About four years ago, Robert D'Alelio, co-manager of the small-cap Neuberger Berman Genesis Fund, had an uneasy feeling about the excessive leverage among consumers and the growing threat of a housing market bubble. His response was to pare down his portfolio positions in economically sensitive sectors such as financials and consumer discretionary stocks.
As it turns out, he made that call a couple of years early. Genesis fell behind the majority of small-cap funds as financial stocks climbed. The portfolio only came out near the top of the pack in 2007, when the credit crunch began to hit.
Given the continuing economic slide, the 51-year-old manager believes investors looking to move lower on the risk curve but still keep a foot in the small-cap door might find Genesis appealing. "Traditional wisdom says that small company stocks are at a disadvantage versus large companies now because higher financing costs and a slow economy hit them harder," he observes. While that may be true of the indexes, he says, the companies his fund invests in tend to follow a pattern of their own. They often boast significant free cash flow, they are not economically cyclical and they have defendable positions in industries posing high barriers to competitors.
Unlike many of his more aggressive small-cap competitors, D'Alelio likes to wade in the conservative end of the small-cap pool with companies that have established market niches, low debt levels and the ability to finance growth by reaching into their cash coffers. The stance has held this small company fund back when the market is roaring, but it has also helped in tough times. Over the long term, the formula has placed Genesis in the top 4% of Morningstar's small-company blend fund category for the three years ending April 15, the top 6% over five years and the top 4% over ten years.
Despite the fund's good relative performance, the market slide has shrunk its asset base from $10 billion at the beginning of last year to about $7 billion today. After a seven-year hiatus from taking in new investors, Genesis reopened its doors in January of this year to replenish a sagging asset base.
That decision comes as good news to Morningstar analyst David Kathman, who notes in a recent report that "this has long been one of the most attractive small-cap funds out there. The management team pays little attention to benchmarks and holds stocks for the long term, so that turnover is low and sector weightings often bear little resemblance to those of the fund's peers." In the current economic crunch, he adds, the fund has been helped by the manager's preference for niche stocks that generate lots of cash and don't have much debt.
Many fund holdings have below-market price-earnings ratios and above-average growth rates. Technology companies are absent-because of their short product cycles and because their industries have low barriers to entry-as are economically sensitive banks and real estate investment trusts. Companies must have a market capitalization of no more than $2 billion when D'Alelio buys them, although they are often much smaller. A typical small-cap fund's annual turnover rate is 100%, but Genesis' rate is 15% to 20%, which makes it possible for D'Alelio to handle the fund's large asset base without getting too overwhelmed.
Buying Opportunities
D'Alelio, a 30-year industry veteran, takes an opportunistic view of the extended bear market. He points out that the companies in the Russell 2000 Index most widely held by hedge funds are down roughly twice as much as those least-owned by the funds, a good indication that forced selling rather than fundamentals is driving prices downward.
"You can either pull your hair out trying to figure out where the market will go or look for stocks of recession-resistant, superior companies with defensible market shares," he says. "I'm choosing to do the latter because it's what we've always done."
Lately, he is finding investment opportunities among property/casualty insurers, which fill the financial sleeve of the portfolio in a way that minimizes credit risk. He believes the current credit crisis has reduced insurance industry capacity to write business, setting the stage for property/casualty insurers with the strongest balance sheets to participate in a price recovery.