Undiscovered Managers: A Proven Approach in Small Caps

In every issue of Morningstar magazine, Undiscovered Manager profiles a manager on the Morningstar Prospects list compiled by Morningstar Research Services' manager research group.

What stands out first about Tributary Small Company Fund FOSCX is its end results. Screen for a small-cap core fund with strong relative performance, and this one comes up near the top time and again. But how it got there doesn't make for a dramatic story. There's no maverick manager making heroic bets against a benchmark here—just careful work from an experienced team in Omaha, Neb.

That's why the fund has a good chance of continued success.

Mark Wynegar, who has run the fund since joining Tributary Capital Management's predecessor in 1999, and Mike Johnson, who joined in 2005 and was named comanager in 2007, are in it for the long haul. Their goal is above-average long-term performance with below-average risk. The fund's 4-star Morningstar Rating as of August indicates their success relative to other funds in the small-cap blend Morningstar Category.

The strategy has earned a place in Morningstar Prospects, a watchlist of up-and-coming and underfollowed funds maintained by Morningstar Research Services. Senior analyst Greg Carlson, who oversees the list, says, "Tributary Small Company was added to Prospects because it features a long-tenured management team plying a proven approach: It looks for good businesses trading at a fair price."

A Careful Balance The process behind the performance is a measured one. Johnson says that while they believe value stocks are likely to outperform with less risk, "we are not deep value managers, because that increases the likelihood of steering yourself into a value trap."

They look for quality companies that can enhance shareholder value over time and provide downside protection in poor economic and market environments. They seek to buy at discounts to intrinsic value to generate excess return and provide a margin of safety. The result is a portfolio of 60 to 70 stocks bought with the expectation of a three- to five-year holding period.

"We are active managers," Wynegar says, "and want all our picks to contribute to performance, but we want to manage company-specific risk." With this in mind, individual position sizes are meaningful but never outsized. On the low end, stakes are generally above 1%. On the top, while positions can go up to 5%, they usually remain under 3%.

"We feel that our primary skill set is stock selection, so we try to isolate market risk," Wynegar says, "and we don't have sector timing skills, so we stay fairly similar to the Russell 2000 in terms of sector allocation." The managers also generally keep cash under 5% of assets.

Extra Eyes Picking the right stocks for the portfolio is also a sensibly diversified process. While Wynegar and Johnson have ultimate authority over purchases and sales, Johnson emphasizes that "this is very much a team-oriented environment." The managers work with five analysts, all of whom are responsible for putting up ideas for the portfolio.

With the exception of Wynegar and a new analyst who is training as a generalist first, the team members have specialized coverage responsibilities. Their sector experience and ongoing research leads to new ideas. They also use a multifactor quantitative model to screen stocks on valuation, profitability, leverage, earnings revisions, and growth; each stock is assigned an overall score. The stocks are sorted into economic sectors for comparison, so that the analysts can look for the best opportunities within each, in keeping with the fund's diversified approach.

That's the starting point. When a team member has a stock to recommend, it undergoes a preliminary review to be sure that there aren't any obvious objections that would prevent it from getting into the portfolio--such as an insurmountable industry concern. Then, the analyst gets to work and comes back with a full-blown research report. That's when the whole team digs in.

"We play devil's advocate, poke holes in the argument, and the analyst finds answers to our questions. Then, we get back together. The research process is interactive right from the beginning," Johnson says. "The more people who look at [a stock], the better."

Stock Picks Many of the stocks that make it into the portfolio tend to stick around. Asked to name a stock that is emblematic of the approach, Johnson singles out Littelfuse LFUS--which predates his own tenure, having been added to portfolio in 2001. He notes that the manufacturer of circuit protection products has benefited from the continued increase of electronic devices coming onto the market and from the fact that cars are becoming increasingly electronic. But Littelfuse is not only growing with the industry, it is taking market share.

"It's a well-known, great brand name that has relationships with the manufacturers of the ultimate products, as well as distributors. The other thing is that they make a product that is really low cost for an auto company, and also very important," Johnson says. That means the auto manufacturer has little incentive to try to skimp on Littelfuse's products. Meanwhile, "a good, trustworthy management team" has successfully steered the company through a five-year plan for growth, both organic and by acquisition.

Morningstar's performance attribution analysis shows Littelfuse as one of the biggest contributors to the fund's outperformance in recent years. The team has trimmed and added to the position as the stock's valuation has waxed and waned, and they expect to continue to own it for some time.

Johnson also points to Franklin Electric FELE. The manufacturer of water and fuel pumps has strong market share for agricultural and housing water pumps, and its fuel pump business benefits from growth in emerging and international markets transitioning to underground systems. The company has the fundamental aspects Tributary seeks, such as a solid balance sheet, and a wetter-than-average summer a few years ago that slowed down replacement of agricultural pumps provided an opportunity to build a position.

American Woodmark AMWD serves as a way to participate as housing markets perk up, but it is not as deeply cyclical as homebuilders are. The maker of kitchen cabinets sees half of sales stem from purchases of replacement cabinetry via retailers such as

While the portfolio is generally sector neutral, there are industries that are challenging to invest in given the fund's quality standards. Wynegar says, "For starters, there is a slice of the Russell 2000, about 15%, that is companies that don't make money, and we want freecash- flow generators. Biotech represents about one third of those nonearners. When biotech does well, we are at a disadvantage. But in the long run, [the lack of biotech] adds predictability and stability to the portfolio. We want a clear idea of where a company is going to be in the future. Biotech doesn't fit."

Sticking to Small Caps Coherent COHR, first added in 2014, provides an example of the selling process. The team has been trimming the developer of laser systems and components because the pick has worked out very well, with the company's sales, margins, and earnings exceeding expectations. Valuation is a key reason for paring a position, but Coherent's valuation was still reasonable as of mid-July. However, its market cap has risen from less than $2 billion at the time of purchase to more than $6 billion, making it a less appropriate holding for a small-cap strategy. Wynegar says that such situations prompted the firm to recently launch a small/midcap strategy, or "smid-cap," with seed money. (He is comanaging that offering with Don Radtke, who runs the firm's large-cap strategy and serves as an analyst here.)

Matthew Terrien of Evanston Advisors in Schaumburg, Ill., says Tributary Small Company's adherence to the small-cap space makes it a good fit for his portfolios: "What appeals to me is that first and foremost it is true to its style in terms of market-cap range." Both the fund's average weighted market cap and weights in small- and micro-cap stocks are in line with the Russell 2000. Like that benchmark, it has minimal mid-cap exposure, less than 5% compared with a 16% average for the small-blend category (which includes some funds with a smid-cap bent).

Terrien invests primarily in individual securities for high net-worth clients but uses mutual funds for those with smaller accounts. He says that Tributary Small Company is now the firm's goto small-cap pick. He likes that the stock-picking process resembles that of his firm. "It's a fundamental, rational process, and they are willing to hold for the long term. [Like Tributary,] we strive to be relatively sector neutral, and we are hanging our hat on superior stock selection."

Raising the Profile While both the strategy's performance and the sound underlying process merit attention, it didn't draw much advisor attention for a while. When Wynegar came on in 1999, under the firm's predecessor, First Investment Group of First National Bank, there was only $10 million in the fund. More than a decade later, assets were still under $100 million—despite the fact that the fund's 9.8% annualized return from 2000 to 2010 trounced that of the Russell 2000 (5.6%) and the small-blend average (7.1%).

At that point, Wynegar says, it was clear the fund needed a different organizational structure for better distribution among advisors. "We wanted an identity in the marketplace that other firms could get their arms around."

First Investment Group's value-oriented teams were brought under a new registered investment advisor, Tributary Capital Management, in 2010. The firm's parent company remains First National Bank, a wholly owned subsidiary of First National of Nebraska, but the rebranding and subsequent push for broader distribution have helped it grow to $1.7 billion in assets under management. Of that, $1.2 billion is in the small-cap strategy, about half of which is in the mutual fund.

Asset growth can hamper execution, particularly for a small-cap strategy. Morningstar's Carlson addresses that concern with another reason the fund made the Prospects list: "Management has set a fairly conservative capacity estimate—it intends to close when total assets hit $1.5 billion."

Wynegar expects to institute a soft close at that mark, while continuing to allow existing clients to invest. A hard close is a possibility, however. "Around $3 billion is probably beyond the strategy," he says, "but by tempering new flows, we should be able to stay open for a while."

Also integral to extending the strategy's successful record is attracting and retaining a strong investment team. To that end, the incentive plan is driven by overall strategy performance to encourage engagement in the team approach. In addition, the analysts participate in a revenue sharing plan put in place over the past several years.

Performance Terrien's research led him to Tributary about a year ago, when he was seeking to replace an underperforming small-cap fund. "I have a high comfort level with it," he says. "In the small-cap space, if you are not careful, you can really lose a lot of money very quickly in speculative names. The best label I can put on the fund is 'quality.' They are high-quality managers with a high-quality portfolio."

Terrien says that the strategy's long track record provides ample evidence of its ability to preserve principal in down markets. "The Russell 2000 was negative in 2007 and 2011, and this fund was positive." The fund also suffered a minimal 63-basis-point loss in 2015, when the benchmark was down 4.4%.

The fund's 4-star Morningstar Rating demonstrates its ability to outperform peers on a risk-adjusted basis. It also beat its peers and the Russell 2000 Index over the trailing three-, five-, 10-, and 15-year periods through August when evaluated by similar risk-adjusted measures, such as the Sharpe and Sortino Ratios.

The fund is competitive on an absolute-return basis as well. It sometimes lags in rallies such as in 2013 and the year to date through August—both periods when speculative biotech names soared. But it also landed in the top quintile of the category in 2016 with a 24.9% return, thanks to strong stock-picking across the board.

Over the past decade the fund has captured 91% of the Russell 2000's upside performance. However, it has also captured only 84% of the downside, which balances out in the fund's favor. Its 8.8% annualized 10-year return through August handily beats the Russell 2000's 7.4%, and ranks in the top 10% of the small-blend category.

The fund has no expense advantage, however, and Morningstar has found that costs are a key predictor of future success. Its older Institutional shares—available at a retail-like $1,000 minimum— have a 1.2% expense ratio, in line with the small-blend category average. The bulk of assets are in the newer, cheaper Institutional Plus FOSBX shares (with a $5 million minimum), where the 0.99% expense ratio is right at the median for small-cap institutional funds.

That said, the odds are good that the fund will continue to be a long-term leader if its strategy and management team remain in place. Johnson's own assessment of the strategy's competitive advantage is a fair one: "First and foremost, we have the right philosophy in place. We also have a history of working together that not all managers have. You can look back at our performance and see how we've done in up markets and down markets, good economies and bad economies. The consistency and continuity of our team is a plus."