3 Questions: Federated Kaufmann Small Cap Fund

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

Q: Can you explain Federated Kaufmann Small Cap Fund’s strategy for pursuing growth? Federated Kaufmann 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 150 of our highest-conviction picks.

Also, nearly 60% of our current holdings were purchased as initial public offerings (IPOs), 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 great managements. Over more than 30 years of investing for growth, we have found that there are plenty of good ideas out there, but it is all about execution. That is a big reason why we personally visit managements before investing in their companies.

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 the potential for achieving 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: Now that the Nasdaq is at a record high, is it difficult to find strong opportunities at reasonable prices? The Nasdaq Composite Index is considered a Technology-sector barometer and it is big tech that has led much of the index’s outperformance; the FAANGS—Facebook, Amazon, Apple, Netflix and Google—account for nearly 30% of the index. But there are solid companies in the tech subsectors, for example in Health Care and Biotech, which are still ripe for opportunity. Also, areas in Consumer Discretionary and Industrials have underperformed relative to those mega-techs and we believe they have room to run. 

To use a hockey analogy, at Federated Kaufmann, we look to where the puck is going next. There will always be demand for new growth ideas, and innovation is in full force to address needs and create opportunities that most of us haven’t even conceived of yet. We are constantly on the hunt for the next FAANGs. In addition, the mega-caps are very likely to spend a good portion of their gains to maintain a high level of growth. So, as small-cap growth investors, we’re evaluating those "pick and shovel" plays—companies that sell the products, services and technologies that the big companies need to grow and compete. Also feeding that growth are strong merger and acquisition (M&A) candidates, many of which are small-cap companies.

Q: What is your outlook and positioning over the next three to five months? We believe earnings will continue to drive the market higher, which typically supports growth investing. That being said, along with an accelerating gross domestic product come headwinds in the form of higher interest rates as well as wage and price inflation, all contributing to greater volatility. In this type of environment, quality matters and selectivity becomes more important—that is where active management can make a difference. 

As growth managers, we like to have cash on hand to take advantage of opportunities, and that’s especially the case this year now that volatility has returned in force. So over the past several months, the portfolio has been holding a higher level of cash to give us “dry powder” that can be used to buy high-quality, mispriced companies caught in a downdraft. It also puts us in solid position to participate in attractive IPOs.

IPOs are a significant source of new ideas for the fund, as I noted earlier, and we’re happy to see that they are on the increase. There were 44 U.S. IPOs in the first quarter of 2018 and the fund participated in seven of them. This IPO uptrend is continuing (see chart, at bottom) and our team of managers and analysts are actively involved in evaluating each one of them for their long-term growth prospects.

Also, M&A activity increased more than 66% during the first quarter, with more than 40% of them in growth sectors, particularly Health Care and Technology. Even large, defensive companies are looking to capture earnings growth by acquiring successful, fast-growing small companies. In fact, one of the fund’s holdings, Blue Buffalo Pet Products, was recently acquired by Consumer Staples giant General Mills. We expect more of these types of deals ahead and believe Federated Kaufmann Small Cap Fund is well positioned to benefit.

Thank you, Steve and Jordan.