MW Four hidden gems in the stock market from a five-star fund manager
By Philip van Doorn
Investors might be well served by expanding beyond the S&P 500
Even an index-fund investor should reassess their investment portfolio once in a while for performance and concentration risk. And despite higher expenses, actively managed funds may still work for you - at least for part of your portfolio.
An interesting example is the Touchstone Small Company Fund SIGWX, which is rated five stars (the highest rating) within Morningstar's "Small Growth" fund category. The fund is managed by Jason Ronovech of Fort Washington Investment Advisors in Albany, N.Y., which is the fund's subadviser, with $112 billion in assets under management at the end of 2023. Both Touchstone and Fort Washington are subsidiaries of Southern Financial Group of Cincinnati.
During an interview with MarketWatch, Ronovech and Chris Shipley, Fort Washington's co-chief investment officer, described their investment philosophy.
The case for small-caps and active management
Index funds continue to grow in popularity, with advantages including low expenses, diversification and the ability to outperform any active money manager. But your index fund may be less diversified than expected - and your index fund may also have gotten pricey.
The SPDR S&P 500 ETF Trust SPY is well known for being the first exchange-traded fund to track the large-cap benchmark S&P 500 SPX. It holds all 500 stocks. But since the index and the fund are weighted by market capitalization, three companies at the top - Apple Inc. $(AAPL)$, Microsoft Corp. $(MSFT)$ and Nvidia Inc. $(NVDA)$ - make up 23.3% of the fund.
The benchmark index for the Touchstone Small Company Fund is the Russell 2000 Index RUT, which is typical for a fund operating in the small-cap space. But this index includes hundreds of unprofitable companies. Another small-cap benchmark that might be a better choice for investors is the S&P Small Cap 600 Index SML, because S&P Dow Jones Indices' criteria for initial inclusion in this index includes positive earnings for the past four consecutive quarters combined.
Now let's look at how weighted forward price-to-earnings ratios have moved for three broad S&P indexes. These ratios incorporate consensus earnings-per-share estimates for rolling 12-month periods among analysts polled by FactSet:
Stock index Forward P/E Forward P/E a year ago Forward P/E to 5-year average Forward P/E to 10-year average
S&P 500 22.3 19.5 112% 121%
S&P Mid Cap 400 16.7 14.5 104% 105%
S&P Small Cap 600 16.6 13.9 107% 107%
Source: FactSet
We are still in a bull market, so all three indexes are trading above their five-year and 10-year average forward P/E ratios. But this effect has been magnified for the top-heavy S&P 500 - especially when compared with its 10-year average valuation.
"Adding small-cap exposure adds diversification and reduces concentration. The S&P 500 has become almost a growth index," Ronovech said.
The large-cap index is expensive because the stocks have performed better over the past five years. Shipley credited the large-caps' outperformance to "better earnings growth," but with interest rates declining and what may turn out to be a friendlier business climate starting next year, "we might have a more favorable earnings growth story [for small cap] relative to large cap," he said.
The small-caps "generate a higher percentage of their revenue in the U.S." than large-cap companies, Ronovech said.
Fund performance
For five years through Friday, the Touchstone Small Company Fund's Class Y shares returned 76%, compared with a 61% return for the S&P Small Cap 600 Index and a 53% return for the Russell 2000. Those returns assume reinvestment of all dividends and capital gain distributions. The return for the fund is net of expenses (currently 0.91% of assets under management annually), while the index returns include no expenses.
For five years, the fund's performance has ranked it in the 23rd decile in Morningstar's Small Growth category, while its 10-year return ranks it in the seventh decile.
"When you think about where to apply active management, small cap is a good place for that. You have a higher propensity for managers to beat the benchmark," Shipley said.
Ronovech cited a focus on quality as the reason for reduced volatility. He said that since the fund was established in May 2007, its downside capture, relative to the Russell 2000 had been 84%, while its upside capture to the index had been 92%.
Fund holdings and four examples of stock picks
The Touchstone Small Company Fund has $1.2 billion in assets under management and holds 74 stocks.
Ronovech said he and members of Fort Washington's research team work together to select investments from a group of about 1,000 companies in the Russell 2,000 that are profitable and pass screens for quality, including relatively low debt levels and high percentages of cash flow relative to net income. They also isolate companies with high net profit margins.
Assuming a company passes all of the team's screens for levels of debt, cash flow conversion and profit margins, they dig further into individual companies to decide which ones are most likely to continue showing "high incremental profit margins and earnings growth."
The fund has a 59% annual turnover rate, which might seem high. But Ronovech explained that about 30% of the fund's holdings tended to be new positions in any given year, with the rest of the turnover resulting in "tactical allocations."
"We hold positions long-term, but we reduce to a core weight and then take advantage of the market to add back to positions," he said. The typical holding period for a stock is three years, he added, with the position changing in size depending on how its share price has moved up and down.
Ronovech discussed four of the fund's holdings. This table shows projected compound annual growth rates for their revenue and earnings per share from 2024 through 2026, along with those for the S&P Small Cap 600, based on consensus estimates among analysts polled by FactSet:
Company Ticker Forward P/E Two-year estimated sales CAGR through 2026 Two-year estimated EPS CAGR through 2026 Globus Medical Inc. GMED 24.3 6.7% 14.5% CarGurus Inc. Class A CARG 19.7 9.3% 15.4% Texas Roadhouse Inc. TXRH 26.2 9.4% 12.8% Progyny Inc. PGNY 24.7 6.2% 28.6% S&P Small Cap 600 SML 16.6 4.6% 18.5% Source: FactSet
Globus Medical (GMED) makes devices used for spinal surgery. The company acquired NuVasive, a competitor, in September of last year. Ronovech said the acquisition hadn't been well received by investors because "historically, mergers in the spine industry have not played out well." But he said he and his colleagues were "big fans" of Globus's management team, as well as the merger.
"They combined two of the best portfolios for spine, with complementary synergies, with customer bases," he said. He added that it was a "rarity" to find a small-cap medical technology company that could show a 20% annual earnings growth rate, which is what he expects Globus to achieve over the next several years. That expectation puts him ahead of the analysts polled by FactSet, as you can see on the table.
CarGurus $(CARG)$ runs a vehicle-sales platform to connect buyers with dealers for local or online purchases. Analysts expect the company to show an annualized sales growth rate more than twice as high as that of the S&P Small Cap 600 over the next two years. According to Ronovech, CarGurus is in a leading position because "50% more people go to their website than the closest competitor." This is another company that he expects to achieve a 20% annual EPS growth rate.
Texas Roadhouse $(TXRH)$ owned and operated 635 restaurants as of the end of 2023, with another 106 franchised. The total of 741 restaurants was spread among 49 states and 11 countries. Smaller brands operated by the company include Bubba's and Jaggers.
Ronovech said the company has shown a compound annual growth rate for sales in the double digits over the past 20 years. He said the fund had held the stock for more than 10 years and that unlike most competing restaurants, Texas Roadhouse's sales growth had resulted mainly from market share increases and not price increases. He said the stock's current valuation was "reasonable for industry-leading profitability metrics."
Progyny (PGNY) provides fertility-benefits management for large companies. This is a highly personalized service, which takes the patient "from preplanning through coordinating IVF cycles and pharmacy benefits," Ronovech said. He also said that more employers were providing higher-level benefits for fertility services.
He said that Progyny had been providing fertility benefits services to more than one million people a year for several years.
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December 16, 2024 13:32 ET (18:32 GMT)
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