Equities: Small caps back to dominate the 1-year performance as investors feel confidence returning

Small-cap strategies reclaimed the top spots in the overall equity rankings for the year ended Sept. 30, according to Morningstar Inc.'s separate account/ collective investment trust database.

“Small-cap players are definitely shining again,” said Andy Kwon, a data analyst for Chicago-based Morningstar. “I think part of that might be because people are becoming more confident. People were pessimistic, and now they see things are steadily growing and are willing to take a little more risk.”

Eight of the top 10 performing managers for the year ended Sept. 30 were using small-cap strategies, which haven't dominated the scene since the third quarter of 2011, according to Mr. Kwon. The other portfolios in the top 10 were mid- and large-cap strategies.

Equity strategies overall improved in the third quarter. The median return for all stock portfolios was 5.8% in the third quarter, compared with -4.39% in the second quarter. But the third quarter median slightly trailed the 6.23% return of the Russell 3000 for the period. For the 12 months ended Sept. 30, the median return for all stock portfolios was 28.3%, compared with 0.18% for the 12 months ended June 30. Meanwhile, the Russell 3000 for the year ended Sept. 30 was 30.2%.

Mr. Kwon also pointed out that every equity investment style exhibited positive median returns in the third quarter. “What it shows is that all the classes have been performing well, so it's safe to say things are improving,” Mr. Kwon said. “July was a rough month, but in August and September there was a turnaround. The last two months of the quarter is where these people were making money.”

The top performer for the year once again was Granahan Investment Management Inc.'s Small-Cap Focused Growth portfolio, with a gross return of 54.2% for the year ended Sept. 30, up 35 percentage points from the previous quarter's report.

“We are looking for what we consider "desert island' companies,” said Andrew Beja, managing director and portfolio manager for the Waltham, Mass.-based investment manager. “These are companies we would take on a stranded island; they have large opportunities for growth, very strong competitive positions and strong management cultures.”

Some of the companies in which the firm invests are SPS Commerce Inc., which provides next-generation electronic data interchange for large retailers, and Demandware Inc., which provides e-commerce software for online retailers.

The small-cap portfolio is just one of two crossovers from the June 30 reporting period, when large-cap strategies dominated the top 10. (The other crossover for the period was Kopp Investment Advisors LLC's small-cap growth portfolio, which was seventh in the rankings with a gross return of 48.22%.)

“Small caps in general can provide very good opportunities for growth given these companies are in some of the most exciting areas of the economy, and naturally it's easier to grow off a small base than it is a very large one,” Mr. Beja said. “However, it can be a treacherous asset class, which is why one has to really pay attention to the risk/reward.”

The second-best performing manager in the overall equity separate account universe for the year was Hotchkis & Wiley Capital Management LLC, with its midcap value portfolio returning a gross 50.65%.

“We are a value manager, so we keep our investment philosophy through thick and thin,” said Stan Majcher, portfolio manager at the Los Angeles-based firm. “It doesn't do well every year, but it does well over long periods of time. When it doesn't do well, managers tend to switch strategies, but it's key to stick with the same strategy.”

The portfolio, which was the only midcap strategy in the top 10, aims to buy companies that are valued low and attractively priced, but still have good balance sheets.

In 2012, the firm bought regional banks that had been valued low because of Greece and the euro debt crisis. “Regionally, U.S. banks don't have the exposure to what's pushed them down in the headlines,” Mr. Majcher said. “If you look at assets and capital, they are profitable today and they are actually putting more capital into the books. They have low risk and high returns, so we have been buying those stocks.” He would not provide specific names.

In third place was the small-cap value strategy of Cooke & Bieler LP, with a gross return of 50.17%.

The value equity boutique firm, based in Philadelphia, also looks for strong balance sheets as criteria for investments. “Our stocks have three characteristics,” said Daren Heitman, partner and portfolio manager for Cooke & Bieler. “First is a ... business franchise that will endure the ups and downs of the economy. Second, we require the businesses we own to have strong balance sheets. And third, we create a discounted cash flow model.”

Mr. Heitman said the firm maintains a concentrated strategy, only investing in 40 to 60 holdings. He would not give specific names.

Slightly trailing Cooke & Bieler for the year ended Sept. 30 was Allianz Global Investors Capital LLC, the only manager to have two portfolios in the top 10. The San Diego-based firm's U.S. Ultra Micro Cap portfolio was fourth with a gross return of 49.96%, while its U.S. Systematic Small Cap portfolio came in eighth with a gross return of 47.84%.

Rounding out the top five was the small-cap value portfolio of Cove Street Capital LLC, with a gross return of 49.56%.

For the five-year period ended Sept. 30, 12th Street Asset Management Co. LLC once again took the top two spots. The manager's small-cap value strategy was the No. 1 performer for the sixth straight quarter, with a return of 24.75%, followed by the Asset Opportunity portfolio with 18.91%. All five-year returns are annualized.

Both portfolios are primarily invested in transportation, retail and environmental services companies. Some of the firm's most successful holdings over recent quarters have been Advanced Auto Parts Inc., FedEx Corp. and Heritage-Crystal Clean LLC.

“We're doing the same thing we've always done,” said Michael O'Keefe, founding partner of Chicago-based 12th Street. “I started this business in 2007 with the thought that you can't be like everyone else and expect to generate different outcomes. We don't think about the stock market or try to beat a benchmark; we look to preserve capital above chasing performance.”

The annualized median return for all separate account strategies in the Morningstar universe was 2.29% for the five years ended Sept. 30, while the Russell 3000 index returned 1.3% for the same period.

Among collective trusts, small-cap strategies also dominated the rankings for the year, grabbing eight of the top 10 spots.

Associated Banc-Corp's financial strategy lead the pack with a gross return of 45.42%, followed by Frontier Capital Management Co.'s small-cap blend strategy with 42.23%. In third was The Boston Co.'s small-cap opportunistic value strategy with 40.36%, followed by Pyramis Global Advisor's small-cap blended strategy with 39.79% and its real estate investment trust strategy with 37.46%. The median one-year return for collective trusts was 30.21%. n