Small-cap growth strategies extend dominance in 1-year returns

Small-cap growth strategies dominated for the year ended June 30, making up eight of the top 10 domestic equity strategies, according to Morningstar Inc.'s separate account/collective investment trust database.

It was the second straight quarter of small-cap growth strategies leading the way in the top 10. For the year ended March 31, five of the top 10 strategies were small-cap growth.

Of the previous top 10, six strategies are making repeat appearances for the year ended June 30.

Tony Thomas, manager research analyst at Morningstar, Chicago, said in a telephone interview that while they performed exceptionally well in the year ended March 31, the recent attention to rising tariffs has helped contribute additional outperformance for small-cap strategies in the second quarter as well.

"They tend to be domestically focused," Mr. Thomas said, "and tend to be benefiting from what is a very strong domestic category. I think in 2017, small-cap growth did OK but it was certainly a large-cap growth market in 2016-17. Now you're seeing the small-cap growth folks join the party."

Mr. Thomas said technology and health-care stocks within that universe have continued to provide significant outperformance in 2018, while others that have lagged in recent years have picked up steam.

"Energy is going a lot better, consumer staples are doing a lot better," said Mr. Thomas. "Those don't look great, say, on year-to-date numbers, but in the second quarter energy looked a lot better. Now they're starting to see some earnings momentum and some stock price momentum come out of that."

While small-cap growth strategies dominated significantly for the year ended June 30 and no value strategies appeared, Mr. Thomas noted solely for the second quarter of 2018, the Russell 2000 Value index performed better than the Russell 2000 Growth index, returning 8.3% vs. 7.23%. For the year ended June 30, the Russell 2000 Growth index returned 21.86% and the Value index returned 13.1%.

Overall in Morningstar's universe, domestic equity strategies returned a median 13.72% for the year ended June 30. The Russell 3000 returned 14.78%.

Morningstar's median return for domestic equity growth strategies for the year ended June 30 was 19.89%, while the median return for domestic equity value strategies was 10.62%.

For the fourth straight quarter, Kayne Anderson Rudnick Investment Management LLC's Small-Cap Quality Select strategy occupied the No. 1 spot — and again by a wide margin — returning a gross 80.36% for the year ended June 30. The manager also took the ninth overall spot with its Small Cap Sustainable Growth strategy returning a gross 44.83% for the year.

The former strategy is a non-tactical strategy that seeks "to invest in businesses with long-lasting competitive barriers," said Todd Beiley, portfolio manager and senior research analyst at Kayne Anderson Rudnick, in an email.

The key, he said, is not to overdiversify. The Quality Select strategy has less than 10 holdings, meaning "the market value of our portfolio can be erratic in (the) short term but ... (we believe it is a) prudent way to invest for long term," Mr. Beiley said.

As of June 30, according to Morningstar's profile of the strategy, Quality Select held six stocks. One standout, particularly in the second quarter, Mr. Beiley said, was The Chefs' Warehouse Inc., a food distributor to higher-end restaurants.

Its competitive advantage is "that large volume distributors have difficulty providing small order quantity delivery and inventory diversity that high-end restaurant customers seek. And Chef has more scale than small competitors," Mr. Beiley said. Its particularly strong second quarter came after a multiyear period of expansion that hurt profitability, he said.

Mr. Beiley also pointed out Fox Factory Holding Corp., a maker of suspension products for mountain bikes and off-road vehicles.

Its second-quarter performance was because its "move beyond their historic core high-end mountain bike products into other areas has been successful, especially off-road-capable trucks like Ford Raptor," Mr. Beiley said.

Ranked second and a newcomer to the top 10 list was Next Century Growth Investors LLC's Small Cap Ultra strategy, which returned a gross 62.6% for the year ended June 30.

Peter M. Capouch, Minneapolis-based portfolio manager, said in an email that the strategy aims to own the highest quality, fastest growing U.S. microcap companies with higher, more sustainable earnings growth and revenue than the Russell Microcap Growth index.

Mr. Capouch said the significant outperformance for the past year can be attributed to the market's overall strong growth mode, as well as the trend toward passive investing.

"We understand the concept of index funds but in small caps, where there are great information and analysis inefficiencies, we think targeted investing in specific companies is a more lucrative approach," Mr. Capouch said. "Because the marginal buyer of small-cap growth stocks today is likely a computer executing an unsophisticated index program, we are benefiting from this reduced human competition in our market. Ironically, we are up 60% in the past year and, due to the popularity of passive, manage fewer assets than we did a couple years ago."

The strategy holds about 50 stocks typically, with a maximum 5% weighting to any one stock, Mr. Capouch said. Health care and technology have traditionally been strong performers for the strategy, although it is very diversified among sectors.

"Industries represented among our past year's biggest winners include: medical devices, payment processing, media, medical diagnostics, software, telecom services, trucking, homebuilding, insurance, machinery and health-care services," Mr. Capouch said.

Ranked third was Quantitative Investment Decisions LLC's U.S. Titans strategy, which returned a gross 53.94% in the year ended June 30. The strategy, which has less than $1 million in assets, held four stocks as of June 30, according to Morningstar's profile: Amazon.com Inc., Facebook Inc., Netflix Inc. and Shopify Inc. The main focus of the Naples, Fla.-based firm, according to its profile, "will be to develop and distribute strategies that focus on downside risk protection."

Granahan Investment Management Inc., Waltham, Mass., for the second quarter in a row had three small-cap strategies among the top 10 domestic equity strategies. Ranked fourth was Small Cap Focused Growth with a gross return of 50.61% for the year ended June 30.

Andrew L. Beja, senior vice president and managing director at Granahan, who manages the focused growth strategy, said in a telephone interview that the strategy tries to identify companies they would take to a desert island for five to 10 years.

"We call them desert island companies because when we came back from the desert island we would want those companies many times larger than they were when we left," Mr. Beja said, "and we're exclusively looking for those companies. We're investing in secular growth companies, not cyclical, that are compounders, and we marry that analysis with a very rigorous valuation discipline that centers on the probability of expected return."

The Small Cap Focused Growth strategy retains a list of 100 of these desert island companies, about 40 of which are held in the portfolio at any given time.

Mr. Beja attributed the vast majority of the past year's outperformance to stock selection. "Our team's done a good job of identifying these desert island companies," he said.

Two stocks he highlighted as standouts in the past year were LivePerson, which develops online messaging products, and 2U Inc., which partners with universities to offer online degree programs. Both companies, Mr. Beja said, have seen considerable growth in the past several years.

"We tend not to have meaningful exposure in areas that don't have sustainable growth or sustainable secular growth," Mr. Beja said. "For example, we have no energy. We don't have banks or utilities or other commodities."

The two other Granahan strategies that appeared in the top 10 for the year ended June 30, were Small Cap Advantage, which ranked seventh with a gross return of 46.94%, and Small Cap Discoveries, which ranked 10th with a gross return of 43.2%.

Discoveries, managed by Gary C. Hatton, Granahan's co-founder, chief investment officer and senior managing director, focuses primarily on the smaller of small-cap companies and Advantage combines traits of both the Focused Growth and Discoveries strategies.

Zevenbergen Capital Investments LLC's Genea Growth strategy, a concentrated growth portfolio that looks for companies that are disrupting industries, ranked fifth on the one-year list, returning a gross 48.68% in the year ended June 30.

The strategy, formerly known as Z/Tech, also led the top 10 for the five years ended June 30, with an annualized gross return of 27.85%. It was the fourth straight quarter the strategy led the five-year list.

Brooke de Boutray, managing director, portfolio manager at Zevenbergen, said the strategy has in part done so well over the past six years in part because it was a very early investor in FAANG stocks: Facebook, Apple Inc., Amazon, Netflix and Google Inc. (now Alphabet Inc.).

"We look very, very long term," Ms. de Boutray said. "We have looked for companies that have strong fundamentals, that are disrupters in their own right and have strong competitive moats."

The concentrated strategy, which has about 25 holdings, looks at strong entrepreneurial, innovative companies in technological areas like autonomous driving and artificial intelligence, among others, Ms. de Boutray said.

She also noted some holdings of smaller-cap companies that performed particularly strongly in the last quarter were e-commerce company Wayfair Inc. and the aforementioned 2U.

Ranked sixth and a newcomer to the top 10 list was Macquarie Investment Management's Small Cap Growth strategy, which returned a gross 47.86% for the year ended June 30.

Alex Ely, Macquarie's New York-based senior vice president, chief investment officer – small/midcap growth equity, said it is a very concentrated strategy with 35 names, although those names represent 14 or 15 ideas or trends in the economy — which include mobile services, biotechnology, streaming services and new media — that they believe are long-lasting.

"A name has to have growth that's significantly above general corporate revenue and earnings growth," Mr. Ely said. "We get there by identifying trends, hopefully early, identifying the leader of that trend and insisting upon growth."

"The result is what we're after in an expansionary period like we are now: We hope to significantly outperform the averages, and that's what's been happening," Mr. Ely said.

Standouts among holdings during the last year, Mr. Ely said, include Weight Watchers International, which has grown significantly because of users' reliance on its mobile services; The Trade Desk Inc., which provides a platform for advertisers in new media; and Neurocrine Biosciences, which manufactures a drug to treat tardive dyskinesia, a motor function disease.

For the five years ended June 30, following Zevenbergen's strategy, the second-ranked strategy was DOMO Capital Management LLC's Concentrated All Cap Value strategy, which had an annualized gross return of 25.32%. The rest of the top five were: Victory Capital Management Inc.'s RS technology composite strategy, which returned an annualized gross 24.95%; MFS Investment Management's Technology Equity strategy, which returned an annualized gross 23.05%; and Kayne Anderson Rudnick's Small Cap Quality Select strategy, which returned an annualized gross 22.95%.

The median annualized return for the five years ended June 30 in the Morningstar universe was 12.51%. The median annualized return for growth strategies for the same period was 14.26%; value was 11.35%.

Among collective investment trusts, growth strategies accounted for nine of the top 10 CITs among a variety of small-cap, midcap and large-cap funds for the year ended June 30. The top-performing CIT for the period was BlackRock Inc.'s U.S. Fundamental Large Cap Growth trust, with a net return of 31.33%.

The rest of the top five CITs for the year ended June 30 were:

• Macquarie Investment Management's SMID Cap Growth trust, with a net return of 29.5%.


• Wellington Management Co. LLP's CIF II Growth trust, 29.2%.


• CastleArk Management LLC's Large Cap Growth trust, 28.89%


• T. Rowe Price Group Inc.'s New Horizons CIT, 28.56%.

The median return for domestic collective investment trusts for the year ended June 30 was 14.37%.

For the five years ended June 30, the highest-returning collective investment trust was State Street Global Advisors' Nasdaq-100 index strategy, with an annualized net return of 20.77%, followed by T. Rowe Price's Blue Chip Growth trust with an annualized net return of 18.83%; Wellington Management's CIF II Growth trust at 18.18%; BlackRock's U.S. Fundamental Large Cap Growth trust at 17.99%; and T. Rowe Price's Growth Stock CIT at 17.71%.

The median return for domestic collective investment trusts for the five-year period was 12.89%.

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 Aug. 2.