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.
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“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%.