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Fund in Focus: Putnam Small-Cap Growth Fund

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In a previous career as an environmental engineer, Rick Weed tackled hazardous jobs like managing noxious gases on Staten Island’s Fresh Kills landfill and removing heavy metals from water at a Midwestern chrome plating plant. Now, as lead portfolio manager of Putnam Small-Cap Growth Fd/A (PNSAX), he handles small-cap U.S. equities rather than toxic waste. But he’s still committed to separating the good from the bad.

Weed’s investment style combines high technology with a human touch, utilizing both computer models and fundamental analysis. The goal is to replicate the benchmark, the Russell 2000 Growth index, in terms of sector and industry weightings, size, volatility, and other measures, while exceeding its returns. The top priority is simply to select the best-performing stocks in the fund’s universe.

For the year ended November 30, Putnam Small-Cap Growth returned 14.3%, versus 10.2% for the index, and 10.5% for the average small-cap growth fund. For the three years ended in November, the fund registered a 21.2% average annualized return, versus 18.9% for the index, and 16.8% for its peers. Launched in March 2002, the $254.8-million fund carries an expense ratio of 1.55%, versus 1.59% for its peers. It is ranked 4 Stars by Standard & Poor’s.

Weed starts with an 1,800-stock universe by choosing stocks in the benchmark that are between $100 million to roughly $4 billion in market cap, and adding another hundred slightly larger companies. He uses computer models to narrow this field to about 600 stocks, screening for traditional analytical measures such as valuation relative to growth prospects and earnings quality. Weed stresses that he doesn’t want a company that is “playing games with its balance sheet.”

The fund’s six fundamental analysts then get to work on evaluating those stocks. They conduct due diligence by talking to the CEO, CFO, and marketing and sales director of each company they’re interested in — together and separately. “If those three people are not on the same page, the company is not going to work — especially if it’s a small-cap company,” he says. The interview process is taken seriously. Several years ago, Weed says, the fund invited former CIA agents to instruct the analysts on techniques for recognizing when people are not telling the truth, such as body language and eye contact.

Based on the analysts’ research, the universe is reduced to about 300 stocks. Weed runs those 300 stocks through a Barra risk model, which composes a portfolio that resembles the weightings of the benchmark. In the end, Weed makes all of the buy, sell, and trim decisions based on the analysts’ and the quantitative models’ input.

On a daily basis, Weed runs computer screens on the portfolio to see whose metrics are rising or falling. If a stock becomes highly valued while company earnings are not growing, he may decide to trim the holding. If the analyst following the stock believes it is no longer performed as expected, he or she may advise selling it. As of November 30, 2005, the fund held 249 securities. Its one-year turnover rate is lower than average — 92.37%, versus 120.78% for its style peers.

The fund tracks the index by sector and industry within four percentage points and seldom excludes any given sector. “If technology were 20% of the index, even if I hated it, we’d have 16% in the portfolio,” Weed says. The fund’s largest sector weights technology (21.9% of assets as of October 31), healthcare (20.0%), consumer cyclicals (16.4%), and financial services (12.6%). Top holdings as of September 30 (latest available) are Comtech Telecommunications (CMTL; 1.4% of assets), ValueClick Inc. (VCLK; 1.3%), Salix Pharmaceuticals (SLXP;1.2%), Intergraph Corp. (INGR; 1.1%), and KCS Energy Inc. (KCS; 1.1%).

Among top performers, Weed gives educational service company Blackboard Inc. (BBBB) a high grade. The company provides colleges with a Web platform for distribution of course materials, notes — even videotaped lectures — and facilitates online discussion. Weed says that once Blackboard is adopted by a school, “students don’t want to give it up,” so that existing customers tend to yield recurring revenues. Additionally, those customers help the company develop its platform by requesting specific features. Once a function is created to satisfy one school’s demands, it can be offered to other schools as well.

Weed also praises CONSOL Energy (CNX) and ValueClick. He likes the earnings growth that the Consol’s high-BTU, low-sulfur coal has been enjoying as a substitute for oil, aided by long-term supply contracts. Asked about ValueClick, Weed says, “[T]hey’re really good at providing companies who are using the Internet with data about who’s looking at what.”

Weed’s background in maneuvering around hazards may have given him insight during the recent troubled years at Putnam. In the wake of 2003 mutual fund industry investigations, Putnam Investment Management agreed in April 2004 to pay $110 million to settle charges that it permitted rapid trading and market timing in its mutual funds. In March 2005, Putnam agreed to pay an additional $43 million to shareholders, based on an independent assessment report of losses incurred by the company’s practices and subsequent redemptions. It also agreed to return $40 million to shareholders to settle SEC charges that it failed to disclose preferred marketing arrangements with broker-dealers. In addition to the fines, Putnam instituted trading restrictions, redemption fees, disclosure of manager and executive pay and brokerage commissions, and other measures to regain investors’ trust.

As a co-manager on the Putnam Small-Cap Growth since inception, Weed was named portfolio manager in July 2004, after the departure of former lead manager Anthony Sellitto in June. (Spokeswoman Sinead Martin wrote in an e-mail that Sellitto’s departure was for personal reasons and not related to improper trading.) Weed stresses the continuity of the fund’s strategy despite the management change. “Since I’ve been with the fund, we haven’t changed anything at all,” he says. “My job is stay above median, to not be in the fourth quartile, use our process, control risk, and outperform over time.”

While the Small-Cap Growth Fund has outperformed its benchmark since inception, Weed holds modest expectations for the asset class in the coming year. For one thing, the stocks have gotten expensive. For another, as of December 31, their returns will have exceeded those of large caps for six years in a row. Although he believes that investors should “be in all asset classes all the time,” he states a preference for adding marginally to large-cap holdings at present. “We at Putnam all pretty much agree with this — large caps should probably do better than small caps going forward for the next year or so,” he says.

Weed considers the economy at present to be in a mid-cycle slowdown, and compares it to 1994, when the Federal Reserve was raising interest rates out of concern that the economy was overheating. “When they stopped raising rates, we had 1995-97 — good markets that made rational sense,” he says. “The Fed is very worried about inflation now, but if we still have earnings growth without the inflation, they’ll probably ease up a little.”

Contact Bob Keane with questions or comments at: [email protected].


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