Growth Potential through Small and Smaller
AIG Small-Cap Fund
K. Murphy, T. Campion, M. Skillman, R. Fitzpatrick
Author: Ticker Magazine
Last Update: Apr 21, 10:34 AM ET
|Underfollowed and often completely ignored, companies smaller than $500 million in market cap are rarely the subject of interest for research teams. However, investors with patience and the willingness to stomach volatility may identify potential gems that could deliver attractive returns. The AIG Small-Cap Fund blends an index sleeve with an active sleeve to help balance its exposure to the lowest end of the market cap spectrum.
“Micro cap is traditionally a difficult asset class to get access to because of limited liquidity, but there also is an opportunity for alpha because these stocks typically don’t get a lot of attention.”
Q: What is the history of the fund?
The AIG Small-Cap Fund was launched on February 6, 2014, to give access to very small-cap or micro-cap stocks with some help from an index sleeve. Micro cap is traditionally a difficult asset class to get access to because of limited liquidity, but there also is an opportunity for alpha or excess return to the benchmark because the stocks typically don’t get a lot of attention among institutional investors. There is a fair amount of volatility among micro cap, but by adding an index strategy in there we seek to dampen that volatility a little bit, and still have access to the potential alpha.
SunAmerica Asset Management, LLC is the fund’s investment adviser, managing the allocations and the index strategy. Cadence Capital Management, LLC is the subadviser of the micro-cap growth strategy.
The index strategy provides broad exposure to small-cap stocks by tracking the Russell 2000 Index (the “Small Cap Index”), which measures the performance of the 2,000 small-cap companies in the Russell 3000® Index. The Micro-Cap Sleeve is actively managed to help enhance alpha potential relative to the Russell Microcap® and Small Cap Index by investing in the common stocks of small-cap or micro-cap U.S. emerging companies with market capitalizations within the range of these indices.
Kara Murphy is the Chief Investment Officer, and Timothy Campion is the Senior Portfolio Manager of the Index Sleeve and the co-portfolio manager of the rules-based investing at SunAmerica Asset Management, LLC, which is a member of American International Group, Inc. (AIG), located in Jersey City, New Jersey.
Michael Skillman is the Chief Executive Officer, and Robert Fitzpatrick is the Portfolio Manager at Cadence Capital Management, based in Boston.
Q: What is the index strategy and market capitalization that you focus on?
The index strategy follows the Russell 2000, so we have a broad universe to draw from. But basically, the idea is to mirror the index exactly. We seek to fully replicate the underlying holdings and rebalance as the underlying index rebalances, but we have the ability to optimize the portfolio as well, investing in a sampling of Small Cap Index stocks.
For now in the index, the market cap at the top is $3 billion and $700 million at the bottom.
Q: What is the allocation in the micro-cap part of the fund?
The allocation within the micro-cap sleeve with Cadence can vary. Today it’s close to 40%. Our mandate is to focus on the companies in the bottom half of the Russell 2000 Index; however, generally, we may include companies whose market capitalizations are equal to or less than the largest company in the Microcap Index during the most recent 12-month period. The average market cap is close to $500 million.
Micro-cap companies historically have reasonable revenues and profitability, but are often ignored, underappreciated, and institutionally underfollowed. There is the potential for a nice tradeoff of opportunity because of that lack of coverage.
Q: Do company earnings factor in your investment strategy for the indexed portion of the fund?
Not in the index construction. We rely on Russell to determine who should be in that index and then we seek to fully replicate it. The potential advantage there is that we are not making those fundamental decisions based on earnings, profitability, or valuation, and that’s why we get such a diversified access to that asset class. Ideally, we may pick up some things that maybe a fundamental manager would ignore for those very reasons.
Q: How would you describe your investment philosophy and process for the micro-cap sleeve?
Our investment philosophy starts with looking for companies with an improving earnings profile. We believe that ultimately earnings can drive stock prices higher. However, the price we pay for that earnings stream ultimately determines our investment experience and drives our growth. We follow a systematic investment process to create our portfolio.
The first step is the use of a proprietary model to identify attractive candidates. Our second step is fundamental research to understand key investment drivers and risk. We try to get a handle on pace and duration of earnings growth. We avoid stocks where the investment outlook is excessively driven by hard-to-call dynamics such as litigation or regulatory outcomes. There’s a lot of information and resources available at Cadence and our asset management input is part of our process. While meeting with management is not a requirement prior to investment, we do get to visit with many companies in our offices in Boston.
The third and final piece of our investment process is portfolio construction. We start with 1% position sizes, resulting in a diversified portfolio. Our top 10 holdings are typically about 15% of the portfolio. We invest across all sectors, but since we have a growth orientation in this portfolio, we can have more exposure to sectors like information technology and healthcare.
We have some risk controls at the individual stock level as well. We trim stocks that get to 2%. And we have some risk controls around sector weights to help prevent undue concentration in any individual sector.
Q: Can you expand more on that stock selection model?
We want to find companies that have improving growth profiles, have quality financials, and represent some value.
From a growth perspective, we are looking at companies that have positive business momentum and have been beating expectations. We also like to see positive price momentum to confirm the market is seeing opportunity.
From a quality perspective, in addition to generally accepted accounting principles (“GAAP”) earnings, we also look for strong cash flow, good returns on capital and improvement in margins.
Finally, from the valuation perspective we are looking historically at cash flow to enterprise value and prospectively at price to forecasted earnings. We focus our time on companies in the top 20% of our ranked universe to help identify candidates with what we believe is a growing bottom line through growing revenue, improving margins and the strengthening of their balance sheet.
Q: Does liquidity factor in your investment model?
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