As the U.S. economy continues along the path of a slow but steady recovery, innovative companies and early developers make for good bets, according to Melissa Chadwick-Dunn, co-manager of the RS Small Cap Growth Fund Ticker:(RSEGX).
“Since last August we've come back toward more promising and developing companies,” she said.
Ms. Chadwick-Dunn, who manages the $600 million fund along with Steve Bishop and Scott Tracy, said the current market environment favors the bottom-up, small-cap, stock-picking strategy.
“We are bullish on the market, because small- and mid-cap stocks tend to be more domestically focused and the U.S. economy is doing better than most other economies right now,” she said. “And we think there's some pent-up demand to spend from the consumer because they're starting to feel better.”
The general strategy divides the portfolio into promising younger companies, developing companies, and proven companies.
The “promising” category, which tends to favor a risk-on market attitude, will include some newly public companies along with businesses that are showing signs of potentially strong growth.
The allocation to the promising category is usually between zero and 10%, with a lot of the names typically representing biotechnology companies with drugs still in the development pipeline.
The “developing” category typically represents between 30% and 50% of the portfolio, and includes companies that have established a competitive advantage, are profitable and are in the steep part of a growth curve.
The “proven company” category represents 50% to 70% of the portfolio, with characteristics such as clear leadership in niche markets, and solid valuations.
An example here is Align Technology Inc. Ticker:(ALGN), a leading developer of clear dental braces. “The market has been around for 10 years and they are starting to take share from traditional braces,” Ms. Chadwick-Dunn said.
Align's stock has gained more than 31% so far this year, compared with a 5.5% gain by the S&P 500 and a 6.5% gain by the medical-device category as tracked by Morningstar Inc.
“When we're buying a stock, the entry points are very important to us, because we want to pay a price that includes a 2-1 upside-to-downside ratio,” Ms. Chadwick-Dunn said. “If we buy in at $20, we have to have a price target of $30 over a 12-to-18-month time frame, and the downside is limited to half the upside based on the low end of the five-year historical valuation range.”
The portfolio of between 70 and 90 stocks concentrates on companies with market capitalizations of between $200 million and $5 billion.
The fund, which has a three-star Morningstar rating, has gained 7.4% from the start of the year, compared with a 4.5% average gain for the small-cap-growth category.
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