Quick Take: Tim Stevenson of Evergreen Special Equity (ESEAX) has found that price momentum has been the best and most consistent predictor of stock price. Unlike many small-cap growth managers, however, Stevenson and his team of four do not meet with management. A stock selection model, which emphasizes price momentum, is used to cull and to rank the stocks that go into the $300-million portfolio.
For the three-year period ended in May, Evergreen Special Equity returned 1.8%, versus 2.5% for its small-cap growth fund peers. However, Special Equity has been less volatile on the downside, as evidenced by its relatively lower standard deviation and beta. For the one-year period ended in May, the fund fell 9.4%, versus a loss of 15.1% for its peers. But Stevenson sees light at the end of the tunnel now, believing that small-cap growth will soon outperform as an asset class. The current pessimism toward small-cap growth and the wide embrace of value are signs to Stevenson that the pendulum is about to swing the other way.
The Full Interview:
S&P: What is distinctive about the portfolio?
STEVENSON: It comes down to the investment style. We are a little more quantitative and have a smaller team rather than a bigger team that does only fundamental coverage. We still dig through 10ks and 10Qs, but company contacts aren’t as important to us.
Price momentum is a large driver of our process. I’m not sure that other investments look as closely at price momentum. It makes up 60% of our quantitative model.
S&P: How do you decide your industry weightings once stocks are selected?
STEVENSON: The industry weightings are a natural fallout of the investment process and the stocks we find. Everything has to be integrated, from the original research to the construction of the portfolio to the trading.
We have the ability, subjectively, to change the risk composition in the portfolio. There are many ways to assume risk — market cap, valuation, momentum — and with some of the risk models like Barra’s risk model, for instance, we can try to decide where risk might bulge out in the portfolio.
S&P: What about the stock selection process. Is that constant?
STEVENSON: Yes. Getting to our group of potential buys and ranking stocks is a systematic, disciplined approach. We don’t change it, except when we find better factors at work. It is unemotional. We don’t fall in love with stocks, and we don’t hate them. It is 60%-70% quantitative. That gets us to the list we work with each week. Technical analysis also plays a big role. We can’t tell you much about a company without looking at its chart as well.
S&P: So for a stock to be a candidate in your fund it must first satisfy your quant model?
STEVENSON: Yes, first and foremost.
Price momentum makes up the majority of the underlying stock selection model (60%). We try to identify the key drivers of small stock prices, specifically small growth stocks. We found that price momentum was the best and most predictable or most consistent predictor of stock prices. This is longer term price momentum that is adjusted for volatility. We are thinking of yearly changes, not chasing this week’s winners.
We also look at forecasts for earnings surprises. Not earnings surprises themselves, but a forecast of which companies may disappoint on earnings.
There is a valuation component, too. What role should valuation play for small growth stock investors? We are already buying stocks of companies that have high expectations and that are high multiple stocks. (Nevertheless) we don’t want to stay at the party too long. If they disappoint, they disappoint in a big way, and can be down 40%-50% in a day.
S&P: The turnover on the fund is around 150%. Has it been higher as the market has become much more volatile?
STEVENSON: As the market has shifted we have sort of followed the trend, to some degree. The turnover has gone up a little bit. We want to fight against that because it is a drag on performance. We spend a lot of time wrestling with this. If it were possible, we would love to identify growth stocks that would keep us in a range of 25% turnover.
S&P: About how many positions does the fund have?
STEVENSON: Anywhere from 125 to 150. We are broadly diversified. Though our benchmark, the Russell 2000, is cap weighted, we don’t have issues such as General Electric (GE), where we must sort of snug up to the benchmark.
S&P: When do you sell?