Manager Jim Margard thinks small-company stock will outperform this year-barely.
Small- and mid-cap stocks haven't run out of steam
after several years of market leadership, proving once again that the
trend can be your friend for a longer time period than you anticipate.
Still, don't expect them to outperform large caps as much as they have
in the recent past, says Jim Margard, one of a team of managers who run
the $2.5 billion Rainier Small/Mid Cap Equity Fund and the year-old,
$90 million Rainier Mid Cap Equity Fund.
The last few years have seen smaller company stocks propelled by the tailwind of an expanding economy and attractive post-bear market valuations. Over the six-year period ending December 5, the Russell 1000 Index, a barometer of larger company stock performance, posted an average annual gain of 2.64%, compared with 10.14% for the Russell Midcap Index and 10.95% for the Russell 2500, a small-cap index.
During the latter half of 2006, however, large-cap stocks began leading the way. The turnaround intensified in May, when investors became concerned about oil prices, inflation, political unrest in the Middle East and a slowdown in corporate earnings growth. For the one-year period, the large-cap Russell 1000 was up 14.22%, compared to 16.53% for the mid-cap index and 16.17% for the small-cap index.
Historically, small-cap stocks outperform large-cap stocks by an average of about 1% to 1.5% each year, says Margard, and he doesn't see the group surrendering market leadership just yet. "People tend to look at the superior performance of small- and mid-cap stocks over the last six years and conclude that their run is over," he says. "But you have to remember those companies were oversold during the bear market and their valuations compared to larger companies were extremely compelling. A lot of their out-performance over the last six years was making up the difference. At this point, I'd say they are fairly valued."
He believes that while there may be some weak spots in the economy, a recession that would drive investors to more defensive large-company stocks appears unlikely at this point. Overall, he expects market returns will be "better than average, and most likely reach double digits." His firm is looking for a deceleration of earnings growth over the next year to about the 8% to 10% range, slightly higher than consensus estimates.
Against the underpinning of a solid economic environment smaller companies are nimble enough to experience better earnings growth than larger ones, and they offer a better hunting ground for mispriced securities that Wall Street doesn't follow. "The major problem that could rattle this segment of the market would be an event like the bankruptcy of a major company," he says.
Beating The Benchmark
Margard and his team of five analysts and portfolio managers try to beat the averages by making a lot of small, calculated bets that differ from their funds' respective benchmarks. They look for stocks that have higher earnings growth relative to similar companies in the same sector, and aim to buy when they are selling at price-earnings ratios below their historic norms.
Rainier Small/Mid Cap Equity, which has been around since 1994 and is currently closed to new investors, uses the Russell 2500 as its bogey. Sector weightings can differ no more than five to six percentage points from the index. It spreads its investments over approximately 100 to 150 holdings. Although about 40% of its assets are in stocks with a market capitalization of $2 billion or below, it has a somewhat higher weighted average market capitalization than its benchmark.
The newer fund, Mid Cap Equity, is a little over a year old and provides access to stocks in the $12 billion to $20 billion market capitalization range that the older fund doesn't invest in. It has the same sector variation constraints, but uses the Russell Midcap Index as a guide and has a higher weighted average market capitalization than its sister fund. Because many holdings are in the $2 billion to $15 billion range, some of the 70 to 120 companies in the portfolio appear in both funds.
Liquidity parameters provide further evidence of a belt-with-suspenders approach to growth-stock investing. To be included in the portfolios, a stock's daily trading volume must be at least $2 million for Small/Mid Cap and at least $3 million for Mid Cap. No holding can account for more than 5% of assets, although most are much lower than that. At the end of the third quarter, the top ten holdings of both funds represented about 19% of their assets.
Despite their spread-your-bets style, the funds can deviate substantially from industry distributions within a sector. In the financial sector, for example, real estate investment trusts are underrepresented because managers feel the stocks are too expensive and have minimal potential for earnings growth. With the group showing surprising strength in 2006, however, the decision to pare down has detracted from relative performance so far. On the other hand, overweighting property and casualty insurers and diversified financial services companies has worked to the advantage of both funds.
Taken together, tweaks like those have made a meaningful dent in returns. Small/Mid Cap produced average annual returns of 19.03% over the three years and 13.61% over the five years ending December 5, compared with 15.77% and 12.74% for the Russell 2500 over the same periods. The Mid Cap Equity fund, opened in December 2005, has beaten its benchmark by about 7% for the year-to-date period ending in early December 2006.
With its benchmark sector weights tied to the tech-light Russell 2500 Small/Mid Cap Equity, the fund has had less exposure to the group than many of its Morningstar mid-growth category peers. While that detracted from relative performance in the late 1990s, being more evenly distributed across a broader swath of sectors worked to its benefit in 2003, when energy stocks had not appeared on the radar screens of most growth funds.
While the fund could have trouble keeping pace if large-cap or technology stocks begin to dominate the market, Morningstar analyst Dan McNeela believes that it still "stands as a very attractive option. Management takes a diversified approach to limit its stock-specific and sector risks. Its 'growth at a reasonable price' strategy keeps the fund out of the priciest stocks in the market while keeping it focused on firms poised to deliver positive earnings surprises."
Margard believes some energy companies could deliver some of those surprises. He doesn't own refining and marketing companies, which he believes are threatened by alternative energy sources and buildup in foreign capacity, preferring instead those that focus on exploration and production. Their ability to grow production at a healthy clip helps insulate them from any decline in the price of oil, while the need to build reserves should solidify demand for their services. Current valuations in the overall market imply that investors are anticipating an earnings contraction for the group in the year ahead, a possibility Margard views as being remote.
Both funds own Diamond Offshore Drilling because it is one of a handful of public companies that focus on deep-water drilling, and is well positioned to meet demand from large oil companies to grow production. The company has multiyear contracts that are expiring and expected to be renewed at much higher rates, providing a cushion against any decline in the price of oil.
At the same time, he believes concerns over the price of oil are leading investors to misprice the stock, which sells at about 6.5 times estimated 2008 earnings. Yet despite the fact that the stock is very inexpensive relative to its historic price-earnings ratio, Margard expect earnings to grow about 80% for 2007, and about 40% in 2008. Another deep-water drilling company, Transocean, holds similar appeal but is only in the Mid Cap fund portfolio because of its size. With a $700 million market capitalization, driller Warren Resources qualifies for inclusion in Small/Mid Cap. Margard says the company expects to increase production from reserves in California and Wyoming and should see substantial earnings growth over the next several years.
In the financial sector, both funds have minimized exposure to small and mid-sized banks, which Margard believes are threatened by an uptick in nonperforming assets and a rising cost of capital due to higher interest rates. Valuations are also unattractive, he says. Over the last ten years, the group has sold at an average price-earnings discount to the overall market of 26%, compared to a discount of 12% today, and expected earnings growth of only around 6%.