Small- and micro-cap stocks get another look as the S&P 500 Index stalls

As large-cap U.S. stocks, as represented by the S&P 500 Index, have stalled this summer, some investors have rushed into smaller companies, which are benefitting from a tax cut and a strong domestic economy.

That has helped shine a light on little-known companies and the funds that own them.

The AMG Managers Cadence Emerging Companies Fund is one of those. Mike Skillman and Bob Fitzpatrick of Cadence Capital Management run the fund, which is rated five stars by Morningstar, the research firm’s highest rating. The AMG Managers Cadence Emerging Companies Fund












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 is a domestically focused portfolio of small-cap and micro-cap stocks.

Skillman is the CEO of Cadence Capital Management, which has $4.5 billion in assets under management and is headquartered in Boston. He has been managing the fund since it was established in 1994. Fitzpatrick joined Cadence in 1999 and has co-managed the fund since 2004. So this is a remarkable track record for a consistent management style and outperformance, as you will see below. The AMG Managers Cadence Emerging Companies Fund has $170 million in assets, and the firm manages a total of $230 million using the same strategy.

In an interview on Aug. 15, Skillman and Fitzpatrick explained that they aim to hold shares of 90 to 100 companies in the fund. These are drawn from “the bottom half of the Russell 2000 Index












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” with market capitalizations ranging from about $50 million to $1.5 billion with an emphasis on companies valued between $500 million and $700 million.

This approach provides diversification from the S&P 500 Index












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which is heavily weighted toward the FAANG stocks, which include Facebook












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Amazon.com












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Apple












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Netflix












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 and Google holding company Alphabet












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(Another highly rated fund we covered recently that provides international diversification away from the large-cap U.S. benchmark is the Evermore Global Value Fund.)

The AMG Managers Cadence Emerging Companies Fund limits its exposure to 2% of assets for any stock, generally starting a position at 1% and then cutting them back when they hit 2%.

A winning strategy

Fitzpatrick said that over the very long term, small-cap and micro-cap U.S. stocks have significantly outperformed shares of larger companies. This chart uses data going back to 1927 to compare the total and average returns of various market-cap ranges:

More recently, the S&P 500‘s average return over the past 10 years has been 10.4%, compared to 9.5% for the Russell Microcap Index












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Fitzpatrick said Wall Street analysts tend to overlook small-cap and micro-cap stocks (many of which are too small even to be included in the Russell Microcap Index) because “the profitability of the sell-side firms is driven by covering the bigger companies.”

He said the firm’s name, Cadence, “came from the rhythmic, repeatable process,” which is designed to lead to “rhythmic, repeatable good results.”

Picking stocks

Skillman described a “growth at a reasonable price” strategy following a “disciplined and rigorous process.” He said that increases in earnings are what ultimately drive stock prices higher, but also emphasized the importance of identifying companies whose valuations to earnings are attractive.

“Investors may be skeptical of a company because of past difficulties, there can be industry effects that would cause investors to be wary of a particular sector and more broadly, cyclical companies are sometimes viewed skeptically by growth investors,” he said.

So there can be overlooked value opportunities among companies that he and Fitzpatrick determine have “improving earnings profiles,” he said.

Fitzpatrick said that after screening stocks for “a manageable list that looks good by the numbers,” he and Skillman then identify the drivers for sales and earnings growth, along with risks that may not be reflected in the numbers, including problems with management, litigation or “binary events” for biotech companies holding drug trials or waiting for FDA decisions.

Three examples

Fitzpatrick named three companies held by the fund as examples of companies on upward earnings trajectories with strong balance sheets that may be underappreciated by the market:

TransAct Technologies

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of Hamden, Conn., provides printing equipment that can be embedded in other systems. Nearly half the company’s revenue comes from manufacturers of gaming equipment, including slot machines that provide winners with tickets they can cash in, rather than spewing buckets of coins. The company also provides printing equipment used in point-of-sale transaction processing, banking, lotteries, restaurants and other industries.

In its second-quarter 10-Q filing, the company said its 9% increase in quarterly sales from a year earlier was driven in part by a “21% increase in sales of our Ithaca 9000 printer, as sales to McDonald’s












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 have returned to the near record levels experienced during 2017.” That increase was partially offset by a 71% decline in sales for legacy banking and point-of-sale products, but the company expects the McDonald’s revenue to remain at the same level during the third quarter.

Earnings for the second quarter were up 33%.

The decline in sales of older banking and point-of-sale products is a long-term trend for the company as it focuses on its restaurant and gaming products. Fitzgerald said the company has opportunities with restaurant chains, which include labeling systems to make “the back office [kitchens] more efficient,” while also addressing food safety efforts and a limited labor supply.

TransAct Technologies has no debt and what Fitzgerald called a “reasonable valuation” at 17 times his estimate of earnings over the next 12 months.

Kingstone Cos.

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is a property and casualty insurer that is based in Kingston, New York. The company has branched out beyond its home state into New Jersey, Rhode Island, Massachusetts and Pennsylvania. Fitzgerald expects it to expand into Connecticut and New Hampshire in 2019.

A.M. Best upgraded its financial strength rating for Kingstone to an A-minus (excellent) from B++ (good) in April 2017, and Fitzgerald said the upgrade had played a significant role in helping the company “win good business.” Kingstone said its direct premiums written during the second quarter were up 21% from a year earlier, while earnings rose 10%.

“The stock trades for about two times book value and 13 times [his estimate of forward] earnings,” Fitzgerald said. He said that valuation was a bit high for an insurance company but that it was appropriate “because of the growth.”

PRGX Global

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 is in a fascinating business: audit recovery. The company helps customers recover money from suppliers. For example, a retailer may have complicated arrangements through which suppliers provide rebates. “There are a lot of details in the contract terms, so it is sometimes difficult to manage properly,” Fitzgerald said.

PRGX uses a customer’s data to prove to suppliers how much is owed to its customers.

Skillman said the standard term for the money that needs to be recovered is “leakage in the supply chain.” This is especially important in mature industries, including retail, because of pressure on profit margins, he said..

Fitzgerald said the company is “well-positioned in terms of investments in its technology platform. It is gaining share, modestly. There are potential applications in oil and gas, pharmaceuticals and other areas.”

Fitzgerald is a believer in the company’s targets for “high single digits” sales growth this year, along with an increase in EBITDA of about 20%. The shares trade for about eight times his estimate for EBITDA — a level he believes is attractive.

More stocks held by the fund

Skillman and Fitzpatrick stressed that their aim is to balance the fund’s holdings among a group of 90 to 100 stocks. Morningstar has a list of the fund’s largest 10 holdings as of July 31. However, the fact that these weights are on the high side for the fund probably reflects how well the stocks have performed. This is in no way a a list of the fund managers’ “favorites.”

That being said, here are the largest 10 holdings of the AMG Managers Cadence Emerging Companies Fund as of July 31:

You can click on the tickers for more about each company, including business profiles.

Performance

The fund’s primary benchmark is the Russell Microcap Index












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but its performance can also be measured against the Russell 2000 Growth Index












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Here’s how all three have performed since June 30, 2000, when the Russell Microcap Index was established:

FactSet

Here’s a five-year chart:

The charts show the performance of the fund’s class N shares












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net of expenses, which are now 1.09% of assets per year, which Morningstar considers “low.” The Class N shares have a $2,000 minimum investment, while the fund’s class I shares












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 have a $100,000 investment minimum and a 0.97% expense ratio.

Digging deeper, here are performance figures for multiple periods against the fund’s Morningstar category and the two benchmark indexes:

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