) is chock full of stocks he thinks will deliver sustainable high earnings growth. The portfolio is quite crowded -- it currently contains about 170 names -- and he is not afraid to pull the plug on a company if it starts to show signs of earnings deterioration. Moreover, to control risk, he will not make big bets on either sectors or individual companies -- no one position can exceed 2% of the portfolio's assets.
In calendar year 2000, the fund rose 10.7%, while its primary benchmark, the Russell 2000 Index, slipped 3.0%. This year has been a little tougher: year-to-date through April 11, the fund fell 11.0%, while the index declined 6.7%. Garfinkel has managed the fund since its inception in October 1998, with assistance from his fundamental analyst, James Behre.
Garfinkel's favorite holdings include Shaw Group (SGR
), a piping systems and engineering services provider. The fund's largest sectors currently are consumer cyclicals (21%) and technology (19%). According to Garfinkel, small-cap equities are in the early stages of a long period during which they will outperform large-caps.
Palash R. Ghosh of Standard & Poor's FundAdvisor recently spoke with Garfinkel about his investing philosophy, the stocks he likes now, and his outlook for the small-cap sector. Edited excerpts of their conversation follow.
Q: How large is the fund in terms of net assets? How many holdings are in the portfolio?A: We presently have about $500 million in net assets comprising roughly 170 stocks. We tend to hold a large number of stocks -- we take an initial position size of 0.8% for each holding. Thus, the weighting of any stock in the portfolio is determined in large part by share appreciation or depreciation. But we will not allow any individual position to exceed 2%. We believe that we can generate significant excess returns with good stock selection -- without taking on excessive company-specific risk.
Q: What kind of stocks do you look for in this fund?A: We use a 'core-growth' investment discipline looking for companies (with a market cap below $2 billion) that have improving earnings momentum, rising earnings estimates and strong sales growth momentum. Plus, they must be trading at reasonable valuations relative to their underlying growth rate and peer group. Historically, a stock that ranks highly in our quantitative model based on any of the aforementioned factors (or combination thereof) has generated significant excess returns.
From a fundamental standpoint, we look for companies with business models that "make sense." Momentum is also important in the business fundamentals, as we want to be able to clearly identify the drivers behind the company's earnings growth to determine the sustainability of these trends. Jim Behre, the fund's analyst, does the bulk of the "dirty work" with respect to company fundamentals.
Q: What are your biggest holdings?A: As of Dec. 31, 2000, the ten largest positions were Shaw Group, 2%; Noven Pharmaceuticals (NOVN
), 1.9%; Cryolife Inc. (CRY
), 1.5%; Patterson Energy (PTEN
), 1.4%; Barr Laboratories (BRL), 1.4%; Advanced Digital Information (ADIC
), 1.2%; Constellation Brands Inc. (STZ
), 1.2%; Radian Group (RDN
), 1.2%; National Oilwell (NOI
), 1.2%; and Rogers Corp. (ROG
Q: Can you take one of your largest holdings and discuss how it fits your investment style?A: Shaw Group is a Louisiana-based provider of piping systems and comprehensive engineering and construction services to the power generation industry. We initially purchased it at the end of 1999 at an average cost of $10-$12 per share -- it now trades at about $53 per share, which explains its large position in our fund. At the time of purchase, Shaw was exceeding analyst's earnings estimates; Wall Street was revising estimates upward for the company; sales were accelerating, and its P/E ratio was quite reasonable -- in the low-to-mid teens. On the fundamental side, their order backlog and bookings were huge, driven largely by the pent-up demand for power generation.
Q: What are your biggest sectors?A: Although we don't make sector bets, our largest industries are currently consumer cyclicals (21%) and technology (19%).
Q: What is your benchmark?A: Our benchmarks are the Russell 2000 Index and the S&P Small Cap 600 Index -- although we are a bit more 'growthy' than either of these indices. On the other hand, we're not as 'growthy' as, say, the Russell 2000 Growth Index.
Q: What are your sell criteria?A: We generally scale back or outright sell a stock when its P/E gets excessively high relative to a company's underlying growth rate. Late last year we sold off Tollgrade Communications (TLGD
) and Anaren Microwave (ANEN
) -- both telecommunication equipment providers -- on concerns over their high valuations. We also dispose of a holding when we determine that its earnings or fundamental momentum are peaking or beginning to deteriorate.
Q: Do you have a high portfolio turnover rate? A: We have an annual turnover of about 110%-125%, which is actually below the average for most small-cap growth funds. However, we don't necessarily view turnover as a negative thing -- it's preferable to replace a poorly performing stock with a more attractive company. We run an efficient fund; we know how to control capital gains and taxes for our retail investors.
Q: How have you dealt with the weakness in the market this year?A: We are committed to being fully invested, so we don't move into cash. This slowing economy is affecting companies across all sectors, particularly technology. But, through our bottom-up stock selection process, we look for those companies with the highest earnings visibility. As a result, we have not yet been adding to our technology weighting for this year.
Q: What is your outlook for the small-cap stocks for the rest of this year?A: When we started this fund in late 1998, the disparity between large-cap valuations and small-cap valuations was at an all-time high. We believe that small-caps are now in the early stages of a multi-year period of out-performance, relative to large-caps. Small-caps will benefit this year from positive liquidity, and the bottoming-out of the economy.