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Up-and-Coming Managers on Prospecting for Value

Insights from three managers in Morningstar's "on-deck circle."

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This analyst blog is part of our coverage of the 2015 Morningstar Investment Conference. 

At the final Friday session at the 2015 Morningstar Investment Conference, three fund managers whom Morningstar’s manager research group has deemed “Morningstar Prospects,” or up-and-coming managers, offered their views on how they think about investing.

For those not familiar, Morningstar Prospects is a quarterly report--available as a download in Morningstar Direct--that provides a look at new, lesser-known and up-and-coming managers and strategies that are on Morningstar’s manager research group’s radar screen for future full coverage. While the reasons vary for why our analysts do not yet rate these strategies--in some cases, the funds are too new, while in other cases, it may be a case of an experienced manager taking the helm of a newly created fund--all managers represented in Morningstar Prospects are ones with the potential to “graduate” to full coverage. And Morningstar Prospects is a terrific way for investors to gain some insights into new strategies that have caught the interest of Morningstar’s manager research analysts.

At the conference, the managers of three strategies recently highlighted in the first-quarter edition of Morningstar Prospects spoke optimistically about their views of the markets. On the panel were Andrew Adams, the lead manager of  Mairs & Power Small Cap (MSCFX), which has a Morningstar Analyst Rating of Silver; Chad Meade, the comanager of Meridian Small Cap Growth MISGX; and Finny Kuruvilla, the comanager of  Eventide Gilead I (ETILX), which has a Morningstar Analyst Rating of Neutral. (The Mairs & Power and Eventide Gilead funds recently have graduated to full coverage.)

All three managers delve into the small-cap arena and offer unusual strategies. Eventide Gilead’s comanagers use religious screens (avoiding stocks having to do with abortion or pornography) as well as secular social screens (such as avoiding tobacco, weapons, and violent video games), and then layers on a positive screening approach evaluating how companies relate to various stakeholders. Mairs & Power Small Cap’s managers, by contrast, focus heavily on small companies headquartered nearby in the Upper Midwest and also runs a fairly concentrated portfolio. Meridian Small Cap Growth’s managers labor to identify companies with competitive advantages that offer downside protection and that are able to avoid falling into the bottom quintile of the small-cap universe, performance-wise.

Adams acknowledged that one minor risk to his strategy is if too many companies based in his home state of Minnesota or in surrounding Upper Midwest states are acquired by firms headquartered elsewhere. While such moves could be favorable from a performance standpoint if the firms acquired are portfolio holdings, he said a shrinking universe of companies in the Upper Midwest might force Mairs & Power to cast a wider net, geographically, in considering potential investment ideas. He also noted that if an acquirer based elsewhere is a company that his firm is comfortable with, Mairs & Power may well choose to continue to hold a position in the acquirer.

Meanwhile, Kuruvilla dismissed a question about whether he feels that the ethical and religious component of his strategy limits his ability to tap good investment opportunities, particularly in the health-care arena. "I actually believe it forces you to a discipline that over the long haul will produce a great return," he said.

Meade, who also manages Bronze-rated  Meridian Growth (MERDX) as well as a small sleeve of Neutral-rated  Vanguard Explorer (VEXPX), said his fund does invest in initial public offerings. "A lot of times we see things we've seen before," he said. "In small-cap, we think we're investing in the American dream."

The managers held differing views on how much cash they will hold in their funds. Meade said his fund tries to keep cash to about 5% of its portfolio, in an effort to preserve some “dry powder,” while Adams said his fund tries to keep cash levels low. Kuruvilla, by contrast, is willing to hold higher levels of cash at times.

The panelists agreed that the small-cap space is inherently less efficient and therefore offers managers more of an opportunity to add value and differentiate themselves. The space also has enjoyed a tailwind, Adams noted, by virtue of the fact that most small-cap firms "are more domestically focused and the U.S. economy has just been very strong relative to the rest of the world."

Kuruvilla emphasized the ways that small-cap companies can build value and grow into much larger entities. "There's unbelievable innovation today that’s setting the stage for in my opinion decades of very interesting small-cap performance," he said.

Meade, meanwhile, cautioned the need to be "selective" with small-cap names in this environment. "We’re six years into a bull market," he said. "It would be tough to argue for multiple expansion, especially with rising interest rates. So it comes down to the fundamentals of the companies you own. In small-cap, you can find companies that create their own economic destiny. Buy a company you like and concentrate."

Robert Goldsborough does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.