Large-capitalization stocks took a back seat to their smaller siblings during the third quarter, according to the latest Pensions & Investments Performance Evaluation Report.
By a margin of almost 2-1, the return for the Russell 2000 small-cap index surpassed that of the Standard & Poor's 500.
The median PIPER managed equity account had a third-quarter return of 11.6%. The median managed account manager showed a 37.9% return for the year ended Sept. 30 and 21.6% for the five years ended on that date.
The Russell 2000 returned 14.88% for the third quarter, while the S&P 500 showed only 7.5%. For the year ended Sept. 30, the S&P 500 returned 40.5%, while the Russell 2000 returned 33.2%. For the five-year period ended Sept. 30, the S&P 500 returned 20.8% compared with 20.5% for the Russell 2000.
Not surprisingly, mid- and small-cap managers dominated PIPER's lists of top equity account managers for the quarter, occupying 8 of the top 10 positions.
Among commingled funds, the median commingled equity fund returned 10.3% for the quarter; 38.2% for the year; and 20.5% for five years. As with the managed accounts, small-cap funds dominated the rankings.
(All returns for more than one year are compound annualized.)
Small-cap financial stocks helped boost some of the top performers during the most recent periods.
The Small Cap Bank managed account of WRM Equity Management Inc., Briarcliff Manor, N.Y., registered the highest one-year return for the period ended Sept. 30; the portfolio returned 72.4% for that period. WRM Equity manages approximately $105 million in assets; the money manager has approximately 40 stocks in that portfolio.
"We're pretty loyal and religious to staying with the idea of investing in modest-sized companies," said Warren Marcus, WRM president. "We regularly invest in banks and thrifts that are under $1 billion in size, and occasionally under $500 million. Our attitude is that, other things being equal, the smaller the general size of the entity the better you'll likely do over an extended period of time."
Mr. Marcus cited one of the smallest stocks his firm owns, Mahaska Investment Co., Oskalooska, Iowa, as an example of a good small-cap value. Mahaska is a bank holding company with less than $300 million in assets.
"Most investment managers couldn't look at a stock like this," said Mr. Marcus. "It's a conventional bank in most senses -- a local retail bank doing business where they're domiciled -- but about 1991 they also got into buying exclusively problem residential mortgages. It's about one-quarter of their total loan portfolio. And doing that has allowed them to receive unusual returns. Some institutional investors might say 'what are these guys doing in a little Iowa town buying problem mortgages?' But we met with them, and were convinced they had the skills and commitment to make it work. Even in today's more competitive environment, they're getting returns of about 15% or 16%."
Mr. Marcus also extolled the virtues of Mississippi Valley Bancshares, Inc. St. Louis, another one of his firm's holdings. "They have about $1.2 billion, and have grown from about $400 million a few years ago," he said. "A few years back, they were constantly able to predict bumps in the prime rate just before it happened, and that gave them some recognition and stature. They're essentially a retail and small business bank, and we have about 2.5% of the portfolio in there, which is average for us."
These days -- with the increased popularity of both small-cap and financial sector stocks -- it has become harder to find good value equity picks, said Mr. Marcus. "I would not be totally honest if I didn't say it's certainly tougher today," he explained. "These stocks have done quite well for several years running. In the early 1990s, there were a number of large and small banks that were tarred with the bad reputation of the S&Ls. Back then, you could buy good banks at very good valuation levels."
In selecting a financial stock these days, his firm pays great attention to both price-to-book and price-earnings ratios. Said Mr. Marcus: "Generally, smaller banks trade about 13 or 14 times earnings, which is comparatively reasonable. But, if you had shown me a bank at that ratio five years ago, I would have said 'Whoa, that's a very advanced price!' . . . it's really all relative."
Small-cap technology was another sector that proved successful in the third quarter. The Small Cap Emerging Growth account of Sterling Johnston Capital Management, San Francisco, returned 31.7% and finished first among PIPER managed equity accounts during the quarter; technology stocks accounted for 39% of the firm's equity account, with energy stocks making up an additional 12% of the account. Sterling Johnston manages $62 million in assets, all in its small-cap account.
"There was an amazing ramp-up in earnings among our small-cap tech stocks," said Scott Johnston, the firm's chairman and chief investment officer. "Current year's estimates for the stocks in our account are 70% year over year." Mr. Johnston cited various technology stocks that assisted the account's first-place performance. Among his favorite technology holdings are Analytical Surveys Inc.; Integrated Circuit Systems Inc.; QLogic Corp. ; Pinnacle Systems Inc.; and Smartalk Teleservices Inc.
"Analytical Surveys and Pinnacle Systems are particularly interesting stocks," he said. "Analytical Systems digitizes utility maps, and to my knowledge they're the only firm in the world that does this. It's quite a big problem for utilities as all their work is on blueprints, so there's great demand for this product. Pinnacle Systems converts from analog to digital, and markets to the video and movie industries."
Among energy sector stocks favored by Sterling Johnston are Basin Exploration Inc.; Friede Goldman International; Hvide Marine Inc.; and Stolt Comex Seaway S.A., in France. "All of those firms enjoyed very large jumps in earnings, with solid prospects for future exploration and drilling," Mr. Johnston explained.
Technology and energy stocks also played key roles in the success of Insight Capital Research & Management Inc., Walnut Creek, Calif., according to Bradley Sasser, vice president. His firm's Aggressive Growth Equity account placed second in the third-quarter among managed accounts, with 31.5%.
"We screen various sectors, looking at all caps, and the most important aspect for us is a stock's growth prospects," explained Mr. Sasser. "Over the last two quarters, we've seen the better opportunities in the smaller caps, particularly in the technology sector. Right now, I'd say small-cap stocks make up about 50% of our holdings in this account." Insight Capital manages about $1.1 billion in assets.
Mr. Sasser cited Semtech Corp., and Smart Modular Technologies Inc. as prime examples of successful high-tech stocks during the quarter. "For example, in the case of Semtech, it's a semiconductor company and there was strong demand both at home and abroad in the PC field over the last two quarters," said Mr. Sasser. "Although some are projecting a slowdown in PCs the next few months, our feeling is that consistently PC demand is underestimated. We believe that there will continue to be very good demand for PCs."
Mr. Sasser said oil and gas, as well as telecommunications, are two other sectors favored by the Aggressive Growth Equity account.
Small-cap stocks also played a significant role in the success of commingled funds during the past quarter.
For the quarter, Oak Tree Partners L.P. run by GEM Capital Management, New York, topped the commingled equity ranking with 38.1%. The fund performed well over the longer period, too: Oak Tree Partners L.P. finished first among commingled funds for the one-, five- and 10-year periods with returns of 81.4%, 42.51% and 38.6%, respectively. Gerald Unterman, president and chief investment officer for GEM Capital, attributes that success to research and a long-term commitment.
"We're really a partnership that is, for the most part, long-only and concentrated on U.S. midcap stocks," explained Mr. Unterman.
Mr. Unterman added GEM looks beyond a company's earning statement, examining factors such as cash flow and balance sheets.
"We're really looking for a company that is doing something special, or changing in some way," he said. "Also, if we can't move in with at least a $5 million position, we likely won't be interested in a stock." GEM manages approximately $1.5 billion in assets.
Among the fund's eclectic mix of core holdings are firms in the communications, defense and financial sectors. "In addition to other firms, we're a large holder of McLean, Va.-based Nextel Communications, and Winstar Communications, of New York," said Mr. Unterman. "We have close to 10% positions in both companies. Nextel is one of the dominant wireless operators in North America and they also possess a lot of very valuable foreign licenses. Winstar is really a local telephone company that uses a wireless strategy."
Along with telecommunications, "GEM also has defense company holdings including Tracor Inc., of Austin, Texas, which is the fastest growing defense company in the country. They're focused on defense electronics and operating systems. We've owned the stock for a number of years and believe they have terrific management."
In the financial sector, GEM holds large positions in Golden State BancCorp. and Dime Bancorp. Another GEM holding is Canadian commercial real estate company, Gentra Inc.
Small-cap technology stocks also helped Bankers Trust Co., New York, in the third quarter. The BT Pyramid Small Cap Fund finished second overall and first place among commingled growth equity funds with a return of 30.8%. Bankers Trust actively managed about $121 billion as June 30.
"From about September 1996 through to this past April, there was a great deal of concern about the overall market and investors moved toward more large-cap value-oriented names," said Tim Woods, portfolio manager at Bankers Trust. "During that period, we found that a lot of small-cap companies were being discarded, despite their good earnings, because of their relatively higher absolute multiples. By April, we hadn't seen valuations that low for many Russell 2000 stocks in nearly four years. Around that time we increased our weighting in a number of technology stocks."
Mr. Woods added that, this past spring, his fund acquired technology stocks such as Veritas Software Corp. and Parexel International. "Veritas produces storage management systems that are used to store data, while Parexel is a contract research organization that provides clinical research to the pharmaceutical and biotechnology industries. We chose those two companies because we found that they were being sold off, even though their fundamentals were very strong."
The energy industry was another sector favored by Mr. Woods' fund during the quarter. "One energy stock we particularly like is Halter Marine Group Inc.," he said.
Mr. Woods added that looking into 1998, he expects investors will continue to be interested in small-cap growth companies.