of a blended result.”

Morningstar's overall domestic equity universe returned a median 17.91% in the year ended March 31; the value and growth universes returned a median 19.41% and 17.15% for the year, respectively.

For the quarter ended March 31, the median large-cap growth return was 8.05%, compared to the median small-cap growth return of 5.12%.

Ranked first overall, both for the one year and five years ended March 31, was ZPR Investment Management Inc.'s volume value strategy, which returned a gross 54.36% in the year and annualized gross 24.82% in the five years ended March 31.

Mark Zavanelli, president and main portfolio manager at the Orange City, Fla.-based firm, said in a telephone interview that it is a pure quantitative strategy that targets microcap stocks with low trading volume and low valuation.

“We apply those two factors together in a screening process,” Mr. Zavanelli said. “We do this in microcap stocks, the theory being microcap is where you would find more neglected companies.”

Regarding the success of the strategy over the past five years, Mr. Zavanelli said he was encouraged because value equities in general had not performed very well during the period.

“Clearly we're getting a bump with the last one year's performance,” Mr. Zavanelli said. “We have had a very strong tailwind from value. There's this value factor, especially in microcap, but it's true across the small-cap universe that value has performed very, very strongly. This was especially true in the fourth quarter of 2016 post-election. That was a quarter that was one of the best quarters for this value factor.”

Mr. Zavanelli also noted the portfolio is weighted to about 60% financial stocks. “It turns out not to be a design, just an application that there are many, many tiny financial companies in the microcap universe.”

“Returns to those microcap financials really were unusually high,” he said.

As of Dec. 31, according to Morningstar's profile, the strategy had 53 holdings, and 13 of the 20 largest were financial services firms. The three largest holdings were 1st Constitution Bancorp, Royal Bancshares of Pennsylvania Inc. and First Community Financial Partners Inc.

Ranked second was Towle & Co.'s deep value small-cap equity strategy with a gross return of 50.69% for the year ended March 31.

The deep value strategy “executes a fundamental, bottom-up value discipline that emphasizes the purchase of companies believed to be significantly undervalued relative to their private market worth,” according to the money manager's website.

The strategy seeks companies with strong market positions in industries such as consumer products, distribution, energy, financial services, manufacturing and transportation, according to the website. While the strategy does hold some larger-cap stocks, the “deep value” approach usually leads to companies with capitalizations of less than $5 billion, according to the website.

According to its Morningstar profile, the strategy held 33 stocks as of Dec. 31. SkyWest Inc. held the largest percentage of net assets at 6.64%, followed by Trinseo SA, Navistar International Corp., Meritor Inc. and McDermott International Inc.

Officials at Towle & Co. declined comment.

Ranking third and sixth on the one-year ranking was Granahan Investment Management Inc., Waltham, Mass., with two small-cap growth strategies. Its Small Cap Focused Growth strategy returned a gross 48.36% in the 12 months, while the Small Cap Advantage strategy returned a gross 44.01%.

Drew Beja, partner, vice president and portfolio manager at Granahan, said in a telephone interview that the strategies benefited from the money manager's long-term approach.

“If you look back to the first quarter of '16 there were a lot of folks convinced we were not only in a recession, (but) it was a very deep one,” Mr. Beja said. “At the time we were not convinced, and that's not our MO. Our modus operandi is not to make top-down prognostications. We've got a fundamental team that looks at companies that can grow at a high rate over the next three, four, five, six years and we apply very strict discipline around valuation in terms of when to own the stock of those companies and when not to.”

He added the strong performance of both strategies was very broad-based, and not limited to any specific sectors or holdings.

The small-cap focused growth strategy as of March 31 had 38 equity holdings compared to the small-cap advantage strategy's 88 holdings. While the former is more concentrated, the two strategies do have their top four holdings in common: Impinj Inc., Affiliated Managers Group Inc., Imax Corp. and SPS Commerce Inc. The four each account for more than 6% of net assets in the focused growth strategy while the top four in the advantage strategy range from 2.77% to 3.49%.

Opportunistic strategy

Ranked fourth was Boston Co. Asset Management LLC's opportunistic investor strategy, which returned a gross 45.87% in the year ended March 31.

David A. Daglio Jr., Boston-based senior managing director, said in a telephone interview that the 2-year-old strategy is a concentrated, unconstrained investment approach. Morningstar includes the strategiy in its midcap blend category.

The strategy has around 20 stocks that its team believes has at least 50% return potential over three years and a limited risk of permanent capital loss, he said.

Mr. Daglio said the success of the strategy was due to “strong stock selection and good sector selection across the board” and “correctly identifying the fears that were misplaced in the market.”

Strong performers, he said, included holdings in specialty pharmaceuticals, regional banks and student lending. He would not identify specific holdings.

Rounding out the top five on the one-year ranking was Bares Capital Management Inc.'s small-cap strategy, which returned a gross 44.05%.

Brian T. Bares, Austin, Texas-based founder and research analyst, said in a telephone interview that “we're pretty unique in that we are very concentrated even by concentrated manager standards.”

“We hold eight to 12 names typically and so that level of concentration can be volatile in the short term, but we have a pretty key structural advantage,” Mr. Bares said.

“We don't run any 40 Act funds,” he said, noting that because the strategy is solely a separate account for institutional investors, the strategy is not prone to short-term retail thinking and helps the firm managers keep a long-term view.

The strategy has been closed to new investors since 2012.

“We manage just under $800 million in the strategy,” he said, “so the capped asset base allows us to stay concentrated where most other managers would follow their economic incentive into greater portfolio diversity.”

There was more variety of styles and capitalizations among the top 10 domestic equity strategies for the five years ended March 31. Domestic small-cap equity strategies accounted for five of the top 10 — four were value and one was growth — while there also were two domestic midcap strategies, and financial, health and technology categories were represented by one strategy each.

For the five years ended March 31, the rest of the top five strategies following ZPR Investment Management were second-ranked Naylor & Co. with its core composite midcap growth strategy, with an annualized gross return of 23.55%; Financial Trust Asset Management's health value strategy, with 20.15%; BMO Global Asset Management's microcap equity strategy, 19.82%; and Towle & Co.'s deep value strategy, 19.71%. (All returns for more than one year are compound annualized figures.)

The five-year median return for domestic equity strategies in Morningstar's separate account universe was 12.77%.

Among domestic collective investment trusts, American Century Investments' U.S. small-cap value equity trust ranked first with a net return of 31.86% in the year ended March 31, followed by Boston Co. Asset Management's small-cap opportunistic value trust at a net return of 30.39%. The rest of the top five was: State Street Global Advisors' Russell small-cap value index trust, which returned a net 29.24% in the year ended March 31; J.P. Morgan Asset Management (JPM)'s U.S. small company equity investment trust, which returned a net 29.17%; and Wellington Management Co.'s CIF II small cap 2000 trust, a net 29.02%.

For the five years ended March 31, the top-performing collective investment trust was State Street Global Advisors' Nasdaq 100 index trust, which fell into Morningstar's domestic large-cap blend category, with an annualized net return of 16.05%. Rounding out the top five were: Thompson, Siegel & Walmsley LLC's midcap value 200 trust, with an annualized net return of 16.04%; J.P. Morgan's U.S. active value fund, a net 15.51%; American Century Investments' U.S. midcap value equity trust, a net 15.16%; and J.P. Morgan's U.S. small company equity investment trust, 14.82%.

Morningstar's overall domestic equity CIT universe returned 18.07% in the year ended March 31, and an annualized 13.11% in the five years ended March 31.

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 April 27.