Just up the road from where Nobel Prize winner Eugene Fama developed his efficient-market hypothesis, Mike Balkin and Ward Sexton are all about finding inefficiencies. Like Fama, the Chicago-based managers favor smaller firms, but their aim is to discover growing companies that the market doesn’t yet see or understand—a firm with an energy-industry technology with much wider applications, for instance, or a retailer of cowboy and work boots whose public debut coincided with the oil patch’s double-digit collapse in prices.
“We’re not afraid to be contrarian at times,” says Balkin, 59, who helped launch the $668 million William Blair Small Cap Growth fund (WBSNX) in 1999. He left the Chicago-based firm in 2005 to work at a hedge fund, then returned in 2008 with a new appreciation for buy-and-hold investing.
Sexton, 44, started working with Balkin as an analyst in 2001 and helped build out the small- and mid-cap team to what it is today—the two portfolio co-managers and nine dedicated sector analysts. Most of them have been together for a decade and share a zest for finding ideas that the rest of the market has skimmed over. It doesn’t happen every day, or even every month, says Sexton, “but when you find something, you don’t want to do anything except figure out if you’re right.”
If their track record is any indication, this happens with some frequency. The fund ranks in the top quartile of its peers for every major trailing time period going back 15 years. Over the past three years, it has returned an average of 19.4% a year, beating 94% of small-growth funds tracked by Morningstar. It has outpaced the Russell 2000 Growth Index (.RUT) by about two percentage points a year over the past decade.
The fund assembles its 80 to 90 holdings through a process that Balkin likens to creating a mosaic. Ideas come from many places and for a variety of reasons, but most companies fall into three categories: traditional growth, undiscovered, and fallen growth.
Ligand Pharmaceuticals (LGND), which the fund has held for five years, was one of the undiscovered. Like many small health-care companies, it started with a single product, but it now manages a portfolio of assets based on its Captisol technology, which improves solubility, stability, bioavailability, and dosing of active pharmaceutical ingredients. Ligand partners with other pharmaceuticals to help them develop their products—and collects royalties on sales.
More than half of its programs are in clinical development or later stages, says Balkin. The company, started in 1987, already is very profitable, he says, and on track to generate $10 in earnings per share—up from less than $6 a share for 2018—by 2021. As a result, Ligand is “now right squarely in the camp of the traditional quality growth names,” he says.
Protein engineering firm Codexis (CDXS) has followed a similar path. The company was originally started with funding from Royal Dutch Shell (RDS/A), which was interested in using protein engineering to speed up the production of ethanol. “Then the ethanol market tanked,” says Balkin, whose fund bought the stock in June 2016 at about $4 a share. But the market was missing something: The company’s technology had much broader applications, including in health-care, food, and industrial markets. Codexis now counts 20 of the largest global pharmaceuticals among its customers. It’s also developing its own therapies—with most of that upside not priced into the stock, which recently traded at $14 a share.
Data security is a hot topic, yet when the William Blair team first came upon security software company Varonis Systems (VRNS), it wasn’t widely followed by analysts or institutional investors. While its software protects companies from external threats, the real differentiator, says Balkin, is what it does for inside threats—spotting employees or vendors acting in a malicious manner or accessing data that should be off limits.
Balkin and Sexton liked the idea even before Europe rolled out the General Data Protection Regulation, or GDPR, but the new regulation for how companies manage and protect customer data should provide a multiyear tailwind for Varonis. “This is a company that could grow earnings 30% a year over the next three to five years,” says Balkin of the holding, which was added to the small-cap portfolio in March 2017.
With more than 200 stores in 29 states, Boot Barn Holdings (BOOT) is the country’s largest retailer of Western wear and work boots. The 40-year-old company missed a step, however, not long after it went public in late 2014—just in time for oil prices to crash. “It’s not that the company is just in the oil patch by any means, but a decline in sales in those areas did have a negative effect,” says Sexton. Believing it was only temporary, the managers bought the stock in July 2017 when it was trading around $8 a share, or about 13 times earnings—a classic example of the Blair fund’s “fallen growth” strategy.
Today, at more than $26 a share, the stock has bounced back, but Sexton and Balkin think the company still has more to offer investors via double-digit earnings growth and multiple expansion.
Its private-label business is growing, and offering higher margins in the process. Unlike other apparel makers, however, Boot Barn’s niche isn’t particularly vulnerable to the whims of fashion. And while Boot Barn has a strong online presence—which gives it insight into future store development—it is one retailer that isn’t losing share to e-commerce behemoths. Chalk it up to the nature of buying cowboy boots, says Sexton. The look and the fit have to be just right, and Boot Barn seems to deliver on both. It’s a great fit for the fund, too.
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