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Timothy Miller, CFA
Portfolio Manager
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Waddell & Reed Advisors Small Cap Fund - October 2011
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2011 got off to a good start in the small-cap equity market. Generally small-cap stocks were outperforming large-cap stocks and growth continued to outperform value. Since the end of first quarter, however, small-cap stocks have come under pressure as a confluence of investor concerns has weighed heavily on the markets. Timothy Miller, portfolio manager for the Waddell & Reed Advisors Small Cap Fund, reviews his fund’s objectives and investment philosophy during these volatile times.
Managing growth portfolios for many years, through many cycles, is always challenging and interesting. For the Waddell & Reed Advisors Small Cap Fund team, it’s all about following a consistent and fairly simple philosophy – no matter the business cycle, we look for innovative companies that are pursuing exciting opportunities for expansion. We focus on companies we think have the potential to develop from small caps into mid caps in the future.
We believe the common characteristics of successful small-cap growth companies are their ability to:
- Pursue markets that are growing at a substantial rate when compared to the industry and/or general economy;
- Be leaders in their industries by increasing market share and creating barriers to entry;
- Produce superior financial returns;
- Use strong management to execute business opportunities.
Differentiating high-quality companies from simply promising ones
First, we ask a lot of questions. What market is this company pursuing? How large is the market or how large do we think it can get? How fast is it growing?
Next, we examine the competitive dynamics of the market. We tend to prefer to own the leading companies in this market; this could mean their leadership position is based on proprietary products, strong distribution or robust marketing. Generally, the more concentrated the leadership, the safer we view the companies are for investors.
A company’s financial model is a critical factor as well. These companies are small. They need financing and must have the ability to generate sufficient profitability and free cash flow to fund growth. Their return on capital has to either be currently adequate, or have the potential to achieve a superior level to attract investors and sustain valuations.
In examining companies, the small cap growth management team analyzes sales and unit growth, and the driving force behind it. We also review trends in gross and operating margins. How’s the operating cash flow? How much operating cash flow is the company generating relative to its capital expenditure (cap ex) spending? This leads to further analysis regarding how much free cash flow is actually being generated. We also need to know the return on capital the company is achieving from its business.
Finally, we conduct a critical assessment of company’s management. We look for depth of management and review its vision, focus and ability to generate good returns for shareholders over a multi-year period.
Reviewing these key philosophical metrics as well as several individual factors allows us to identify what we consider to be the best growth companies in the emerging small-cap marketplace.
Structuring the Fund’s portfolio and managing risk
We believe in owning companies across the growth spectrum.
This includes:
- Aggressive growth companies: Less seasoned firms that offer the potential for faster growth for longer periods of time.
- Accelerating growth companies: More seasoned firms that offer the potential for strong growth and deliver margin expansion.
- Consistent growth companies: Most seasoned, larger firms that offer the potential for predictable revenue and earnings growth.
- Out-of-favor growth companies: Firms not priced for growth that may have experienced a management misstep or set back. Sometimes, these companies fall into this category because of the current business cycle, environment or investor sentiment.
Using the growth spectrum classification system assists our management team in dealing with market volatility, which is heightened in the small-cap growth space. This method, along with others, helps us strive to generate consistent returns over time, whether we’re in an expansionary environment or a sluggish one, or a period where sentiment is very bullish or somewhat cautious. We believe that having a structure like this provides over time better consistency of performance.
Waddell & Reed Advisors Small Cap Fund vs. others
The primary difference is the concentration of the Fund’s portfolio. The Waddell & Reed Advisors Small Cap Fund tends to focus on a group of about 55 to 60 companies. We blend larger firms in which all of the business elements are aligned and in place with dynamic, faster growing smaller firms. Each of these companies should typically demonstrate strong competitive and differentiated positions. We believe these are the companies that will reflect healthy financial returns and cash flow over time.
As a result, the Waddell & Reed Advisors Small Cap Fund is managed toward having a higher quality bias than many of our small-cap growth peers. In addition, the Fund is trending toward lower volatility than its peers as indicated by a lower standard deviation on both a three-year and five-year basis, according to Morningstar.1
Fund’s outlook
As anticipated in the first quarter, the rate of earnings growth is likely to continue to fade in 2011. Companies are still struggling with rising commodity and labor costs and a slowing economy, but nevertheless, we expect small-cap earnings to continue to outperform larger companies for the year. This should be the foundation for another healthy year for the group, and relative earnings performance may be the key differentiator. The focus this year remains on adding exposure to industries such as health care, employment services and others that we believe have favorable operating leverage opportunities.
Regardless of the economic environment, we believe that there will always be opportunity for small-cap innovators to generate excitement in the market. In today’s volatile times, the necessity of economic hardship just may be the mother of invention.
1 Morningstar, August 31, 2011. Comparison of Waddell & Reed Advisors Small Cap Fund vs. average small cap growth class A funds. Standard deviation: Three-year basis (25.63 for Waddell & Reed Advisors Small Cap Fund vs. 26.80 for peers) and five-year basis (21.70 Waddell & Reed
Advisors Small Cap Fund vs. 22.64 peers). Standard deviation of an asset return series measures the deviations of a return series from its average. This metric is often used as a determination of risk for an asset. A relatively large standard deviation implies there have been large swings in the return series and thus riskier, whereas a relatively small standard deviation implies there have been small swings in the return series and thus less risky. To gauge the relative risk of an asset, it helps to compare similar assets together and compare standard deviations and returns.
Past performance is not a guarantee of future results. The opinions expressed are those of the Fund’s manager and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through October 1, 2011, and are subject to change due to market conditions or other factors.
Consider all factors. As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. Investing in small or mid-cap stocks may carry more risk than investing in stocks of larger, more well-established companies. Not all funds or fund classes may be offered at all broker/dealers. These and other risks are more fully described in the Fund’s prospectus.
Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available a summary prospectus, containing this and other information for the mutual funds offered by Waddell & Reed, call your financial advisor or visit us online at www.waddell.com. Please read the prospectus or summary prospectus carefully before investing.