3 Questions: Federated Kaufmann Small Cap Fund

08-29-2017

“3 Questions” delves into investment approaches used by Federated Investors strategists. This installment features Portfolio Manager Steve DeNichilo.

Q: Can you explain Federated Kaufmann Small Cap Fund’s strategy for pursuing growth? Federated Small Cap Fund is rooted in the same stock-picking approach we employ with our mid-cap and large-cap funds. We believe the way that investors can compound return in the stock market over time is by owning great growth companies—those capable of growing faster than the economy. For that reason, we don’t want to own the index, which in the case of small caps amounts to thousands of companies. Our fund holds just 100-150 of our highest-conviction picks.


Source: FactSet, as of 6/30/17
Portfolio holdings are subject to change.

Also, nearly 60% of our current holdings were purchased as initial public offerings, which represent growth opportunities seldom available to most investors. That further differentiates our capabilities and process.

Our process is straightforward. First, we look for companies with a competitive advantage—a wide economic moat that will allow that company to potentially make excessive amounts of profit over a long period of time. Second, we seek out great managements. Over more than 30 years of investing for growth, we have found that there are plenty of good ideas and products out there, but it is all about execution. That is a big reason why we personally visit managements before investing in them.

The third component is intensive fundamental analysis. The objective is to find companies whose intrinsic value is or could be greater than its value in the marketplace. As growth investors we’re focused on pursuing companies with accelerating levels of sustained growth—at least 20% over a 3- to 5-year period.

We don’t buy a stock unless we understand the company, its business and its competitive environment inside and out. In researching a promising company, we talk with its management, employees, competitors, customers and suppliers. We participate in more than 1,500 such meetings a year.

Q: What’s different about investing in small-cap growth stocks? Whether they are familiar names or undiscovered gems, small-cap growth stocks share the common attribute of potentially higher-than-average growth rates within their industries or within the broad market for years and even decades. The challenge is identifying the best of those companies early on. Small caps are a very dynamic part of the market with lots of innovation, much less coverage by Wall Street analysts and, of course, greater volatility. But it’s volatility that creates opportunity—especially for active managers like ourselves. Inevitable market dips only enhance our ability to seek out attractive, mispriced stocks.

As stock pickers, we’re looking at all areas of the market and are unconstrained by index sector weightings. Each stock has to earn its way into the portfolio based on all the quantitative factors—growth of sales and free cash flow, steady-to-increasing profit margins, etc. But an important difference with Federated Kaufmann is knowing how to identify the intangibles behind a company that can create tremendous value or destroy it in a short period of time. Our investment team includes a number of sector specialists who know their industries, know the people, know the science and have an insider’s access to unpublicized developments, company dynamics and trends.

That could include biotech companies on the cusp of a major pharmaceutical breakthrough or a service-as-a-software innovator with the ability to transform how people work and shop. And with small caps in particular, we’re looking to identify companies that are poised to play an ever-growing part in larger trends. For example, innovators like Amazon, Facebook and Google are tapping a wide range of smaller tech companies to develop key components for cloud computing and artificial intelligence services. Ford and GM are doing the same to enhance their autonomous vehicles. These unknown companies have potential to benefit shareholders as they grow or become attractive acquisition candidates.

Q: What’s your outlook and positioning over the next three to five months? Although early optimism regarding the Trump administration’s agenda and its impact on the economy has faded somewhat, we continue to see evidence of a continued stable or improving economy. We also believe that renewed emphasis on tax reform should benefit small companies in particular. That said, our fund management team has long held that whether the markets and economy are booming or more fragile, there will always be companies that have the potential not only to survive but to break through and achieve exceptional growth.

We remain focused on owning companies that can control their own destinies, investing in innovations that are less sensitive to economic changes. For example, even in a benign tech capital investing environment, software-as-a-service companies can continue to provide significant growth as companies utilize cloud services across the board—from “etailers” and medical/life sciences to government agencies—to improve coordination and work efficiencies. These types of companies, in our view, tend to create more value over time, and the market tends to value those business models with higher valuations.

Thank you, Steve