New Home, Same Hunt for Small-Cap Gems

Undiscovered Manager profiles a manager on the Morningstar Manager Prospects list, which is compiled by Morningstar's manager research group.

When Amy Zhang buys and sells stocks as manager of Alger Small Cap Focus AOFAX, the decisions are grounded in more than just the numbers in front of her. Zhang puts to work an investment approach shaped by the varied path she's traveled since trading her native Shanghai for New Mexico as a teenager in 1988.

In February 2015, Zhang joined New York City-based Fred Alger Management to lead the focused small-company portfolio after more than 12 years at Brown Capital Management. At Brown, she was a senior portfolio manager on the team running the Morningstar Gold-rated

Along the way, Zhang has learned lessons by seeing the benefits of a diversity of opinions at her internationally flavored high school, learning to write and synthesize information at a liberal arts college, training in understanding and explaining complex credit derivatives at Citigroup, long-short investing at Franklin Templeton, and finally, discovering the appeal of small-cap growth stocks at Baltimore-based Brown.

"I was always very impressed by the very deep understanding of the companies" that Zhang had in the Brown portfolio, says Morningstar analyst Janet Yang, who covered the Brown fund during Zhang's tenure. "It wasn't just the potential and the bright side. They really seemed to dig deep into the downside risks. There's a big difference there in the depth of how well you know a company and she really showed that."

During Zhang's tenure on the Brown Capital Small Company portfolio, the fund returned an average of 13.3% per year, outpacing the annual return of 10.7% for the average small-growth fund and besting 97% of the competition. Since joining Alger, Zhang has been overhauling the portfolio from its previous strategy, a transition that has come as small-cap stocks have broadly tumbled. The Alger portfolio lost 12.3% for the trailing one year through April 21, compared with a 10.8% loss for the average fund in its class.

Zhang joined Alger as part of a recent push within the firm to take its more than 50-year history of investing in growth stocks and emphasize its high-conviction ideas through focused portfolios.

"The value in (a focused portfolio) is that the winners more than make up for the losers, but bigger winners are less frequent than the smaller losers," says James Tambone, executive vice president and chief distribution officer at Alger. "As investors think about using index funds for beta more frequently, they see focus as a better alpha play than diversified portfolios." Alger launched its first focused fund, Alger Capital Appreciation Focus ALAFX, at the end of 2012 and added Alger Mid Cap Focus SPEAX at the end of 2015. Zhang, whose fund at Brown typically held less than 40 stocks, took the helm of an existing, more diversified fund, Alger Growth Opportunities. In August, the fund's strategy and name was formally changed to Small Cap Focus, and it will hold less than 50 stocks.

The expansion of Alger's fund lineup comes as the money manager extends its remarkable recovery. Founded in 1964 by Fred Alger, the firm suffered tremendous losses after the 9/11 attack on the World Trade Center, where it was headquartered. In all, 35 employees, including Fred's brother David and most of the investment staff, were killed.

Alger's mutual funds had nearly $11 billion in assets at the start of 2000. But the combination of the tech-stock collapse--which hit Alger's portfolios especially hard--and the aftermath of 9/11, saw assets under management slide below $7 billion by the end of 2003 and remained near that level through 2007. But by the end of 2015, Alger managed more than $16 billion in funds and $22 billion overall.

A Mini-U.N. Zhang's path to Alger began when as a 17-year-old she was accepted to the Armand Hammer United World College--an upper-level secondary school--and joined students from some 70 countries around the world. That move took her from Shanghai to Montezuma, N.M., an hour's drive from Santa Fe.

The school was like a "mini-United Nations," she says. "I realized the importance of having that cognitive diversity, to take it all in and listen to other people, but also have your own opinion. In investing, you have high-caliber, type-A people, and it's a balance of how to be the best performer you can be, to be self-motivated, but also be a team member."

Zhang, whose family were engineers and doctors, wanted to broaden her scope, so she headed cross-country to a liberal arts college, Manhattanville College, in Purchase N.Y. "That really helped serve me later in my investment career," she says. "It's very important to be able to synthesize information, to be able to clarify and simplify a thesis."

While at Manhattanville, she developed an interest in finance, and graduating in three years, she headed to Columbia University for her master's degree. There, as part of the program, she took a job at Citigroup in credit structuring and origination.

The training at Citigroup shaped her awareness of downside risks, Zhang says. "To look at things from the credit side, (you ask) what could go wrong?"

In 2002, she joined Brown and developed her interest in small-company growth stocks, where she thinks investors can have an edge. Brown, she says, was "doing exactly what I was looking for, to really find the gems--extraordinary, small companies very early in their corporate life cycle but having real products and operating histories."

The benefits of a focus on downside risks came in handy during the financial crisis. In 2008, the average fund in the small-growth category lost 42%, while the Brown portfolio lost 30%, better than 97% of the competition. Providing buoyancy for the fund was its lack of financial stocks, an avoidance of economically sensitive energy names, and the overall high-quality focus of the portfolio.

Then in 2009, the fund gained nearly 46%, versus the 36% gain on the average fund in its class, and ranking it in the top 20% of its category.

The approach Zhang developed at Brown has been carried over to Alger, where it's made for a natural fit, she says.

A Focus on Revenue Many managers break the stock market into small, midsize, and large companies based on market capitalization, but Zhang prefers to look at revenue. She hunts among companies with operating revenue of less than $500 million.

Her broad approach is to look for companies whose revenue could double in five years and have earnings-per-share growth faster than their revenue growth. Other important characteristics include strong balance sheets, high levels of recurring revenue, strong management, dominant and defensible market positions, and leadership in a highly fragmented marketplace.

That meshes with the broad, growth-stock investment philosophy at Alger of what it calls investing in "positive dynamic change."

One difference from many other Alger strategies is turnover. With a three- to five-year investment horizon, the Small Cap Focus fund is targeting turnover of less than 25%. The average Alger fund has a turnover rate of 119%.

Zhang's approach to stock-picking can be seen in Cantel Medical CMN, which had been a top holding at Brown and was the Alger fund's biggest position at the end of January, with a 4.3% weighting.

She first came across Cantel, which focuses on controlling hospital-acquired infections, in 2010 at a conference. At the time, the largest of its four segments was dialysis reprocessing systems, but those profits were declining.

Cantel was a leader in its other markets: water purification for dialysis, automated cleaning systems for endoscopy, and healthcare disposables, such as masks and exam gloves. Zhang thought the dialysis business could provide the cash flow to help grow its other lines. "I thought, ‘This is interesting. What could it become?'" she says.

Zhang started investing in Cantel at Brown at around $8 per share. She added it to the Alger portfolio last February at approximately $41 per share; the stock was priced at $69 as of April 22. The company's revenue has roughly doubled since she first bought the stock and she thinks Cantel can double revenue again over the next five years.

Another top holding at Brown and Alger is Neogen NEOG, which specializes in food safety at the processor and manufacturer level. "It's a very fragmented market and they are the largest and best in class," she says. She adds that the company stands to get a boost from the Food Safety Modernization Act, which became law in 2011. She bought the stock for the Alger portfolio at approximately $46 per share. It traded at $48.50 as of April 22.

The fund's fifth largest position at the end of January was Internet-bubble survivor Stamps.com STMP. "It has a very proven product, services, and operating history, and they have reinvented themselves to get to where they are now." The Stamps.com position was purchased in July when shares were approximately $75 each. The shares were recently trading near $93.

Zhang's sell-discipline is based on a combination of changing company fundamentals and valuation. She points to Cepheid CPHD, a molecular diagnostics company, which she inherited with the fund. While the company had built a great franchise, she says, she thought its product pipeline wasn't as robust as hoped and doubted it could meet profitability goals.

"It fit into a lot of things we look for, but it's a case where the path to profitability is fuzzy," she says. Zhang closed out the fund's Cepheid stake in October.

Benchmark-Agnostic Similar to the fund at Brown, Zhang's investment approach at Alger has led to a portfolio exceptionally concentrated on a sector basis, with information technology comprising 60% of the fund at the end of January and healthcare 30%.

But Zhang instead focuses on the customer base of the portfolio's companies. "The end markets of our holdings are quite diverse," she says. "We really focus on risk-reward in terms of the quality of the companies."

Zhang stresses she uses a benchmark-agnostic approach. Tambone, the Alger executive, recalls one early conversation with Zhang when he discovered that she didn't know the makeup of the so-called GICS sectors, the widely used taxonomy for carving up the market by sectors--details that an index-hugging manager would likely know by heart.

While the fund may see wider short-term, sector-driven swings in tech and health stocks than the competition, her approach should be less volatile long term, Zhang says. "Over the long term," she says, "we're confident we can deliver attractive returns."

This article originally appeared in the April/May 2016 issue of Morningstar magazine. To subscribe, please call 1-800-384-4000.