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By Richard Hefter, Editor, Small Cap Manager Typically investors think of analysts as professionals that research stocks. But Brian Portnoy, senior analyst at Chicago-based Morningstar, Inc., has the job of evaluating equity funds. Small-cap blend funds, in particular. This month, we talked to Portnoy about how he assesses funds, which funds he likes, what investors should look for and what the trends are in the small-cap space. How would you describe your work at Morningstar? |
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What are the characteristics of small-cap blend?
As the name suggests, the blend category is going to be a mix of growth and value stocks. If you look at valuations across our three small-cap categories - value, blend and growth - it should come as no surprise that the small-cap value funds have the lower price to earnings, price to book, and price to cash flow ratios, and the small growth funds are in the higher spectrum for each of those variables. Small blend is in the middle. Within small blend funds there are some differences - some tilt toward growth and some tilt toward value - but by and large you're going to find middle-of-the-road offerings in terms of valuation, which is why we often say the small blend category is a good place to look for a core small-cap offering.
What do you look for in evaluating funds?
There's a short but important list of features you'd be looking for in any type of equity mutual fund. You want to look at performance, but make sure you understand the market that fund is trying to get ahead in. So you look at performance through up and down markets, and whether the fund is really good in up markets and protects on the downside.
You also want to look at who's managing the fund, what sort of experience they have, and whether that experience is germane to running that sort of product.
You want to look at risk and how the manager conceives of risk and how they've structured the portfolio to deal with different types of volatility. Do they make big bets on stocks? On sectors? Do they keep stock positions small so that no individual stock can hurt performance? Do they go way off on the valuation spectrum, and are they willing to take on a lot of price risk? So, in short, understand what types of risk the fund takes.
Finally, in terms of this broad list of what to look for, I flag expenses. If there's one thing that's proven to directly and significantly impact long-term performance, it's expenses. If your fund is overpriced in terms of its annual expense ratio, then that's going to be a serious drag, more than most people would realize, and will make you less able to meet your investment goals.
What funds do you like best in the small-blend category based on this analysis?
One pick that's at the top of the list is Fidelity Low-Priced Stock (FLPSX). This is a fund whose manager, Joel Tillinghast, just won Morningstar's "Domestic Equity Manager of the Year." He's done an unbelievably good job of managing the portfolio for more than a decade. This is a unique looking fund. He holds anywhere from 700 to 1000 stocks, which is not typical. Most small blend funds hold maybe 100-150 stocks, some a lot less than that. The fund has a very large asset base which is typically a red flag for small-cap investors, but in this particular instance Tillinghast has managed that asset base remarkably well, and his performance on a calendar year and trailing basis is very, very good.
He can get away with diversifying so broadly?
Most people who speak to Joel consider him a genius. My colleagues who have interviewed him over the years typically will pick one of the very bottom holdings in the portfolio, say holding #684, and ask him detailed questions about that stock, and he knows that company as though he has just studied it in-depth.
Any others you like?
Let me mention Royce Premier (RYPRX). The entire Royce family of funds is known for its small-cap line-up. It's a shop that focuses on small-cap stocks, and they have a good number of funds in that space. We picked this one because the managers Chuck Royce and Whitney George have done a very good job over time giving investors a very competent core small-cap exposure. Most of the Royce funds fall in our small-cap value category because it's a valuation-sensitive shop. This one falls in our small-cap blend because they're willing to take on a little bit more price risk. That said, their general sensitivity to valuation has allowed them to hold up relatively well through the bear market in general.
I'd also put FPA Paramount (FPRAX) on the list as well. The managers there, Eric Ende and Steven Geist, have experience at another FPA small-cap fund called FPA Perennial (FPPFX). That has a very good long-term record, while FPA Paramount does not because Ende and Geist just took it over about 2-3 years ago, but they have more or less identical portfolios at this point. Like the Royce Premier Fund, it's very good small-cap exposure. You're going to get a mix of growth and value stocks, but regardless of where the stocks fall on the valuation spectrum, you know these two guys are going to keep valuation in mind, so it's not going to take too much price risk.
Why do you pick one over the other?
We pick Paramount over Perennial because Paramount had some pretty significant losses in the past, and has a sizable tax-loss carry forward. So for those investing in a taxable account the Paramount fund is good because it's going to be tax efficient for quite some time. It's got a lot of losses it can use against gains and therefore neutralize any capital gains payouts going into the future.
Are fees and tax issues more of an issue with small-cap funds than with larger ones?
Small-cap expenses tend to be higher than large-cap. The line you hear is that research is more difficult to do on smaller-cap stocks. In the large-cap space, for example, there's a lot of common knowledge floating out there about, say, AOL, Wal-Mart or General Electric, but with $100 million or $500 million companies Wall Street doesn't know that well, you have that much more of a research effort to understand those companies, and that gets expensive. That's typically the reason given for why small-cap funds are more expensive.
That said, there's a pretty wide spread of expenses across small-cap funds and, because expenses matter so much for long-term performance, investors would be wise to shop for a cheaper small-cap fund, all else being equal.
How can investors limit their tax expenses - choose funds with less turnover?
Turnover isn't always a direct indication of tax efficiency. Typically, when you see a fund with single-digit or low double-digit turnover, they tend to be tax efficient because they're not churning the portfolio and picking up any gains that could be taxed. That said, you could have a higher turnover fund that is managed in a tax-efficient way. The extra turnover could mean that the manager is actively buying and selling positions in order to manage that tax position. So if they're going to be selling something at a gain, they might also sell part of a position at a loss in order to balance out the fund's tax position. You can look on Morningstar or elsewhere for a fund's after-tax performance, and that's important to do because that's the money you actually get to keep. This is all assuming you're investing in a taxable account rather than a tax-sheltered account like a 401(k) where it's not an issue.
Is the size of the fund typically a limitation in the small-cap space?
Yes. I want to emphasize that the Fidelity Low-Priced Stock example is an extreme outlier. A $15 billion small-cap fund is unheard of, except for this one example. When a small-cap fund climbs over $1 billion in size, that's a flag for me as an analyst. That's when I begin to look more closely at the type of securities that it's buying in terms of whether it has to buy more mid-cap stocks, or buy some extra small-cap positions in order to manage risk. When a fund's asset base grows too large, it's cause for concern.
Why?
When a fund's asset base grows too large, it can have one of several impacts for the portfolio going forward. One is that because small caps are relatively illiquid, meaning that they're harder to buy and sell, if a fund has too much money on hand, it might have to start buying mid-cap stocks, which are more liquid, easier to buy, and that could defeat an investor's allocation plan.
Secondly, if a fund has too much money, it could mean the portfolio manager has to hold a lot of cash. They just can't invest the money, so they'll build up a large cash stake, and that might not also be what an investor wants. An investor might want to make his own asset allocation decision in terms of cash held in a portfolio.
And third, if a small-cap fund has a large asset base, it might expand the number of positions. So if the manager's preference is to have a portfolio of 60-70 names, and that's how he or she likes to approach the portfolio in terms of risk management, and if too much money is in the fund then he or she might need to spread his bets even more widely, adding more positions and not running the portfolio as he originally preferred.
Being familiar with both growth and value funds, do you have an opinion on the prospects for small-cap growth versus value?
We don't make those sorts of market calls. I'm not in a position to say one way or another. These things do tend to go in cycles among the small-cap stocks and across the equity universe generally. Value has outperformed growth for three straight years now.
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I wouldn't be surprised if we saw some rebound in the growth space, but we don't spend our time, and that's not our competence, to evaluate one part of the market versus the other.
It seems from your picks that comfort with the management is key is selecting small-cap funds?
Absolutely, because in the bigger debate on whether investors should buy actively managed funds or index funds, I think the evidence shows that in the small-cap space, which is typically less efficient than the large-cap space, managers can add some value. So you want to take time to research those fund companies and those specific managers that have proven an ability to outpace both their peers and benchmark over time. Certain shops like Wasatch or Royce are well-known for their small-cap investing ability, and other individual funds, whether they be Buffalo Small Cap, or Fidelity Low-Priced Stock, or William Blair Small-Cap Growth, have shown on an individual fund basis that they can outperform over time.
(c) 2003 Small Cap Manager, a publication of AdviceTrade, Inc., and sponsored by JM Dutton & Associates (www.jmdutton.com).
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