The secret to investing in small-cap stocks isn't just knowing how to spot winning ideas. It's also knowing when to let them go.
As a reminder, Samantha Lau has some rules to that effect scribbled on a whiteboard in her office in Midtown Manhattan. "Rule No. 1 is never sell half of your position," says Lau, co-manager of the $1.9 billion AB Small Cap Growth Portfolio (QUASX) and co-chief investment officer of small and SMID growth strategies at AllianceBernstein. "If you think something is wrong, exit and revisit."
Other rules: It's never too late to sell a loser, and "CFOs don't quit to spend more time with family," she says. In most cases, Lau maintains, financial chiefs of small companies leave because they see better opportunities elsewhere or trouble ahead–neither is a good sign. Perhaps the most important axiom of all: "A good company is not always a good stock." To make a distinction, Lau and her four co-managers adhere to a 25-year-old process that combines fundamental research and quantitative indicators.
Their goal is to find small companies that can grow faster than the market expects—and minimize the opportunity cost of owning stocks that stumble along the way. Upshot: The fund has returned, on average, 20% a year over the past decade, better than 95% of its small-growth peers.
Born and raised in Hong Kong, Lau won a scholarship to a U.K. boarding school at age 16. From there, she headed to the University of Pennsylvania's undergraduate business program. "The first time I ever set foot in the United States was the weekend before school started," says Lau, who after graduation landed a job in equity research at Goldman Sachs.
A few years later, she followed a colleague to boutique asset manager Chancellor Capital Management, where she began covering small technology stocks in 1997. Small-cap investing was still nascent and focused on story-driven stock-picking. Chancellor's strategy was unusual, in that it was built on a process and backed by a quantitative tool. In late 1998, Invesco bought Chancellor and consolidated its small-cap portfolio management. Lau and her co-managers opted to stay in New York and found a home for their strategy at what is now AllianceBernstein.
Two decades later, Lau and her colleagues adhere to the same process. They start with the 1,200 stocks in the Russell 2000 Growth Benchmark, and quickly cut that list in half, using liquidity, growth and quality screens. They divide the remaining names by sector—Lau continues to focus on technology—and independently assign subjective rankings of one to five for the companies' 12- to 18-month outlooks: 10% of the names get the highest ranking of one, 20% get twos, 40%, threes, and back down the bell curve. "We focus on the ones and the twos," says Lau.
Meanwhile the team's quantitative analyst runs a weekly model that scores those 600 stocks using such factors as revenue and earnings revisions, as well as price and earnings momentum. The team combines the two rankings, with a 60% weighting for fundamentals and 40% for quantitative factors. They ultimately come up with 200 stocks that they can buy or continue to hold.
"What that quantitative tool does is keep us on track," says Lau. There is some discretion for managers to keep holdings that don't make the final ranking—they cap that group at 5% of assets—but they can't add to such positions.
Although the process forces the managers to revisit stocks weekly, many of AB Small Cap Growth's (QUASX) roughly 100 holdings have been in its portfolio for years. The fund first took a small position in cloud-based communications company RingCentral (RNG) in 2013 when it had less than $200 million in revenue. RingCentral offers smaller firms an inexpensive alternative to traditional business phone networks. Among other things, the service routes inbound calls to IP phones, smartphones, tablets and computers.
As RingCentral's profitability improved—and its customer base expanded to larger enterprises—Lau added to the position. "I've owned it for 5½ years, and it's now on track to hit $1 billion in 2020, two years ahead of schedule," she says. While the fundamental story has been consistent, the quantitative model supported Lau's decision to hold on. "It's never missed a quarter," she observes.
Likewise, Lau first took a meaningful position in The Trade Desk (TTD) in March 2017 when the stock was around $35. The company is a leader in programmatic ad buying, a $30 billion market that's growing at a double-digit pace. You've been subjected to programmatic ad buying "after you search for a vacation destination a few times and things start popping up left and right," she says. "It uses software and automation to match ads with eyeballs." She figured the company could exceed the consensus outlook of 30% top-line growth, which it did handily.
Another top holding, exercise juggernaut Planet Fitness (PLNT), has also grown at a healthy pace during its more than three years in the portfolio. At first glance, the fitness market seems saturated, Lau acknowledges, but Planet Fitness has a price point that caters to the casual gym goer and ultimately gives the chain an edge. "You have a phenomenal operator that is very good at managing both the company-owned facilities and the franchises," she adds. At the same time, same-store revenue is increasing. Put it all together, and it adds up to double-digit top-line growth and still better earnings gains, thanks to economies of scale.
When a holding runs into challenges, AB Small Cap Growth's quant model flashes a yellow light, and Lau makes the call on whether to hold on. Such was the case when energy prices plummeted in 2014 and software and services outfit Aspen Technology (AZPN) suffered because of its close ties to the sector. Even so, the fundamental story was one of a single player offering mission-critical services to oil and gas producers and refiners that continued to invest in research and development throughout the downturn. Result: The company rolled out a new category of products, boosting its share of its customers' spending and making itself more indispensable, she says.
Had the fundamental story not been so strong, however, Lau would not have thought twice about exiting the position. "I don't like to dawdle," says the self-described pragmatist. "As I say to my team, 'If you can't explain in five minutes why we should keep a holding, we need to move on.'"
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