Growth equity extends winning streak for another quarter

For the second consecutive quarter, small-cap growth strategies dominated the overall one-year domestic equity rankings in Morningstar Inc.'s separate account/collective investment trust database.

Six of the top 10 equity strategies for the 12 months ended Sept. 30 were small-cap growth strategies. Of the six, four had significant microcap investments.

Daniel Culloton, associate director of manager research, equity strategies at Mor-ningstar in Chi-cago, said microcap is a “tricky” section of the investment universe and that its strong representation in the top 10 was surprising. It's a “volatile” and “unpredictable” asset class, Mr. Culloton said. “It's hard to predict when it's going to do well.”

One positive contributor might be the current low-interest-rate environment, Mr. Culloton said. Sustained low interest rates encourage more risk-taking and raise the returns of riskier asset classes such as microcap equities.

Less surprising was the dominance of growth equity, occupying nine spots on the top 10. Over the trailing year, “growth has generally done better than value,” Mr. Culloton said.

Domestic growth equity managers in Morningstar's database returned a median 2.48% for the year ended Sept. 30, below the 3.21% return for the Russell 3000 Growth index but ahead of the median -2.77% return for the database's domestic value equity managers. The Russell 3000 Value index returned -4.22% during the same period. The overall one-year equity median was 0.12% and the Russell 3000 returned -0.49% for the year.

The top return for the year ended Sept. 30 was Emerald Advisers Inc.'s diversified small-cap growth strategy, with a gross return of 18.53%.

The portfolio team invests in the “top growth companies” in the small-cap universe, with an emphasis on companies that are “underfollowed and underresearched,” said Joseph W. Garner, director of research and portfolio manager at Leola, Pa.-based Emerald Asset Management.

Three sectors drove much of the strategy's performance over the last year — health care, financials and technology, he said.

In health care, Bluebird Bio Inc., a biotech company focused on gene-based therapy, produced strong gains. In financials, a top gainer was LendingTree LLC. The financial search engine is the classic company that is not as followed or researched by analysts, Mr. Garner said. A top performer in technology was cyber security solutions provider Imperva Inc.

The strategy benefits from the “breadth and depth” of its 14-person research team, Mr. Garner added. Collectively, the team was able to attend more than 2,000 company meetings this past year.

In the second spot was Polen Capital Management LLC's focus growth strategy with a gross return of 18.11%.

The portfolio team targets competitively advantaged large-cap companies with strong balance sheets and strong growth expansion. About 20 companies are held at a time, said Dan Davidowitz, chief investment officer and portfolio manager at the Boca Raton, Fla.-based money manager.

Among the portfolio's top producers over the past year were Starbucks Corp., Nike Inc., Allergan PLC, Visa Inc. and O'Reilly Automotive Inc.

On Nike and Starbucks, Mr. Davidowitz said: “These companies have a unique value proposition for consumers and a steadiness to business that stands up to any environment.”

Ranking third with a gross return of 17.94% was Rice Hall James & Associates LLC's microcap opportunities strategy, which invests in companies with a market cap of $1 billion or less.

Lou M. Holtz, a Pasadena, Calif.-based portfolio manager and analyst at the firm, described the investment strategy as “very much” buy and hold. “We stay away from short-term, one-hit wonders that can't sustain their business longer term,” Mr. Holtz said.

Broadly speaking, microcap is a “wonderful area for investors,” Mr. Holtz said. The asset class is less “scrutinized” and portfolio managers can find “great opportunities that the market may be ignoring.”

Health-care stocks provided “decent” gains for the portfolio over the year, he said. Two winners there were Abiomed Inc. and NPS Pharmaceuticals Inc. The portfolio also benefited from a minimal exposure to the energy sector — 0.15% vs. a 2.39% exposure to energy for the Russell Microcap Growth index.

In fourth place was Driehaus Capital Management LLC's microcap growth strategy, with a gross return of 17.58%. The portfolio team looks for companies undergoing positive change that hopefully will beat growth expectations going forward. The strategy's average-weighted market cap was $764 million as of Oct. 31.

On an absolute-return basis, the best-performing sectors for the portfolio over the past year were technology and health care, said Jeffery James, portfolio manager at the Chicago-based money manager.

Top gainers for the portfolio included LendingTree and Paycom Software Inc., which provides cloud-based human resources technology and payroll services.

Michael Buck, assistant portfolio manager, added that having a “nimble and flexible” investment strategy allows the team to capture new ideas.

The portfolio's holding period ranges from six months to three years.

Mr. Buck said he continues to see emerging opportunities in the energy sector, including Flotek Industries Inc., an oil field services company.

And even though health care has sold off in the last few months, there are still strong growth stories — in therapeutics and medical devices, for instance, Mr. Buck said.

Rounding out the top five was Mazama Capital Management's emerging small-cap growth strategy with a gross return of 16.84%. The strategy also ranked fourth for the five years ended Sept. 30 with an annualized growth return of 20.37%.

The average weighted market cap of the younger companies Mazama targets is $1 billion, compared with the Russell 2000's average weighted market cap of $2 billion.

Small-cap strategies also dominated the rankings for the five years ended Sept. 30, occupying seven of the top 10 spots. Small-cap growth and small-cap value occupied three spots each. Small-cap blend had another. The five-year median return was 13.1%, just below the Russell 3000's 13.28% benchmark return for the same period. (All returns for periods of more than one year are annualized.)

For the third consecutive quarter, Naylor and Co. Investments LLC's core composite strategy ranked first with an annualized gross return of 27.39%.

The strategy also ranked sixth on the one-year list with a gross return of 16.47%. Chad Naylor, CEO and CIO at the San Francisco firm, describes the strategy as a “refined value investing strategy.”

Mr. Naylor said he looks for relatively inexpensive companies in the beginning stages of recovery that have the potential to grow fairly rapidly. “We'll go into a place where there is negative press ... take a hard look and say, can there be companies here (that) if (we're) patient enough, will recover and give the portfolio long-term growth?”

Airlines and automotives fall into this category, Mr. Naylor said.

Another industry that's produced strong returns for the portfolio is online banking. Top gainers there include Bank of Internet USA and First Internet Bancorp.

Ranked second on the five-year list was DRS Value, a midcap value equity strategy managed by DRS Asset Management, with an annualized gross return of 25.04%, followed by Analytic Investors LLC's small-midcap equity strategy at 21.05%, Mazama's emerging manager small-cap growth strategy and BMO Global Asset Management's microcap equity institutional separate account at 20.29%.

In the collective investment trust universe, J.P. Morgan Asset Management's JPMCB Diversified Commercial Property was No. 1 with a one-year net return of 13.9%, followed by JPMCB U.S. Real Estate Securities Inv at 11.84%.

Rounding out the top five were State Street Global Advisors' REIT Index NL Series A at 11.72%, William Blair & Co.'s small/midcap growth strategy at 10.81% and American Century Investments' U.S. real estate securities trust at 10.48%.

The median return for collective investment trusts for the year ended Sept. 30 was 0.38%.

All data for Pensions & Investments top-performing managers report are provided from Morningstar's global separate account/ collective investment trust database.

The rankings that run in print were pulled from Morningstar data available on Oct. 28; online rankings might differ.

Information on the database may be obtained by e-mailing separate [email protected] or calling 312-384-4087.