As co-managers and subadvisors of the Reserve Private Equity Services Small-Cap Growth Fund (REGAX), Edwin Vroom and Adele Weisman make a point to talk not only to each other, but to the advisors who have entrusted them with their clients’ hard-earned money. “We are not hotshot portfolio managers in some ivory tower who won’t talk to the people who are investing in the fund,” says Vroom.
After working together as senior portfolio managers at Roanoke Asset Management in New York since 1978, the two have been subadvising the Reserve small-cap fund since its inception seven years ago. “There is consistency in our [professional] relationship and I think that is important,” Vroom continues. “That makes us a little unique. We have some gray hairs here and there, but we have worked together for a long time and we have a solid team in place.”
From researching investments, to answering investor questions, to even sharing an office, Vroom and Weisman have steered their fund and its shareholders through the bursting of the technology bubble in 2000 and a sluggish economy in 2001 and 2002. After staying true to their style, they are now reaping the benefits of their strict investment philosophy in 2003. “When someone invests in our fund, they are going to get small-cap growth,” he says. “We are very careful not to style-drift.”
For the five-year period ended August 29, 2003, Reserve Private Equity Services Small-Cap Growth/R had an average annualized total return of 19.4%, versus a total return of 2.5% for the S&P 500 Composite Index, 5.29% for the Russell 2000 Growth Index, and 8.3% for all small-cap growth funds. However, the fund’s returns have fluctuated over the last few years–from 135.83% in 1999 to -17.39% in 2001 and -38.17% in 2002–not unlike the majority of their peers.
“While we slightly underperformed our peers and the Russell 2000 Growth benchmark in 2002,” notes Vroom, “we outperformed both benchmarks during the three-year bear market that lasted from 2000 through 2002.” The fund’s technology weighting “impacted our performance negatively in 2002, but helped us in 2000,” he continues, but “is obviously helping us now as we stuck to our guns.”
We recently spoke to Vroom about the volatility of his fund, his firm’s research process, and how to recover and survive after a three-year bear market.
Tell me about your team management style. What are your roles in this fund? Roanoke Asset Management is the subadvisor for the Reserve small-cap growth fund. There are two managers on this fund, Adele Weisman and me. We are both principals and majority owners of Roanoke, and have been subadvisors since the fund’s inception [in November of 1994]. We each have very defined responsibilities for areas of the market. For example, Adele is responsible for anything that touches telecommunications, media, specialty retail, biotechnology, and a few others. I am responsible for technology, enterprise software, semiconductors, and semiconductor equipment, healthcare services, the financial area, and some portions of retail and energy.
We also have a third colleague who is strictly responsible for technology. While we work as a team, and all decisions are processed by the two of us, we each have very distinct areas of responsibility, and that facilitates accountability. If we run into an issue of semiconductors, Adele looks to me. If I am working on something in the semiconductor area and maybe [the company is] providing components to telecommunications, there is overlap there. We work with each other in idea processing. All of the ideas that go into the fund have been researched and analyzed by one of the two of us.
Can you go through your research process in selecting equities? We are small-cap growth managers. We define that as companies that are under $2 billion in market capitalization. The average market cap of our fund now is $800 or $900 million. In terms of what defines growth, we are looking for companies that can grow their top and bottom lines in excess of 15% over the next 18 to 36 months.
Two years ago that number was 20%, and it may return to 20%, but under the current economic scenario, it has just been a little more difficult to find companies that can grow [that strongly]. That’s the first cut. Then we look at characteristics that would define a growth company, [such as] profitability ratios. We are looking for financial characteristics that would define a vibrant and growing business, starting with the actual top and bottom line, but then we look underneath to make sure that the growth expectations are supported by levels of spending within the company that would fortify those kinds of expectations. That is the quantitative part [of the screen].
The real work is getting to know the company, understanding its products or services, understanding the dynamics of the particular space in which it operates, the size of the market available, and competitive issues facing the company. Small companies must be able to defend their competitive position against competitors either through patent protection, leading technology, or mindshare.
Finally, we get to know the people who are managing the company, the ones who are responsible for executing the growth strategy. It is a two-part process: quantitative, then qualitative. That’s where a lot of our work goes. That’s why the managers have defined areas of responsibility. It is hard to be knowledgeable across the board.
One of the tricky things about small caps is that they become mid caps as they become more successful–yet REGAX’s turnover is much smaller than its peers’. How do you handle the “grow-out-of-small-cap” issue? About 85% of the [holdings in the portfolio are] under $2 billion [in market cap] at time of purchase. But if we buy a company that has $1.5 billion of market capitalization, and it doubles, we are not forced to sell it, and we don’t. As we define small cap by market cap the company may be above $2 billion, but by the definition of growth characteristics, it will be exhibiting the same characteristics as any dynamic small-cap company. We find that putting an artificial sell criteria based on size in a growth stock portfolio doesn’t make sense.
Occasionally one of our companies will be bought by a large company, and at that point, the situation changes. At some point, a company’s size really does interfere with its ability to grow at those very high rates, and if in our judgment that is the case, then we sell it.
Your returns in 2001 and 2002 were in pretty deep negative territory–how did you perform relative to your peers? 2001 and 2002 were the only two years in the fund’s existence that we underperformed relative to our benchmark and our peers. If you look at the historical performance, the fund began in 1994 and through June of this year the compound rate of return for the fund was 13.5%, and if you look at the Russell 2000 Growth as one of the benchmarks we measure against, the compound rate of return for the same period was 4.2%.
So 900 basis points of compound outperformance is a very significant number. On a cumulative basis, our performance is 197% versus 43% [for the Russell Growth index], so it is quite a significant outperformance.
What sort of due diligence have you put in place to ensure such a large drop won’t happen again? 2002 was a very unusual year, and to try to remake the process based on what we think was a once-in-a-decade kind of occurrence would be a mistake. On the other hand, I think we pay a greater deal of attention to industry overweightings and underweightings, so we have modified the process going forward so that we will focus a little bit more attention on when our sector weightings begin to get too high. The nature of small-cap growth is such that if you make a correct industry sector bet, the weightings in those sectors can get very big very quickly. We told people a year ago that we would diversify a little bit more and hold [more] individual names in the portfolio. And we have done that. Two years ago, this was a portfolio of 40 names. Now we have 50, and we have a little bit more industry representation. We have a more important representation in the financial and energy areas so we can cut down some of the volatility going forward.
The volatility is something that we would like to try to reduce, but the fact is that small-cap growth is a volatile area and we have to accept that.
How do you determine the weight of each of your holdings? It’s mechanical. Typically, if you were running a 50-name portfolio, the names you really like would go in at 2%. For us, an individual name will go in between 1.5% and 2.5%.
What index do you benchmark against? How closely do you manage to the index? There is the Russell 2000 Growth, and then we use other mutual funds with characteristics similar to those of our fund as our benchmarks. Ultimately, on a year-to-year basis, you want to look at the Russell 2000 Growth, because that will explain short-term outperformance or underperformance.
In the long run, a fund like this should outperform all of the relative stock market indexes. After all, if you can’t beat the Standard & Poor’s 500 with a fund like this then you shouldn’t be [managing money]. Any manager that is actively managing a portfolio–particularly in the growth segment–should be able to beat the S&P 500, and we have done that hands down.
How often are current holdings reviewed? We review them daily because of the kinds of information that are accessible today. If there is any news coming out, or an earnings report, it is up there [on my computer screen]. My partner and I have a large trading room and sit 10 feet from each other, so our day consists of talking about what is going on in the market. I know what she is working on and she knows what I am working on, and the sharing of information is facilitated because we are in the same place.
Are you particularly careful not to allow style drift, since a consistent style appeals to advisors practicing asset allocation? Style drift is a very big issue for us. To a certain extent, not that adhering to our style is an excuse for underperformance, but we are as aware as anyone else of what’s in and what’s out at any particular time in the market, and we pretty much stick to our guns.
Is there a ceiling to your fund? This fund, given its characteristics, could grow to $800 million without liquidity being an issue. The real issue for any manager is how quickly assets come in.
How much of your sales are made through the advisor channel? Seventy-five percent are generated through the advisory channel.
What are you thoughts on New York Attorney General Eliot Spitzer’s accusations and indictments charging market timing and late trading fraud within the mutual fund industry? Do you expect greater scrutiny of the overall fund industry? I would consider our group to be so squeaky clean and the Reserve Fund to be so particular about any kind of regulation that I don’t worry about that. It doesn’t keep me up at night. I know what we do and as RIAs we have to follow all of the SEC items. We follow the letter of the regulation.
To the extent that there will be new regulations put upon us, that also doesn’t concern me. I think that what has happened is appalling. It is unfortunate, but it happens.
Any suggestions to advisors on how to ferret out the bad apples in the mutual fund barrel? I think the first thing you want to look at is how long the managers have been running the fund. If you have people who have been doing this for a fair amount of time, they [tend to] have good reputations and have followed the rules.
Why should someone invest in your fund–or recommend their clients invest in your fund–as opposed to a similar fund? Adele and I make ourselves available to the advisor community on a much more interactive basis, so when an advisor decides to put his client’s money in this fund, we will make ourselves available, if it is appropriate.
This is a very volatile world we live in, and maybe they want to touch base with the managers of the fund, and that takes 10 minutes. We respect that. We are portfolio managers and that is our primary responsibility.