Rebalance Fire Drills

Every year there are scores of managers, quants and analysts poring over data trying to predict the companies that may be added or removed from respective Russell Indexes and the amount of buying and selling of those stocks that may occur. This extends to analysis on market caps, sectors and industries and style, as between growth and value.  Obviously for passive investors trying to replicate indexes, manufacturers of ETFs, and active managers who are in fact closet indexers, such data is vitally important.

As small cap growth managers building conviction-weighted portfolios from the bottom up, we read with some detachment these reports that purport to predict which stocks might be benefited or hurt by the coming moves at Russell. In fact, many obsess over the dates of changes in market cap ranks, style and adds and deletes, especially those on the index-driven side of the equity markets. While we attempt to understand the characteristics of our benchmark, The Russell 2000 Growth, we are a manager whose style and strategy creates high active share portfolios and seeks to solely understand the benchmark and avoid having it drive our research or decision making process. For example, it is important for us to know that biotechs account for 17% of our benchmark or that money-losing companies comprise over one-third of the index, but our traditional avoidance of biotechs and unprofitable companies that cannot fund themselves to growth will not change.  From an investment strategy perspective, the binary nature of the biotech’s business models and the risks they take are unattractive to us. Often these risks lie in product development coupled with the constant need for capital raises as these products are developed and brought to commercialization.  In the case of unprofitable companies (also many biotechs), we avoid the inherent risks in investing in a company that needs an accommodative financing market to achieve their growth plans. We do, however, spend time analyzing biotechs and unprofitable companies as those are important drivers of innovation and disruption, particularly biotech which serves as important sources of growth for large pharmaceutical companies. Further, we do have exposure to these areas of the market through companies providing services to biotech firms, such as bioproduction and logistics, to also owning a company possessing a valuable portfolio of royalties generated by biotech drugs.  We keep a close eye on those smaller growth companies (the farm team in baseball analogy) that may soon reach a level of growth and maturity and fewer accompanying risks, that may ultimately qualify for deeper analysis and potential inclusion in our portfolios.

Our clients should not expect our strategy to change if an index weight of a specific stock, sector or industry increases or decreases.  There are, however, market capitalization weight-driven indexers who are forced to buy more of a security at ever higher valuations as individual stocks, sectors or industries rise in the index weights. One interesting recent phenomenon is the decline in the number of publicly traded companies which drives the annual rebalances to include smaller firms at the lower end of the market capitalization scale.  This plays to one of our competitive strengths of being smaller and nimbler than some of our small cap growth peers who have taken on larger amounts of AUM.  We are able to take meaningful positions in companies, even below $200 million in size, which have, to date, been important sources of alpha.

Our history as generalists is a strength allowing us to analyze companies regardless of the sector or industry that they reside in or whether they are characterized as “growth” or “value.” Our goal is to find sustainable future compounding opportunities wherever they might lie.  As a small cohesive team, we are able to avoid the territorial issues that beset most managers who split their teams by industry and sector.  We have the demonstrated flexibility to uncover profitable investment ideas often overlooked by larger peers, especially those driven by changes in management teams, new products or service models, and those that arise from acquisitions and divestitures or as newly public companies emerge through mergers.

In this mid-and post-COVID-19 world, there is perhaps one constant that is almost guaranteed – change will continue.  Positioning to analyze, capture and leverage investments that will benefit by change will separate those that can add real value to clients.

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