TOP MANAGERS: Small-cap, energy strategies top charts once again

When it comes to equity portfolio performance, size matters. And so does energy.

Small-cap and energy portfolios continued their reign as the top-performing equity separate accounts for the year ended June 30, according to data released by Morningstar Inc., with two energy strategies managed by BlackRock Inc., New York, taking the top two spots. BlackRock's small-cap energy portfolio returned 49.9% while its all-cap energy approach gained 49.2%.

The latest data continued what is shaping up to be a tradition in the Morningstar Separate Account/Commingled Fund Database: small-cap and energy stocks drive performance these days. Indeed, five of the 10 best-performing accounts included in the Morningstar data were small-cap portfolios, while three of the top performers came from the energy category.

The strong showing by small-cap and energy portfolios helped drive the median return for the composite U.S. stock category to 11.7% for the year. By comparison, the S&P 500 index gained 6.6% for the 12-month period, while the Russell 3000 index returned 9.6%. The small-cap oriented Russell 2000 index returned 14.6% for the year. The Dow Jones Energy index returned 26.3% for the year.

Following the BlackRock portfolios, in third place, was a small-cap strategy from Insight Capital Research & Management, Walnut Creek, Calif., which returned 45.4%, followed by the small-cap to midcap value portfolio of Lord Abbett & Co., Jersey City, N.J., which gained 44.6%.

The small-cap growth strategy from San Francisco-based Wells Capital Management snagged fifth place with 43.7%, followed by a classic hedge fund and concentrated-growth strategy, both managed by Husic Capital Management, San Francisco. Husic's hedge fund returned 42.4%, and the growth portfolio returned 41.4%. Mandeville, La.-based Orleans Capital Management Corp.'s energy portfolio was next with 41.3%, followed by a small-cap growth approach managed by Husic that gained 41.2%. A small-cap strategy run by Boston Asset Management Inc., Clearwater, Fla., filled out the top 10 with a return of 40.9%.

Ironwood Capital Management, Boston, which snagged the top spot in the second quarter with its small-cap growth portfolio, was knocked out of the top 10 for the most recent period.

For Daniel J. Rice, managing director and portfolio manager at BlackRock, the latest Morningstar results were another affirmation of a strategy that is more analogous to a marathon than a sprint.

"Our strategy has always been to predict longer-term commodity prices," Mr. Rice said. "We spend no time analyzing spot (prices), and that helps us focus on what really runs the longer term performance. People's myopic fascination with spot prices tends to keep them from making money."

It's a strategy that means Mr. Rice will occasionally stick with stocks that have fallen out of favor with the rest of Wall Street. Such is the case with coal-mining company Massey Energy Co., Richmond, Va., whose stock price has tumbled 35% since the start of the year and is trading around $26 a share these days. Mr. Rice's analysis says the stock should be trading at $40 to $45 a share, and he reckons either the stock market or a buyer will eventually push the stock to that level.

At Husic Capital, which has three portfolios in the top 10, Frank Husic, the firm's managing partner and chief investment officer, said his firm has always focused on spotting trends early enough to respond accordingly.

"We think one of the things we do well is to anticipate change and be early in spotting trends," Mr. Husic said. "Once we identify new themes, we are very good at ferreting out who is most leveraged to that new theme, and we move our portfolio and concentrate in those themes."

To that end, Mr. Husic said the firm is paying close attention to the industrialization of emerging markets, and is placing bets that demand for goods and services long out of favor in industrialized markets — including copper, steel and cement — will become highly coveted as those developing countries look to modernize their infrastructure. Likewise, challenges confronting the housing and automotive industries in the United States are leading him to short stocks of companies that supply to those industries. Among those shorted: retailers Costco Wholesale Corp., Issaquah, Wash., and Wal-Mart Stores Inc., Bentonville, Ark., both of which serve customers vulnerable to higher energy prices.

Steven McBoyle, Lord Abbett senior portfolio manager, said his investment technique is less about investing in sectors than identifying stocks that offer promise of high returns. "The (fund's) performance is driven more by stock selection," Mr. McBoyle said. "Sector bets have had a neutral impact."

Indeed, at a time when Wall Street was hot for energy stocks, Lord Abbett was underweight in the sector, and instead had holdings in technology, which has completely fallen out of favor with most investors.

"We look for quality companies with long operating histories that are not new to the public domain," Mr. McBoyle said, noting that the companies he selects show positive fundamental change, improvements in net operating margin and sequential earnings improvement. He also mines data, including insider buying patterns, to identify companies with positive outlooks. Some of the companies he likes include magnetic resonance imaging maker Intermagnetics General Corp., Latham, N.Y., and cable and wire distribution company Anixter International Inc., Glenview, Ill.

Brandon Nelson, portfolio manager at Wells Capital Management, deploys a three-pronged approach of identifying companies with robust and sustainable growth, revisions of earnings and revenue estimates by Wall Street analysts and the confirmation by market indicators of a company's fundamental strength.

"The way we see the world is that we think growth-stock returns are driven by financial performance relative to market expectations, and that market expectations adjust very slowly to new information," he said. "We've designed our process to try to exploit that."

That means that Mr. Nelson and his team focus on identifying leading indicators of future underestimated growth, and then try to respond quickly to that new information.

He also believes in diversity, and as such has focused his attention on technology, health care, financial services and energy. "Any economic environment has pockets of opportunity and our job is to find those pockets," he said.

Mr. Nelson said a stock that has performed well for Wells Capital in terms of performance is weight loss company NutriSystem Inc., Horsham, Pa. "It's one stock that we have owned for over a year now, and clearly met all of our criteria," he said. "We had high hopes for NutriSystem when we purchased it, and it has exceeded our estimates.

At Insight Capital, the current economic environment has led portfolio managers Lee Molendyke and Lance Swanson to become more defensive in their strategy as growth stocks continue to struggle.

"We are very bottom-up growth managers looking for, when possible, top-line accelerated, earnings-driven growth," Mr. Swanson said. "But when headwinds occur, we don't try to fight for sure. We become a lot more defensively positioned."

The small-cap strategy they manage is currently overweighted in energy stocks, most notably oil-services companies that provide tools for the large oil companies to improve production. They have pared their technology holdings on the belief that downward earnings revisions are likely in technology companies' future.

Another stock they have nearly completely sold their position in is beverage company Hanson Natural Corp., Corona, Calif. After being a top performer earlier this year, the stock has tumbled more than 40% in the last month.

"We have been surprised how quickly cyclicals have reversed in the last few months," Mr. Swanson said.

For the five-year period ended June 30, energy, small-cap and real estate funds comprised a large portion of the top 10 performing separate account funds.

BlackRock's small-cap energy strategy again snagged the top spot, with an annualized return of 33.5%, followed by Pasadena, Calif.-based First Wilshire Securities Management Inc.'s managed account, which gained an annualized 29%, and by Lake Forest, Calif.-based WCM Investment Management's managed-account portfolio at 28.8%. The small-cap value portfolio managed by ZPR Investment Management, Orange City, Fla., was next with a return of 28.5%, followed by Ativo Capital Management, Chicago, whose small-cap strategy returned 27%.

The median return for the five-year period was an annualized 6.8%, compared with 3.5% of the Russell 3000.

In the commingled fund category, funds made up of small-company stocks accounted for a majority of the top 10, led by Fidelity Investment's Pyramis Global Advisors, Boston, whose small-company commingled fund returned 25% for the 12-month period. That was followed by Atlanta-based INVESCO's REIT fund, which gained 24.9%, and Chicago-based ABN AMRO Asset Management's North American REIT, which gained 23.7%. Rothschild Asset Management Inc., New York, was next, with a 21.8% return for its small-cap trust commingled fund. Rounding out the top five was a small-cap value fund run by Donald Smith & Co., New York, that gained 20.6%.

The median one-year return for commingled funds was 11.8%, while the five-year median return was an annualized 5.7%.