Another Strong year for Shaker's Small Cap Growth Strategy
US Equity returns were strong in 4Q19 and for FY2019 as the S&P 500 was up 9.07% and 31.49%, respectively. For the year, small cap stocks underperformed large cap stocks which was a headwind for the Shaker Small Cap Growth (SCG) strategy. In the fourth quarter, however, small cap stocks narrowed the performance gap. Small cap stocks, as measured by the US Small Cap Growth Index, returned 9.94% for the quarter and 25.52% for the year, and large cap stocks, as measured by the US All Cap Index, returned 9.10% for the quarter and 31.02% for the year.
Small cap stocks often perform better than large cap stocks when there is more certainty in the economy. At present there appears to be greater certainty in the economy than there was in the prior year. The Federal Reserve has indicated an intention to maintain their position on short-term rates unless incoming data warrants further action. The economy is growing slowly, but still growing. The consumer side of the economy, which accounts for almost 70% of GDP, remains mostly healthy. The president signed a Phase I trade agreement with China on January 15th with a Phase II trade agreement expected to follow. We are hopeful that a trade deal leads to improved manufacturing activity, higher CEO confidence and provides more certainty in the economy.
Portfolio Update:
The following is a summary of returns for the Shaker Small Cap Growth strategy and selected indexes for the fourth quarter, trailing twelve months, and last three years:
| 3 Months Ending 12/31/19 | 12 Months Ending 12/31/19 | 3 Year Annualized Returns | |
|---|---|---|---|
| Shaker Small Cap Growth | 11.73% | 35.23% | 18.61% |
| Shaker Small Cap Growth (net)* | 11.48% | 33.98% | 17.44% |
| US Small Cap Equity Growth Index | 11.39% | 28.48% | 12.49% |
| US Small Cap Equity Index | 9.94% | 25.52% | 8.59% |
| *returns are preliminary and net of 1% management fee and expenses | |||
Approximately four years ago, Shaker implemented changes to our portfolio construction process in an effort to reduce portfolio risk. The effective changes were 1) be more cognizant of portfolio sector weightings relative to the benchmark and 2) better manage individual position sizing. These moderate improvements had significant impact on risk adjusted performance. While still running a concentrated portfolio, improving sector diversification versus our benchmark and capping individual position sizes has allowed us to be more nimble and helped us avoid momentum reversals in our growthier names. As demonstrated in the performance over the past four years, we believe maintaining this new discipline will help us achieve success in the years to come.
The Shaker Small Cap Growth Strategy (SCG) performed well in Q4 2019 returning 11.48% (net), and slightly outperformed the Small Cap Growth Index benchmark, which returned 11.39%. For the year, the SCG Strategy was up 33.98% compared to the Small Cap Growth Index benchmark which was up 28.48%. The SCG has now outperformed its benchmark in five consecutive quarters and ten of the last twelve quarters. Diligent effort by our analysts to find growing companies that meet our rigorous stock selection criteria and improved discipline in our portfolio management continue to drive performance.
Q4 Key Portfolio Notes:
Shaker’s Small Cap Growth strategy ended the quarter with 53 holdings. We have made incremental changes to the portfolio during the quarter, but have not fundamentally changed our positioning. We remain close to a market weight (+/- 2%) for most sectors, except for Health Care, which we are underweight 7%, and Technology, which we are overweight 4%. We continue to look for attractively valued and growing Health Care stocks that meet our investment criteria.
Since the end of the third quarter we have purchased new positions in Cabot Microelectronics (Materials), CyberArk Software (Technology), Kadant (Producer Durables), Livongo Health (Health Care), PagerDuty (Technology), PGT Innovations (Materials) and Preformed Line Products (Producer Durables).
We liquidated positions in Alamo Group (Producer Durables), iRhythm Technologies (Health Care), Insperity (Producer Durables) and Synovus Financial (Financial Services).
We are pleased with the portfolio’s recent performance and will continue to work diligently at identifying the best small cap growth stocks to drive future performance.
The Top Q4 Contributors:
1) Dexcom Inc. (DXCM) is a health care company that produces a continuous glucose monitoring (CGM) system for diabetics that is recognized as best in class for accuracy. Shaker Investments believes the diabetes care industry is at an inflection point due to technology innovations that can dramatically improve the lives of patients. DXCM is one of the largest holdings in the portfolio and the largest contributor to performance in Q4. The stock was up 46.57% in Q4 and 82.59% for the year.
2) The Trade Desk, Inc. (TTD) is a technology company providing a self-service platform that enables clients to purchase and manage digital advertising campaigns across various advertising formats. The company was one of our top detractors in Q3, down 19.77%, but it rallied up 38.51% for the fourth quarter and finished up 123.83% for the year.
3) Paycom Software (PAYC) is a human resources SaaS company. PAYC makes HR processes more efficient and less costly for small and medium sized companies. The stock was up 26.38% for the quarter and 116.22% for the year.
DXCM, TTD and PAYC are all in the top ten holdings by weight in the SCG strategy despite rebalancing in the fourth quarter and earlier in the year.
The Top Q4 Detractors:
1) NiSource Inc. (NI) is an energy holdings company primarily in the natural gas business in 7 states. NI was down -6.28% for the fourth quarter, but returned 13.02% for the year. NI is the first utility we have purchased in the SCG strategy in over 10 years. However, this does not represent a deviation from our investment philosophy. We purchased NI early in the fourth quarter of 2018 with a realization that we were late in the market cycle, and in an effort to better align portfolio sector weightings with the benchmark. We felt comfortable buying NI because the fundamentals were solid and the company’s characteristics matched well with Shaker’s evaluation criteria – the 11 Characteristics of a Superior Growth Company.
2) Insperity Inc. (NSP) is a leading provider of human resources and business performance solutions for small and medium sized companies. We reduced our position in NSP earlier this year on valuation concerns and ultimately decided to liquidate the entire position in the quarter after fundamentals further deteriorated. NSP was down 12.42% for the quarter. Even with negative performance for the quarter NSP was a very successful investment, outperforming the benchmark by 76.9% over the holding period.
3) LGIH Homes Inc. (LGIH) is a leading home builder focused on entry level, single family homes. The stock returned -15.21% for the quarter after announcing in-line third quarter earnings. The original investment thesis, that the long-term outlook for entry-level homebuilders is good, remains intact and we expect LGIH’s backlog to rise. However, LGIH has some risks including rising competition in entry level homes which could further impact LGIH’s industry-leading gross profit margin. We slightly reduced our position in homebuilders broadly in the quarter.
ESG Investing:
We have received questions from several investors about our thoughts on ESG investing. Environmental, Social and Governance (ESG) investing is being discussed industry-wide to an excessive degree. Simply speaking, ESG represents companies that are doing “good”. Other terms commonly associated with ESG are sustainable, green, socially responsible, inclusive and ethical. To date, there is not an industry accepted definition for what constitutes an ESG company. ESG rating systems and criteria differ by firm, sometimes significantly. This makes it difficult to design an ESG compliant portfolio.
At Shaker Investments, many of the common factors driving ESG analysis are already part of our criteria for investment analysis, particularly in the way ESG principles can improve efficiencies, lower risk, or increase sales. Examples include energy efficiencies lowering costs, independent audit committees reducing risk of financial reporting errors and input from a diverse management team leading to broader appeal of products and services.
We would not feel comfortable calling Shaker Investments ESG compliant, but we are aware of ESG investing and think many ESG factors align with our currently established research process. In addition, because our investment strategies are offered primarily through Separately Managed Accounts (SMA), we have the flexibility to cater to our investors’ unique needs, including ESG.
We look forward to providing you with an update next quarter.
Sincerely,
The Shaker Investments Team
General Disclosures:
The information contained in these materials is as of 1/31/2019. This document is confidential and for the sole use of the intended original recipient. It is not intended as investment advice or recommendation, nor is it an offer to sell or a solicitation of an offer to buy any interest in any fund or product.
Risk:
An investment in any of our strategies is speculative and involves a high degree of risk, including potential loss of principal. There is no guarantee that the investment objective will be achieved, or that the investment strategies will be profitable. Investments in smaller companies may be riskier, less liquid, more volatile and more vulnerable to economic, market and industry changes than investments in larger, more established companies.
Performance:
Past performance is not indicative of future results. Returns in the current year are preliminary. The strategy’s overall return is a composite of clients’ separately managed account returns. Some clients’ investment returns were more or less than the overall strategy return. Not all our client’s returns surpassed the benchmark. The index return information herein has been obtained from public sources and we do not guarantee its accuracy. The following disclosures applies to information mentioned in this document:
1. Gross returns are net of expenses.
2. Net returns are net of expenses and a 0.25% quarterly (1% annual) management fee for the corresponding period.
3. Inception date for the Small Cap Growth Strategy is 07/01/2004.
4. The benchmark for the Small Cap Growth Strategy is a US Small Cap Growth index. At times, the iShares Russell 2000 Growth ETF is used as a proxy. The strategy is more concentrated than the benchmark.
5. Risk metrics are estimated using monthly returns net of fees for the last 3 years, unless otherwise noted.
Recommendations:
The specific securities identified and described in this report do not represent all of the securities purchased, sold or recommended for clients. It should not be assumed that investments in the securities identified and discussed will be profitable in the future. Holdings and sector weightings in any strategy are subject to change and should not be considered investment advice or a recommendation to buy or sell a particular security. Actual holdings may vary by client. A list of the stocks selected for any of our strategies during the trailing twelve months is available upon request.