The Hampshire County Retirement System, a $100 million regional public employee fund in western Massachusetts, was recently looking to redeploy $10 million that was invested in a small-capitalization growth portfolio. The pension fund, which had no midcap exposure, considered divvying up the proceeds into four sections -- small-cap value and growth and midcap value and growth -- but quickly realized that it would be expensive and time-consuming to oversee. The solution? It shifted all the money into a combined portfolio of small and midcaps -- or “smid” in industry argot -- managed by Rice Hall James & Associates in San Diego. Says Mary Baronas, the plan’s administrator: “We don’t have a fund large enough to justify having small and midcap separately. Smid allows us to have both small cap and midcap.”
More and more money managers are stepping up, or down, to the smid asset class, loosely defined as companies with market capitalizations between $100 million and $10 billion. Although average market caps vary widely, smid funds typically range from $1 billion to $3 billion. Most U.S. managers use the Russell 2500 as their benchmark. (The Russell 2000 tracks small caps, and the Russell 3000 is a total market proxy.)
Although the Russell 2500 lost an average of 8.9 percent annually for the three-year period ended March 31, it beat the Russell 2000, which lost an average of 11 percent a year, and handily topped the Russell 3000, which lost an average of 16 percent per annum. “It’s ahead of the broad market,” says Greg Nordquist, a senior consultant at Frank Russell Co. in Tacoma, Washington. “And that attracts people.”
This year returns have been strong. Among smid funds, the Provident Investment Smid Cap Growth Equity fund had gained a hefty 22 percent through mid-June; the $1.3 billion Strong Advisor Common Stock fund was up 17 percent, as were the $7.2 billion Franklin Small-Mid Cap Growth Fund and the $70 million CMC Small/Mid Cap fund; the $215 million Rainier Small/Mid Cap Equity fund had returned 18 percent. All have outpaced the mostly large-cap Standard & Poor’s 500 index, which had posted a 12 percent gain through mid-June. That follows negative returns for both 2001 and 2002, when the bear market spared no sector.
In Europe the small- to midcap category is less established, though consultants suggest that is beginning to change. Morningstar UK defines the top 5 percent of companies in the market as large cap. The next tier, down to 20 percent, are midcap. Small-cap companies make up the remaining 80 percent.
Most European portfolio managers who blend small and midcaps tend to favor the larger stocks over their smaller brethren. For example, midcaps make up 71 percent of the assets at Aberforth UK Small Companies Fund. The breakdown at Axa Rosenberg Pan-European Small Cap Alpha Fund: 59 percent of assets are midcap, and the rest are small cap.
“Moving up the scale hits the market cap sweet spot,” says Gary Dowsett, a senior investment consultant at Watson Wyatt Worldwide in London. Dowsett notes that in the U.K. self-defined small-cap managers aren’t drifting too far by going into midcap. Midcap companies in the FTSE all-share index top out at a market cap of $1.4 billion, whereas the cutoff between small and mid is $1 billion. And many small-cap managers in continental Europe tread into midcap carefree, making stock picks with companies with market caps as high as $3 billion.
What explains the appeal of this hybrid asset class? Often small-cap managers find that their winning stocks grow too large to meet the small-cap limit -- moving the portfolio’s mandate to smid solves that problem. “Good small-cap managers tend to get maxed out in their capacity,” says Edward Jamieson, a portfolio manager of the Franklin Small-Mid Cap Growth Fund. “By moving into smid you can leverage the skill of small cap.”
Adds David Stella, executive director of the $2.1 billion Denver Public Schools Retirement System, “We want a small-cap manager to be able to hold on to his winners if he thinks they will be good bets in the future.” Stella has invested 64 percent of the fund’s assets in domestic stocks, with half of that -- $672 million -- in a smid portfolio. (The other half is in large cap.) The pension fund uses five managers for its smid portfolio, including Boston Company Asset Management and Cordillera Asset Management.
Another appeal for pension funds and endowments that are cutting costs by paring money manager rosters: They can replace a small-cap and a medium-cap manager with one smid stock picker. “Smid cap is just an excellent complement to large cap,” says James Landreth, portfolio manager of the Provident Smid Cap Growth portfolio. “And it is a good way for plan sponsors who want to reduce the number of managers they work with.”
“Large plans might say, ‘Let’s have a smid instead of a small,’” says Landreth. “We’re hearing that quite a bit.” Late last year Provident Investment Counsel, a $5 billion-in-assets money manager, began offering its new smid product, which now has $110 million in assets.
Critics of smid charge that bundling asset classes can remove much-needed investor discipline and deprive plan sponsors of stronger long-term gains. On average small cap is riskier but offers a better payoff than midcap, says Brian Bruce, director of equity investments at PanAgora Asset Management in Boston. “You want a manager to trim winners and reinvest in the $200 million cap firm,” Bruce says. “Those riskier securities are essential for having enough money in 20 years for paying off liabilities.”
At the moment, says James Margard, co-manager of the Rainier Small/Mid Cap Equity fund, smid stocks seem to offer greater earnings potential than their large- or small-cap counterparts. Analysts expect earnings in companies of the Russell 2500 to grow 13.5 percent this year and at an annualized rate of 14.4 percent over the next five years, according to Frank Russell Co. Corporations in the S&P 500 are expected to grow by 12.5 percent this year and average 12.8 percent growth for each of the next five years.
Smid stocks look attractively priced as well. Stocks in the Russell 2500 are trading at 13.6 times estimated 2003 earnings, versus 15.3 times for the S&P 500, according to Frank Russell Co. “Smid stocks are still relatively inexpensive,” says Margard. “Even though they have outperformed, they come at a modest discount.”
Meanwhile, the recent cutbacks of small- and midcap research analysts at Wall Street firms could give an edge to portfolio managers who look for smid stocks that have fallen off the sell-side research screen. “There’s an opportunity here for investors if they have good information,” Margard says.
In this asset class good information often comes from on-the-ground research, portfolio managers say. “We are a classic fund, with bottom-up stock picking and a research-intensive approach,” says Franklin’s Jamieson. The portfolio manager looks for companies with no debt, declining inventories and shrinking accounts payable.
Franklin Small-Mid Cap Growth began as a small-cap fund in 1992. In 1999 the $7.2 billion fund returned 97 percent, which left it with many holdings above its market cap limit. Rather than hold a fire sale of good names, it changed its mandate in 2000 and included midcap stocks in its target range.
Jamieson buys stocks with market caps up to $8.5 billion. About one third of his fund’s assets are in small-cap names, with market values under $1.5 billion. The remainder of the portfolio is in midcap stocks. Companies in the fund average $3 billion in market cap.
These days Jamieson is especially bullish on Bunge, an agribusiness and food company that went public in August 2001 at $16. The world’s largest soybean processor, White Plains, New Yorkbased Bunge competes against titans such as Archer Daniels Midland Co. and Cargill by dominating South American markets, especially Brazil and Argentina. Consensus estimates for earnings per share in 2003 are $2.03, up from 85 cents in 2000, and are predicted to rise to $3.31 in 2004. Franklin’s average cost is $17.72; Bunge traded in early May for $27.50, when the position accounted for 1.3 percent of total fund assets. “We’ve let this one ride with our smid portfolio,” Jamieson says.
Provident’s Landreth has done well with pharmaceutical companies that manufacture generic drugs based on patents that have just expired. In October 2001 the portfolio manager started buying Taro Pharmaceutical Industries, a $213 million-in-revenues, Israel-based drug company, whose stock trades on Nasdaq. At that point it ranked as a small-cap stock with a market cap of about $1 billion. Landreth especially liked Taro’s 60 percent gross profit margin, about twice the typical level. He was also impressed that the company spends more on R&D than do most of its rivals in the generic field.
In the first quarter of this year, Taro sales hit $69 million, up 55 percent from the same period in 2002, largely on the strength of sales of its generic drugs and recent new product launches. Landreth’s average cost is $35.71; the stock traded recently at $48.
With the run-up, in fact, the stock, with a $1.4 billion market cap, is now nudging into midcap territory. Small-cap portfolio managers would have to contemplate unloading their positions, but Landreth’s smid mandate allows him to ride the stock for as long as he likes.
