This Small/Mid-Cap Fund Holds Promise

The following is our latest Fund Analyst Report for LKCM Small-Mid Cap Equity LKSMX

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LKCM Small-Mid Cap Equity's veteran leader and strong supporting cast support its Morningstar Analyst Rating of Bronze for its lone share class.

The strategy has ample resources. Steve Purvis started the separate-account version in April 2005 (and the open-end vehicle in May 2011) and has led sibling LKCM Small Cap Equity LKSCX since 1999. Purvis is backed by LKCM's 14-person equity analyst team, whose members average an impressive 17 years at the firm. Firm CEO and CIO Luther King and his son Mason King join Purvis as managers, though they aren't as involved in day-to-day operations--Purvis remains the driving force behind the strategy.

Purvis relies on a sensible valuation-sensitive growth approach that is sometimes hampered by a top-down element. He looks for companies with strong market share and returns on capital, putting a premium on stable balance sheets and avoiding unprofitable or speculative areas like biotech. Purvis also incorporates macroeconomic views but with limited success. For example, the strategy underperformed its Russell 2500 benchmark and peers in the latter half of 2016 after Purvis shifted the portfolio toward more economically cyclical names.

This strategy's portfolio has long maintained a growth bias as Purvis hangs on to winners and tolerates higher price multiples for companies with attractive growth prospects. Purvis' preference for established competitive advantages and attractive valuations has led to a consistent overweight in industrials, but he has found fewer opportunities in consumer stocks--he usually underweights discretionary while avoiding staples entirely. Following the coronavirus crisis, Purvis looked to add cyclical names that would benefit sharply from a rebound, such as Wingstop WING and insurance providers like Kinsale Capital Group KNSL and Palomar Holdings PLMR. Purvis has tweaked the portfolio's breadth several times in seeking to improve performance but with lackluster results. While the strategy has not outperformed in recent years, its infrastructure still gives it a chance to succeed going forward.

Process | Average While Purvis' approach is sensible, its unsuccessful incorporation of top-down analysis limits its Process rating to Average.

This strategy's hybrid nature reflects Purvis' leadership, balancing aggressive growth elements with a focus on profitability. While bottom-up analysis primarily dictates positioning, Purvis also incorporates top-down macroeconomic views into his allocation, shifting between stable growers and more cyclical companies. While Purvis' tenure dates to the April 2005 launch of the separately managed account, his approach's effectiveness has waned. For example, top-down analysis drove Purvis to shift the portfolio toward more economically cyclical names in the first half of 2016, contributing to underperformance in the latter half of the year. Purvis often looks to comanager and firm founder Luther King, who focuses more on high-level guidance, for macroeconomic input.

Purvis focuses on stocks in the $1.25 billion-$18.00 billion market-cap range, looking for companies with sturdy economic moats as proxied by market share, returns on capital, and strong balance sheets. He's often willing to pay higher multiples for stocks with favorable growth prospects such as pet food provider Freshpet FRPT, especially when he views the broader economic outlook favorably.

People | Above Average Although Purvis has struggled in recent years, his experience and the firm's deep analyst roster contribute to an Above Average People rating.

Purvis has led this fund since its May 2011 launch and its accompanying separate account since its April 2005 inception. He joined the firm as director of research in 1996 and took over LKCM Small Cap Equity in 1999. His cast of comanagers here has shifted. Analysts Jonathan Deweese and Benjamin Cowan, who weren't involved in the strategy's day-to-day management but were listed as managers until May 2017, continue to cover industrials and consumer stocks, respectively.

Purvis is joined by firm founder Luther King, a listed manager since the strategy's inception who spends most of his time running LKCM Equity LKEQX. Mason King, son of Luther King, became a comanager of this strategy in 2017 after joining the firm in 2004 and spending time as a small-cap analyst. Although a listed manager since 2017, Mason King spends more time on his other charges, and Purvis retains decision-making responsibility.

A long-tenured team of 14 equity analysts averaging 16 years at the firm supports Purvis, including a pair of small-cap generalists who help generate ideas for this strategy and its small-cap sibling. Purvis invested over $1 million in the fund as of June 2020.

Parent | Average Luther King Capital Management faces some challenges that have somewhat dimmed our view of the firm, which now earns an Average Parent rating.

While the long-term performance of many of this quality growth shop's funds is sound, flagship offerings LKCM Equity and LKCM Small Cap Equity haven't kept pace with peers since the 2008 financial crisis. Along with industry pressures facing active domestic-equity managers, this has led to significant redemptions--the small-cap fund is down to $170 million in assets under management from more than $1 billion at its peak. (Most of the firm's $18 billion in AUM was in institutional accounts as of September 2019.) Moreover, the firm exhibits significant key-person risk as its founder Luther King, 79, remains active at the company as portfolio manager on several funds, president, and chairman of the firm's corporate board.

While King hasn't shared the firm's succession plan, steps have been taken. There are 13 employee-owners other than King (two are his sons), and equity grants continue to be awarded through annual bonuses, though grants aren't necessarily awarded every year. It's reasonable to expect that one or both of his sons, who have been involved with the firm for more than a decade, will eventually take the reins. The firm deserves credit for sticking to a well-articulated process, but some concerns give us pause.

Price It's critical to evaluate expenses, as they come directly out of returns. The share class on this report levies a fee that ranks in its Morningstar Category's middle quintile. That's not great, but based on our assessment of the fund's People, Process, and Parent Pillars in the context of these fees, we think this share class will still be able to deliver positive alpha relative to the category benchmark index, explaining its Morningstar Analyst Rating of Bronze.

Performance The strategy's separate-account vehicle gained an annualized 9.4% from its April 2005 launch through June 2020, lagging the Russell 2500 Growth Index's 10.2% but besting the Russell 2500's 8.1%. While the strategy is benchmarked to the Russell 2500, the growth index is a better measuring stick because of the portfolio's holdings and return patterns. In the coronavirus-driven drawdown from Jan. 16, 2020, through March 23, 2020, the strategy lost a brutal 38%, slightly better than the benchmark's 40% loss but worse than the Russell 2500 Growth's 35% drop. Positions in entertainment providers Nexstar Media Group NXST and Live Nation Entertainment LYV were particularly painful over that time.

Purvis' valuation sensitivity and small-cap lean have been out of favor since the mutual fund's launch compared with mid-growth competitors. His execution has also cost investors at times. Bad stock picks sank the fund in a market rally in 2014, and poor consumer and tech picks also contributed to the strategy's bottom-quintile performance in 2016, a year in which value's outperformance should have provided a tailwind to returns. Since April 2005, the strategy has exhibited strong downside protection thanks to Purvis' quality-oriented style, notably during the 2007-09 financial crisis. However, it has not kept up enough in rallies to remain competitive.

Portfolio This strategy looks different from its mid-cap growth peers and the Russell 2500 Growth Index, a better fit than the Russell 2500 benchmark because of this strategy's return patterns and lead manager Purvis' growth tilt--he hangs on to winners and tolerates higher price multiples. Like many LKCM managers, Purvis has tended to invest heavily in industrials while avoiding biotech stocks and keeping the consumer discretionary allocation light. He also avoids telecoms and utilities entirely, citing their low growth potential. A hefty 24% of the June 2020 portfolio was allocated toward healthcare stocks (compared with the benchmark's 16%), which Purvis attributed to the companies' strong fundamental positions.

While relatively cheap compared with its peers, this portfolio's profitability metrics have fallen behind the mid-cap growth Morningstar Category's as measured by returns on equity and returns on assets, partially owing to the fact that it owns far more small caps than its average category rival. Nevertheless, it still tends to have lower leverage than its category and the relevant indexes.

Purvis tends to hold 55-60 stocks in this portfolio, though he has ventured outside that range several times over his 14-year tenure. As the fund shares roughly 45% of its holdings with LKCM Small Cap Equity, Purvis' workload is manageable.