Equities: Small caps dominate with a solid second quarter; 2 strategies repeat in top 10

Small-cap strategies accounted for five of the top 10 domestic equity strategies in the year ended June 30 in Morningstar Inc.'s separate account/collective investment trust database.

The median return for all equity strategies for the 12 months was 22.47%, slightly above the Russell 3000 index for the same period at 21.46%.

Andy Kwon, Chicago-based data analyst at Morningstar, said the median returns for all small-cap domestic equity strategies were better than those of midcap and large-cap strategies in the second quarter, accounting for much of the advantage for the year ended June 30.

“This quarter it looks like small cap is doing the best out of the three,” said Mr. Kwon in a telephone interview. “The second in line is large cap.”

The median small-cap gross return for the second quarter was 3.71%, while large-cap returned 2.7% and midcap returned 2.29%, all showing drops from the first quarter.

The first quarter's median returns for all capitalizations were small cap at 12.43%, midcap at 12.1% and large cap at 10.55%.

“The slip in performance wasn't as bad as in the fourth quarter. (For example), the large-cap median (in the fourth quarter) was 0.46%, so we're not seeing the performance as bad as the fourth quarter, it seems to be,” Mr. Kwon said.

Only two of the top 10 separate accounts for the year ended March 31 reappeared in the top 10 list for the second quarter's report. They are the small-cap value equity strategy of Cooke & Bieler LP and the master limited partnership portfolio of Invesco Ltd. And while small-cap strategies dominated the top 10, they did not make it into the top three.

Wellington Management Co. LLP's all-cap opportunities strategy led Morningstar's domestic equity universe in the year ended June 30, with a gross return of 44.73%. (All figures reported in this story are gross returns; data for periods of more than one year are annualized.)

Sara Sherman, vice president and counsel at Boston-based Wellington, said the firm would not provide any comment.

According to its Morningstar profile, the strategy's objective is “to provide significant capital appreciation by investing opportunistically in the equity securities of undervalued companies.” Holdings in the portfolio are selected based on business momentum, fundamentals and value.

The top five holdings based on market value of shares owned as of March 31 were Cobalt International Energy Inc., Fifth & Pacific Cos Inc., Karoon Gas Australia Ltd., Bank of America Corp. and Dana Holding Corp., according to Morningstar.

Cushing MLP Asset Management took the second and third spots in the top 10, with its Cushing master limited-partnership institutional alpha strategy returning 44.46% and its Cushing MLP institutional core strategy, 44.03%.

Libby Toudouze, Dallas-based president of Cushing MLP Asset Management, said the focus for both strategies is a bottom-up, fundamental analysis with portfolio construction that focuses on lower-concentration risk and higher levels of liquidity.

“The core strategy is a more basic or more balanced approach to investing in MLPs. It balances the yields, closer to an asset class yield, but we're still going to focus more on growth. The alpha will give up yield all day long,” said Ms. Toudouze.

Overall, she said the firm has benefited from changes in the MLP marketplace.

“It's now become a stock-picker's market and that plays right into what our strengths are,” said Ms. Toudouze. ”We would expect to see this kind of significant outperformance given the intensity with which we look at the fundamentals.”

Among the energy sectors that have performed particularly well for the strategies is crude oil. General partnerships also have brought benefits. “We've always loved playing the general partnership game. If you understand the management you understand the assets,” Ms. Toudouze said.

In the past year, “We got a great run in the crude and logistics names, with the spread with the crude differential contraction,” she said.

Cushing also has had success with “the supply and logistics business which in the first quarter had strong numbers. We're beginning to see that abate; those margins have come in dramatically (and) there's great growth potential there,” said Ms. Toudouze.

Cooke & Bieler's small-cap value strategy came in fourth, 43.5% in the year ended June 30. The strategy also ranked fourth in the earlier quarter, when it returned 33.59% in the year ended March 31.

“We require three characteristics,” said Daren Heitman, partner and portfolio manager at Cooke & Bieler, Philadelphia. “One is an enduring business franchise that will thrive in the long term. Secondly, we require a conservative balance sheet (and many of our companies have net cash) and third, we require the stocks to be selling at a significant discount.

“That philosophy has generated competitive returns that protect our investors in down markets without giving up much potential in up markets.”

The Cooke & Bieler strategy typically holds 40 to 50 stocks — and could go up to 60 in the long term — with an annual turnover rate of between 30% and 50%, according to Mr. Heitman.

In the second quarter, “I think my first thought is that we got a glimpse of what tapering will look like, and it wasn't pretty for utilities and REITs. We have zero weight in both sectors and we feel really good about that,” said Mr. Heitman.

Among the portfolio's holdings are Winnebago Industries Inc., AMN Healthcare Services Inc. and American Woodmark Corp.

Tieton Capital Management LLC's small-cap value strategy rounded out the top five for the year, returning 43.35%.

Matt Dhane, principal and senior analyst at the firm in Yakima, Wash., said the strategy is very research intensive, taking a bottom-up approach to undervalued companies, with staff spending a great deal of time on the phone and on location with the companies in which they invest.

“We approach it as an owner of the company, so we end up developing a strong belief in the company, in its strategy and confidence in the management as well,” said Mr. Dhane. Portfolio holdings “tend to be more unique. If they're not unique, they have different approaches within a space,” he said.

While the portfolio is overweight more in technology for example, Mr. Dhane said “we don't pay a lot of attention to the indexes.”

The portfolio's time window is “two years, but sometimes ... three to five years,” he said. It usually has 25 to 35 holdings and “right now, we're on the lower end of that,” Mr. Dhane said.

Horizon Kinetics LLC's small-cap institutional strategy came in sixth, with a return of 42.55% in the year ended June 30. The strategy performed particularly successfully in the last year because of investments made many years ago, according to Doug Kramer, New York-based CEO.

“The overarching philosophy of the firm relates to the fact most investors are very preoccupied with the short term and we believe that if you're patient, so to speak, that you can earn an above-market rate of return by exploiting things other people don't focus on,” said Mr. Kramer.

A top performer for the portfolio was Icahn Enterprises LP. “Icahn Enterprises is what we would deem to be called an owner-operated company,” said Mr. Kramer. “We believe they're considered a predictive attribute, an attribute that says something about their forward rate of return. Our research, which goes back 15-plus years, shows investing alongside owner-operated companies is a great way to make money.”

“It's something we bought years and years ago,” Mr. Kramer added. “It traded virtually range-bound (for years) in the 40s. Carl Icahn did a number of things, call it "unlock value in his entity.' One thing was to start paying dividends.”

Rounding out the top 10 for the 12 months were: Kennedy Capital Management's small-cap fundamental growth strategy at 40.07%; Zevenbergen Capital Investments LLC's Z/tech strategy, 39.76%; Invesco's MLP strategy, 39.48%; and PENN Capital Management's small-cap equity strategy, 39.47%.

For the five years ended June 30, Good Harbor Financial's tactical equity income strategy led the domestic equity manager universe with an annualized 27.94%.

“The primary economic premise behind all of our stuff is time-varying risk,” said Marcus Franklin, Chicago-based partner.

While focusing on cash flow analysis, the strategy also focuses on the importance of the discount rate, based on the idea that stock market volatility is dominated by the premium demanded by investors to hold equity risk.

The strategy averages 15 to 20 holdings in companies with high risk premiums and liquid assets.

“We look for companies that have stable cash flows,” said Mr. Franklin. “These types of companies (include) REITs, MLPs, metals, mining, utilities.”

Other managers in the top five for the five years ended June 30 were: Invesco's MLP, with 24.23%; Tortoise Capital Advisors' midstream MLP, 21.81%; Granahan Investment Management's small-cap focused growth, 20.42%; and Westwood Management Corp.'s MLP infrastructure renewal strategy, 20.35%.

The median return of the separate account equity universe for the five years ended June 30 was 7.98%, while the Russell 3000 returned 7.25% for the same period.

Among collective investment trusts, five of the top 10 performers for the year ended June 30 were large-cap managers.

The top four were all managed by The Boston Co. Asset Management LLC: The small-cap opportunity value equity strategy returned 34.61%; the U.S. dynamic large-cap value CF strategy, 33.38%; the midcap opportunity value equity strategy, 33.32%; and the U.S. dynamic large-cap value EB strategy, 33.23%.

The fifth was the large-cap value CIT of Brandywine Global Asset Management, at 32.82%.

The median return for collective investment trusts for the year ended June 30 was 22.95% and for the five years, an annualized 7.32%.

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 [email protected] or call (312) 384-4087.