) has found that price momentum has been the best and most consistent predictor of where a share's value is going. He uses a stock-selection model that emphasizes price momentum to cull and rank the stocks that go into the $300 million fund.
Unlike his peers, Stevenson and his team don't meet with company management. With all the scandals surrounding so many execs these days, along with the restrictions on what managements can say because of the Securities & Exchange Commission's Fair Disclosure rule (also known as Regulation FD), sticking to quantitative measures and technical analysis is quite understandable.
For the three-year period ended in May, the fund returned 1.8%, vs. 2.5% for its small-cap growth fund peers. However, Special Equity has been less volatile on the downside, as evidenced by its relatively lower
standard deviation and
beta. For the one-year period ended in May, the fund fell 9.4%, vs. a loss of 15.1% for its peers.
However, Stevenson believes that small-cap growth will soon outperform as an asset class. The current pessimism toward small-cap growth and the wide embrace of the value style are signs that the pendulum is about to swing the other way, Stevenson says. Rick Micchelli of Standard & Poor's Fund Advisor recently spoke with Stevenson about his investing strategy and portfolio moves. Edited excerpts from their conversation follow:
Q: What's distinctive about the portfolio?
A: It comes down to the investment style. We're a little more quantitative and have a smaller team rather than a bigger team that does only fundamental coverage. We still dig through 10-Ks and 10-Qs, but company contacts aren't as important to us.
Price momentum is a large driver of our process. I'm not sure that other investments look as closely at price momentum. It makes up 60% of our quantitative model.
Q: What about the stock-selection process. Is that constant?
A: Yes. Getting to our group of potential buys and ranking stocks is a systematic, disciplined approach. We don't change it, except when we find better factors at work. It's unemotional. We don't fall in love with stocks, and we don't hate them. It is 60% to 70% quantitative. That gets us to the list we work with each week. Technical analysis also plays a big role. We can't tell you much about a company without looking at its chart as well.
Q: So for a stock to be a candidate in your fund, it must first satisfy your quant model?
A: Yes, first and foremost.
Price momentum makes up the majority of the underlying stock-selection model. We try to identify the key drivers of small stock prices, specifically small growth stocks. We found that price momentum was the best and most predictable or most consistent predictor of stock prices. This is longer-term price momentum that's adjusted for volatility. We're thinking of yearly changes, not chasing this week's winners.
We also look at forecasts for earnings surprises. Not earnings surprises themselves, but a forecast of which companies may disappoint on earnings.
There's a valuation component, too. What role should valuation play for small growth-stock investors? We're already buying stocks of companies that have high expectations and that are high-multiple stocks. (Nevertheless) we don't want to stay at the party too long. If they disappoint, they disappoint in a big way, and can be down 40% to 50% in a day.
Q: The turnover on the fund is around 150%. Has it been higher as the market has become much more volatile?
A: As the market has shifted, we have sort of followed the trend, to some degree. The turnover has gone up a little bit. We want to fight against that because it's a drag on performance. We spend a lot of time wrestling with this. If it were possible, we would love to identify growth stocks that would keep us in a range of 25% turnover.
Q: About how many positions does the fund have?
A: Anywhere from 125 to 150. We are broadly diversified. Though our benchmark, the Russell 2000, is cap-weighted, we don't have issues such as General Electric (GE
), where we must sort of snug up to the benchmark.
Q: When do you sell?
A: We sell when a stock loses relative attractiveness in our universe. We assess expected returns and excess returns vs. our benchmark. If it drops down to a negative range it's an automatic sell.
We can also employ kind of a "pairs" trading strategy, knowing that there are always alternatives. We may own a semiconductor company, but there may be a buy for one that we don't own. We then try to decide which is a better opportunity for us. We will look at them fundamentally with subjectivity. As long as they're of relatively equal attractiveness, purely on a quantitative basis, we can make a subjective decision on news, corporate events, or accounting issues that we discover, and then swap.
Q: Do you visit management?
A: We do not. The team is too small with four individuals, and with the push on Regulation FD, we don't know how valuable that is. People are very successful meeting with management, I am assuming still, but everyone is complaining about Reg FD with the approach [which restricts "selective disclosure" of material and nonpublic information about a company].
Q: There's a school of thought that it makes sense to meet with management of smaller companies, which aren't as widely followed, while mid- and large-cap stock managers may be less inclined to visit management.
A: When they are smaller, it makes a lot of sense, since they don't have the coverage from the Street. What we found after Reg FD, in many cases, is that the managers just clamed up completely. They did not have the big compliance departments or PR departments that sort of govern what they could and could not say.
Q: As a result of Reg FD have you taken further measures or precautions with the portfolio?
A: No. But we question earnings surprises as a factor in driving a stock's price down, as well as momentum from earnings estimates. Some of these things used to work very well from a quantitative perspective. We question how effective they are going to be going forward.
Q: How is the portfolio positioned now? Are you lighter in technology than you have been historically?
A: Actually, the opposite is true. The catch phrases that we now use in small-growth land are "out-of-favor" and "unloved" -- labels that were applied to value investing.
Up until about the third quarter we were very defensive, cheating toward the core box in the small-cap asset class. In the October-November time frame, we started becoming much more aggressive. We saw more and more technology companies in our screen. Information technology is now closer to the 30% level in the fund. Biotech was an addition here in the last couple of months, too.
Q: Is it fair to say you're contrarian at the moment?
A: I think we are taking more of a contrarian approach. Stepping up to tech and biotech here makes us feel more comfortable. We think there's going to be a huge move up in small-cap growth stocks, if, for no other reason, because everyone is in love with small-cap value right now.
Things go to extremes. How long did it take for small-cap value to come back? People thought that growth would go on forever.
Q: Why do you think small-cap growth will come back?
A: Pessimism. We have tried to develop models to identify when the shift will occur. Over the last several years, people were calling for small stocks to do well for a long time. It took a while for it to happen. It's hard to predict.
We see lots of money flowing to small-cap value managers now. The cash levels are building, and they're having to cheat up to the mid-cap range. The large-cap guys are cheating down a little bit. One group that no one really wants right now is small-cap growth. Whenever you start to question any asset class, you're getting to the point where it is going to do very well.
Q: Have you noticed any macro trends that have come through your analysis?
A: One of the themes that seems to come through in all our work has been the consumer spending and leisure-time entertainment. Everything from Hollywood entertainment to video-sort-of-things, to stocks of boating companies, to autos. The consumer has had the confidence to stay pretty high in all this.
Q: Is that something you would expect to continue going forward?
A: I don't see any reason for it to be shaken up if unemployment doesn't get out of whack. We are pretty positive on the economy. We have got a relatively positive market outlook -- a high single-digit positive return. From these levels that's pretty good. Twenty percent-plus return years are a thing of the past.