Small-cap managers lead year of meteoric returns

Small-cap strategies chalked up triple-digit returns and exclusively dominated the overall top 10 domestic equity rankings for the year ended June 30, according to the latest data from Morningstar Inc.'s separate account/collective investment trust database.

Every one of the top 10 strategies was a small-cap strategy, featuring a diverse lineup of styles. Of the top 10 strategies, five were growth strategies, three were blend and two were value, according to Morningstar categorizations.

It was the second quarter in a row that small-cap strategies dominated the top 10 rankings. For the year ended March 31, nine of the top 10 domestic equity strategies fell within Morningstar's small-cap category.

The overall median return for domestic equities within the Morningstar separate account universe was 43.86% for the year ended June 30, compared to the Russell 3000 index return of 44.2%.

Tony Thomas, Chicago, associate director, equity strategies, manager research at Morningstar, said the extraordinary performance of small-cap strategies especially in the fourth quarter of 2020 and the first quarter of this year "were so strong it's kept a lot of them among the top performers for the whole period.

For the year ended June 30, the Russell 2000 index returned 62%. The Russell 2000 Value index returned 73.2% during that same period.

For the year ended June 30, the median return for overall value strategies was 49.17% in Morningstar's universe, while growth strategies returned a median 44.33%. The Russell 3000 Value index returned 45.4% for the year ended June 30, while the Russell 3000 Growth index returned 43%.

For several years up to the end of 2020, large-cap growth stocks had dominated while small-cap value stocks struggled. Mr. Thomas conjectured that perhaps because large-cap growth stocks had outperformed so well over the past few years, investors feared there wasn't that much room left to run, making small caps the inevitable place to go.

Leading the rankings for the year ended June 30 was Germantown, Wis.-based DOMO Capital Management LLC. Its sole strategy, the Concentrated All Cap Value strategy, had a gross return of 174.76%.

The firm and its strategy, which held six stocks as of June 30, believes that increased diversification increases risk as capital is allocated to strategies that fall outside those of the highest conviction. Justin Dopierala, founder and president, said in a phone interview that one of the firm's largest holdings right now is Gannett Media Corp., long considered primarily a newspaper company.

"I think it's just this situation of recency bias where people have just become convinced that newspaper companies are dead," Mr. Dopierala said. "It was just trading at significantly depressed levels and we see a significant upside."

He cited how Gannett has been transforming itself through technology, digital subscriptions and live events as some of its upsides.

Morgan Stanley Investment Management's Inception strategy was the second-ranked separate account for the year ended June 30, with a gross return of 153.65%.

Inception is a small-cap growth strategy that "seeks high-quality companies with sustainable competitive advantages and focuses on long-term growth potential rather than short-term events," according to its Morningstar profile. As of March 31, the strategy had 55 holdings, the most recent data available.

The top five holdings as of March 31 accounted for 24.4% of the portfolio. Those were RedFin Corp., AppFolio Inc., JFrog Ltd., Utz Brands Inc. and Vroom Inc.

Penn Capital Management Co. LLC, Philadelphia, had the third-ranked separate account for the year ended June 30. Its Small to Micro Cap Equity strategy had a gross return of 144.08% for the period.

Eric J. Green, chief investment officer-equity, senior portfolio manager and senior partner, said the firm's overall investment philosophy involves a strong connection between equity and credit research.

"We do a lot of the same types of analysis as our equity peers do, but we also do a deep credit analysis, and this allows us to buy companies that many equity managers would stay away from," he said.

Mr. Green said this gives the firm an opportunity to allow themselves to invest in companies with higher leverage as long as there is a clear path to deleveraging.

The Small to Micro Cap Equity strategy is intended to find value in companies on the lower end of the Russell 2000 index, with at least 50% of companies below the largest market capitalization of the Russell Microcap Index.

"We're forced to own a bunch of companies that are smaller in the portfolio, which allows for more of a full mandate with more choice and more flexibility than most managers."

Golden Entertainment Inc., a Las Vegas-based gaming company, was a primary driver of performance, having successfully navigated the COVID-19 pandemic to reinvent itself, Mr. Green said.

Ranked fourth was Fuller & Thaler Asset Management Inc.'s microcap core strategy, which returned a gross 142.15% for the year ended June 30.

Frederick Stanske, San Mateo, Calif.-based partner and portfolio manager, said in a phone interview the firm uses behavioral finance methodology in its stock selection.

"Investors are pretty rational and pretty efficient, but in some cases they're not rational and not efficient," Mr. Stanske said. "They're influenced by biases and emotions and that can create anomalies in the stock market."

The microcap core strategy utilizes both a growth approach, in which the market underreacts to information, and a value approach, in which the market overreacts to information. One of the drivers of the success of the strategy was finding stocks that were significantly undervalued during the COVID-19 pandemic, and specifically had a high volume of management and employees increasing their stakes in the firm, reflecting ownership and employee confidence of a post-pandemic recovery.

"In our microcap portfolio, about two-thirds of the value names had insider buying," Mr. Stanske said. One value-oriented holding that performed exceptionally well was energy company Matador Resources Co.

Old West Investment Management LLC's All Cap Opportunity strategy ranked fifth with a gross return of 141.83%. The Los Angeles-based manager's small-cap strategy also ranked seventh with a gross return of 134.82%.

Joseph Boskovich Jr., co-founder and partner, said he and the firm are value investors at their core, and their approach is to align themselves with strong management teams that have significant ownership stakes in their companies.

He said their process begins with companies' proxy statements because "those are going to tell you who's management, what's their background, how much they've done in the past, how much stock they own and what their compensation looks like."

"We just want to make sure that management has more to gain and lose through their ownership rather than their compensation," Mr. Boskovich said. "When you look at (our) portfolios, most of the companies are owned or run by a management team that treats us as shareholders well, and the main reason for that is they're the largest shareholders themselves."

There is an overlap of about 70% to 80% between the all-cap and small-cap strategies, he said.

Among contributors to the success of Matador's strategies are uranium mining and nuclear fuel companies Denison Mines Corp., Energy Fuels Inc. and NexGen Energy Ltd.

"We've identified the uranium mining space as an opportunity where there's a huge disconnect in the supply-demand scenario. There's no supply and there's a lot more demand," he said.

For the five years ended June 30, seven of the top 10 strategies were growth-oriented. Four of those strategies fell within Morningstar's small-cap category, while three were categorized as midcap strategies. Two of the top 10 strategies fell within Morningstar's technology category, and one that fell within its health category.

One of those technology strategies was New York-based ARK Investment Management LLC's Next Generation Internet strategy, which had an annualized gross return of 52.93% for the five years ended June 30.

Three other ARK Investment Management strategies also appeared the top 10 for the five-year period: its Disruptive Innovation Full Composite, Genomic Revolution and Disruptive Innovation Strategy SMA ranked fourth, seventh and eighth, respectively, with respective annualized gross returns of 45.48%, 43.61% and 43.07%.

Morgan Stanley's Inception strategy ranked second for the five years ended June 30 with an annualized gross return of 47.4%, and Zevenbergen Capital Investments LLC's Genea growth strategy ranked third with an annualized gross return of 45.72%.

The median five-year annualized return for domestic growth strategies in Morningstar's domestic equity separate account universe was 21.16%, and the median among all domestic equity strategies was 15.9%. The Russell 3000 Growth index returned an annualized 23.3% for the five years ended June 30, and the Russell 3000 index returned an annualized 17.9%.

Within the collective investment trust universe for the year ended June 30, eight of the top 10 domestic equity CITs were small-cap strategies and two were midcap strategies. Of the top 10, there were eight value strategies and two growth strategies.

Leading all trusts was American Century Investment Services Inc.'s U.S. small cap value equity CIT with a net return of 83.02% for the year ended June 30.

The median return of domestic equity collective investment trusts in Morningstar's universe for the year ended June 30 was 44.08%.

For the five years ended June 30, T. Rowe Price Group Inc.'s New Horizons Class A CIT led all trusts with an annualized net return of 28.33%, followed by State Street Global Advisors' Nasdaq 100 Index Class A CIT, with an annualized net 28.26%

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. 5.