Separate account managers using a small-capitalization style reported returns as high as 73% for the year ended March 31, taking the five top slots among all managers for that period, in Pensions & Investments' Performance Evaluation Report.
And the outperformance by some small-cap managers came in a period when a small-cap indexes like the Russell 2000 and Russell 2500 lagged the performance of large-capitalization counterparts, such as the Standard & Poor's 500 Index.
The median manager reporting returns to PIPER lagged the S&P 500. International equity separate account returns, while strong, also lagged the booming U.S. market for the year ended March 31.
The median overall PIPER equity manager reported a one-year return of 31%, compared with 32.1% for the S&P 500. The Russell 2000 returned 29.1% and the Russell 2500 returned 29.8% for the same period.
But the underperformance of small caps in general didn't stop small-cap managers from performing well.
Small-cap stocks underperformed larger-cap stocks for about two years until February and March 1996, said William Chenoweth, senior portfolio manager in small cap for Turner Investment Partners Inc., Berwyn, Pa. But in that period, small-cap stocks saw some "pretty dramatic outperformance," Mr. Chenoweth said.
Looking ahead, he said small-cap stocks have a way to go in strong performance, as long as the market as a whole continues to do well.
Turner's small-cap growth equity composite portfolio returned 73.2% for the year ended March 31, and was the top-performing separate composite portfolio among U.S. equity managers.
Mr. Chenoweth said Turner's small-cap performance is an outgrowth of its sector neutral approach.
"We never take any sector bets with our clients' assets" and try to keep the portfolio sector neutral to the benchmark of the Russell 2500, he said.
"We don't think we can call the sector rotations any better than we can time the market," Mr. Chenoweth said.
And Turner invests in broadly diverse companies, holding 110 to 130 names.
A sector that gave Turner a particular boost was financial services companies, which most small-cap managers probably don't emphasize, he said.
Financial services is not just banks and insurance companies. Turner has focused on "transaction services" companies, "a huge growth area." The companies do things such as assist credit card companies process transactions.
"Every time you swipe the card ..... somebody's got to process that transaction," he said.
Transaction services companies such as National Data Corp., PMT Services, First USA Paymentech Inc., and Concord EFS are companies Turner owned last year and continues to hold, he said.
Mr. Chenoweth works with a team of six analysts who also do work in the large-cap area.
TCW Group, Los Angeles, reported the second-highest return for the year, 72.5% for its small-cap growth equity composite. Its portfolio also ranked eighth overall for the three-year period, with an annualized return of 32%, and eighth for the first quarter, with a return of 13.2%.
The median PIPER manager returned 15.8% and 6.1% for the same periods respectively.
Like at Turner, TCW executives stress diversification. Charles Larsen, managing director with TCW, said they keep more than 120 names in the small-cap portfolio.
A boost to TCW's small-cap portfolio last year was its lack of emphasis on technology-related stocks; Mr. Larsen said TCW didn't get "caught up" in the semiconductor stocks that "got ravaged in the fourth quarter."
Interestingly, he said that "retail was a terrible group last year, yet it was one of our stronger performing areas" for the year.
Just For Feet Inc., a specialty retailer, was a company that did well for TCW, as did Tiffany & Co., he said.
TCW finds companies to buy for its small-cap portfolios using bottom-up research. Its portfolio managers like to buy companies that have some type of proprietary product or service to sell.
He said TCW executives will take a look at initial public offerings, but in part to see what is happening with the competition. They want to find out if there's a new company out there that will be able to eat into the market share of companies TCW already owns, he said.
Looking ahead, Mr. Larsen said health care stocks offer a lot of "opportunity and controversy."
Mr. Larsen said controversy in some companies has led Wall Street to shy away from health care stocks. TCW executives will look selectively at buying shares of companies that are far along in getting major products approved by government regulators.
TCW will limit the risks in health care by taking small positions in those companies, he said.
"It's a tough area, but the rewards are huge," he said.
Mr. Larsen works with Chris Ainle and Doug Foreman, both managing directors, on the small cap portfolios.
The small-cap composite portfolio of Alliance Capital Management L.P., New York, had the third-best performing composite, returning 68.6% for the year. Alliance's small-cap composite also was the fourth-ranked manager overall for the first quarter with a return of 15.7%.
Michael F. Gaffney, senior vice president heads up the management of institutional small-cap portfolios for Alliance.
Mr. Gaffney said small-cap stock in general underperformed large cap stocks. But some small-cap managers have been able to outperform other managers because there have been "pockets of performance" within the small-cap sector. Technology, "if you played it right," produces strong returns, he said.
One technology move that paid off occurred last fall, when it sold off semiconductor issues. At the time, the supply and demand for semiconductors was "out of whack," and Alliance's small-cap portfolios had owned a large share. But Alliance executives believed semiconductor stocks were owned by too many investors, that if and when the selling began, "it was going to be pretty bad."
He said getting out of semiconductors wasn't the easiest thing to do because share prices had been doubling and tripling in some instances.
"This is one of those career decisions, where everyone was telling us we're wrong," he said.
But the decision to sell off semiconductor stocks in small cap-portfolios turned out to be a good one. In the fourth quarter, Alliance's overall technology weighting dropped to 12% from its previous 25%.
Consequently, while small-cap stocks were up about 2% to 3% in the fourth quarter, Alliance's small-cap composite was up about 11%, he said.
Mr. Gaffney said Alliance small-cap portfolios "don't look like other small -cap portfolios."
He said Alliance executives will look at any type of stock as long as it fits its growth parameters. And they will look in unusual places.
Take Wisconsin Central Transportation Corp. for example, he said. "Most people aren't going to look at a railroad (as) a growth stock," he said.
Alliance paid a price in the low 60s for shares of Wisconsin Central in December 1995 and just sold its position a few weeks ago at 94, he said.
Two other stocks that contributed to Alliance's small-cap performance were HFS Inc. (formerly Hospitality Franchise Systems) and BMC Industries. HFS has the rights to Days Inn and Ramada hotel names, among others, and last year bought Century 21 Real Estate Corp., the real estate company. BMC makes television aperture masks, which give television pictures their definition, and polycarbonate eyewear lenses.
"We let this ride for a while" until its market cap got too big - it reached about $5 billion - to be considered small cap, Mr. Gaffney said.
BMC has benefited from a trend among consumers to buy larger televisions. Aperture masks for televisions with screens larger than the typical 19 inches carry higher margins than smaller ones, Mr. Gaffney said. The market also grew dramatically for polycarbonate lenses, which are thinner and lighter than glass, he said.
Alliance has a group of six people working on small cap. Mr. Gaffney runs the institutional side, while Randall Haase, a senior vice president, runs Alliance's small-cap mutual fund, the Alliance Quasar Fund Inc.
The small-cap growth composite at Pilgrim Baxter & Associates, Wayne, Pa., reported the No. 5 return for the three years ended March 31, with an annualized 32.8%.
Gary Pilgrim, president and chief investment officer, said Pilgrim looks at earnings momentum, earnings revenue, and earnings surprise.
"It's not a high-velocity approach, but it is looking for stocks with growth - period," he said. Pilgrim wants to own "high growth stocks for as long as nothing goes wrong," he said.
Mr. Pilgrim said the firm will usually have a technology weighting of 30% to 40%.
Non-U.S. managers beat market
Non-U.S. equity managers posted a median return of 17.9% for the year, while the Morgan Stanley Capital International Europe Australasia Far East Index was up 12.7% for that period.
The highest ranking manager was Pinnacle Associates Ltd., New York, which reported a return of 38.7% for the year. Pinnacle was followed by TT International Investment Management, London, with 34.9%; Wellington Trust Co., with 32.2%; and Newgate Associates, New York, with 29.1%.
Pyrford International, London, returned 26.6% for the year, ranking it fifth among all non-U.S. equity managers in PIPER. Pyrford also ranked fourth among all international equity managers for the three years with an annualized 23.6%, and seventh for the five years with an annualized 15.8%. MSCI EAFE had annualized returns of 13.8% and 11.1%, respectively, for the same periods.
Bruce Campbell, managing director and chief investment officer, said Pyrford's managers are not heavy traders, and they don't invest in the emerging markets. And perhaps more importantly, Pyrford does not get too focused on what stocks the benchmark indexes contain.
"It's more important to us to seek out absolute return, rather than relative return," Mr. Campbell said.
Hence, Pyrford has not invested in Japan for about nine years, having exited that market in March 1987, he said.
That allocation is not likely to change soon, he said.
"In terms of real value, there is none in the Japanese market today," he said. "Japan for a long time has been relationship driven, and not value driven," he said.
Mr. Campbell said Pyrford's returns have been boosted in part by a large position in the Switzerland market, which once was 18.75% of its portfolio but has since been reduced to 6.25%.
Pyrford has also reduced its holdings in the Netherlands, putting more emphasis on stocks from the United Kingdom, France, Australia and Malaysia.
Its most recent country allocation was: 17.5% to the United Kingdom, 15% to Australia, 11.25% to the Netherlands, 10% each to Spain, France, Malaysia, New Zealand and Singapore, and the rest in Switzerland.
He said Pyrford executives spend about 70% of their efforts on country selections with the balance on stock selection. Executives visit each country and each company it invests in, making 300 visits a year.
Principal Mutual Life Insurance Co.'s international equity composite was eighth for the year, with a return of 26.1%, and fourth for the quarter, with a return of 8.3%.
Scott Opsal, vice president at Invista Capital Management Inc., Des Moines, Iowa, the unit that runs Principal's international equity portfolios, said three things contributed to its performance.
Invista's managers are bottom-up investors, and basically is a dividend discount model manager. Invista will pay higher price multiples if the expected income stream is high enough, Mr. Opsal said.
Invista bought European cyclical companies late last year on the basis that they were oversold, meaning prices had been driven below fair value. They then "made a terrific run in the first quarter," he said; it was basically a value play. Also, Mr. Opsal said Invista's country weighting turned out to be "about ideal." They were overweighted in the Netherlands, Sweden, Spain, Austria and Switzerland, underweighted in Japan and overweighted in the rest of Asia, he said.
Hotchkis and Wiley, Los Angeles, reported a return for its international equity composite of 26%, ranking it ninth.
Sarah Ketterer, portfolio manager, said Hotchkis and Wiley focuses on EAFE countries, plus Canada, and also will invest in Korea for selected clients.
She said the depreciation of the yen vs. the U.S. dollar gave Hotchkis and Wiley a boost, because they were underweighted in Japan.
She said currency is a part of the stock selection process at Hotchkis and Wiley, and while they have the ability to hedge, they have yet to do so.
Some companies it still owns that contributed to Hotchkis and Wiley's performance are Australian financials such as Westpac Banking Corp. and QBE Insurance Group, and Hong Kong-based companies such as Oriental Press Group Ltd., Sun Hung Kai Properties Ltd. and New World Development Co.
Ms. Ketterer said Hotchkis and Wiley still has a significant weighting to Hong Kong because of the continued "inexorable growth" seen there, despite the political risk.
In Europe, Hotchkis and Wiley benefited from its ownership of Hafslund Nycomed A/S, a Norwegian medical imaging company.
She manages international portfolios with Harry Hartford and David Chambers, both portfolio managers.