The past year has been a challenging one for the small-cap sector. Although small caps had a few stellar periods of quantum bursts over the past two years, at times, far surpassing their larger brethren in the S&P 500, the overall annualized rate of return has trailed the overall large-cap sector.
The Russell 2000 Index has returned 12.5% year to date, including dividends, compared to a 19.6% total return for the S&P 500. Small caps are also trailing large caps over the last one-, three-, five-, and 10-year periods on an annualized basis. One fund, however, has compiled above-average returns over its benchmark as well as its peers in the small-cap sector. The $625 million small-cap-focused Wasatch Ultra Growth Fund, which has a gold rating from Morningstar, has bested 95% of other small-company growth funds over the past three, five, and 10 years. Over the past five years, the fund has exceeded its benchmark, the Russell 2000 Growth Index, by more than seven percentage points a year.
Fund manager John Malooly shepherded the fund over the past seven years. He focuses on companies with unique attributes in their industry and ones with recurring or repeat revenue streams, as they tend to hold up better in economic downturns. How does Malooly find companies that are selling below their intrinsic values?
First and foremost, for Wasatch, a company must have good management. Here, Malooly’s criteria is similar in significance to the enormous weight Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) accord to astute and honest managers. If a company has poor management, Malooly is not interested, period. How serious is the fund about the importance of good management? Wasatch retains a former investigative journalist to research a company’s managers.
For Malooly, a business strategy that incorporates a novel factor or advantage within their business operations is key. "Disruptive," in terms of analysis, need not mean a high-tech engineering process or factor that can lead to market dominance, but rather whatever it is that gives the company an advantage over its competitors.
Malooly also believes that successful investing requires finding the right balance between skepticism and imagination, or the ability to look farther out into the future, which at that time can mean thinking outside of the box.
One example of the fund’s philosophy of imagination and skepticism informing its purchases is Freshpet (FRPT, Financial), a company that sells refrigerated pet food. Malooly was attracted to Freshpet’s business model, as well as the overall steady growth in household pet expenditures, which has accelerated 5% each year since 2008.
Malooly passed on the Freshpet’s initial public offering and one year later, the stock dropped by 50%, selling for $28 a share in December of 2018. The fund took interest in the company when a new manager with extensive experience in global consumer goods and refrigerated distribution took over. Malooly was betting a change in management would help the company expand. The stock is currently trading at $47 per share.
Malooly acknowledges that the current market environment is skewed toward growth stocks and he admits Wasatch’s returns could drop when value stocks take the lead. Malooly is not interested in acquiring small-cap growth companies if they don’t match his criterion for value and market leadership; at times, that means the fund may not have as many suitable opportunities for growth candidates to buy as were available in previous years. As Malooly notes, “I don’t expect to see the levels of outperformance I’ve had simply because I don’t expect to have those types of return opportunities in front of me.”
This investing posture is indicative of the fund’s discipline in buying only those companies that can excel in their business sectors due to a unique “disruptive” factor or Buffett “moat,” that keeps the competition at bay. Like Buffett, if Malooly can’t find suitable corporations that are selling below their intrinsic value, he will maintain a cash position in the portfolio, rather than chase “growth.”
Malooly refuses to buy companies that may be favored by the fund industry in general, such a low-volatility stocks, because their valuations exceed their potential for growth.
The fund doesn’t use macroeconomic projections or factors to guide their investment decisions. Here, they follow the advice given by Munger, who advised investors to shun complex econometric models or projections as a factor that informs your decisions. "If you’re agnostic about macro factors and, therefore, devote all of your time to thinking about individual businesses and the individual opportunities, it’s a way more efficient way to behave,” said Munger.
Wasatch is, however, as Malooly notes, “macro aware.” That is to say, after the 2008 financial crisis, the fund's periodic volatility reinforced its fundamental investing philosophy that concentrates on selecting only high-quality companies with savvy management teams that can weather economic downturns.
The fund can hold up to 30% of its portfolio in global stocks, but its current allocation is approximately 10%.
Disclousure: I have no position in any of the securities referenced in this article.
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