A Newly Reopened Small-Cap Fund Worth Considering

The following is our latest Fund Analyst Report for Loomis Sayles Small Cap Growth LCGRX. Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

Loomis Sayles Small Cap Growth's tenured managers employ a well-executed process. The recently reopened fund receives a Morningstar Analyst Rating of Silver.

Comanagers Mark Burns and John Slavik are experienced. Burns took over in January 2005, and Slavik joined shortly thereafter in April, placing their shared tenure in the top decile of the small-growth Morningstar Category. The two lead a team of four experienced sector analysts, and collectively the group averages 19 years' industry experience and 10 at the firm. While an analyst departed in 2017, the team added back to its ranks, and the steady tenure of Burns and Slavik eases turnover concerns.

The managers have deftly employed a repeatable process. They favor rapidly growing firms with strong business models. To find stocks with improving but still-unrecognized prospects, they focus on those with upward price momentum and relatively low share turnover. Burns and Slavik have demonstrated skill in recognizing emerging growth companies. They first bought Guidewire Software GWRE in early 2012, and it earned a wide Morningstar Economic Moat Rating in 2015. The managers limit potential damage with modest positions and a stop-loss trigger for stocks dropping 20% in absolute terms and relative to the benchmark.

The strategy has a strong record. Since Burns started in January 2005 through year-end 2018, its 10.4% annualized return comfortably beat peers and the Russell 2000 Growth Index, largely through strong stock-picking. However, screening for rapid growers with upward momentum has also been a liability in periods when market sentiment abruptly shifts. For example, the fund trailed its benchmark by 12 percentage points as stocks with the weakest fundamentals rallied from March 2009 to February 2010.

Overall, though, the team has managed risk well. The fund reopened in October 2018, giving investors a chance to invest in a competitive option.

Associate analyst Michael Schramm contributed to this report.

Process Pillar:

Positive | Christopher Franz, CFA 01/09/2019 Management has implemented its approach consistently and effectively, earning the fund a Positive rating for Process. It seeks stocks with solid business models, budding competitive advantages, and managers who effectively allocate capital. To find these firms, the managers use a mixture of quantitative screens and fundamental analysis. The screens first rank stocks based on a growth score, which includes past and projected earnings. The screens gauge investor interest during the prior three- and six-month periods using metrics like trading volume to determine the extent to which the stocks may be overlooked. If a firm's shares place in the top 30% of each criterion, they use a discounted cash flow model to develop a 12-month price target.

The managers size positions in relation to how each company's share price and business risk interact with other holdings. For example, they assess industrials firms' indirect exposure to energy. Not-yet-profitable firms and IPOs also typically make up less-than 10% stakes. They sell when a stock hits its price target, their investment thesis changes, or fundamentals deteriorate. A strict stop-loss discipline helps limit the impact of mistakes. Share-price declines of 15% within a month on an absolute basis and relative to the Russell 2000 Growth Index prompt a review, while a 20% drop forces a sale.

The strategy minimizes individual stock and sector risk. The portfolio tends to own between 90 and 110 stocks, and held 95 holdings as of November 2018. Position sizes stay under 2%, minimizing the impact of individual stock blowups. Ideas are spread out, too. As of November 2018, 15% of assets were in the strategy's top 10 holdings, below the small-growth category average. The strategy also keeps close to its benchmark's sector weightings, allowing stock-picking to drive the portfolio. Indeed, as of November 2018, healthcare was the largest underweighting at 19.8% versus 24.2% in the index.

Management requires a minimum trading volume of $4.0 million to $4.5 million per day for potential holdings to help reduce liquidity risk. This results in less micro-cap ownership against its benchmark; as of November 2018, for instance, it held no assets in micro-cap companies while its index held 8%. It stays in small-cap territory because it sells stocks above $8 billion in market cap. Its $2.8 billion average market cap was below peers. The strategy also trades less than its typical peer, with 2018 turnover clocking in at 41% compared with 71% for the category.

The strategy’s focus on price momentum and earnings growth leads to inflated price/earnings and price/cash flow metrics relative to the benchmark and typical peer. It also skews the portfolio toward the high-growth side of the Morningstar Style Box.

Performance Pillar:

Positive | Christopher Franz, CFA 01/09/2019 Strong long-term results earn the fund a Positive Performance rating.

The fund has delivered impressive results under current management. Since Mark Burns took over in January 2005, the fund has returned 10.4% annualized, beating its Russell 2000 Growth Index's 8.0% and small-growth category's 7.1% returns. Volatility has been average versus the peer group but below the benchmark's. The Sharpe and Sortino ratios, both measures of risk-adjusted performance, have been noticeably higher than both.

Because the fund screens for strong growth and momentum, it can look sluggish when market sentiment rapidly shifts, as it did in the post-financial-crisis recovery. From March 2009 to February 2010, it trailed its benchmark by 12.1% and lagged the category average by 9.6%. Still, the fund has held up well in market downturns, capturing 87% of its benchmark's losses. The fund modestly outperformed its benchmark and typical peer in the 2007-09 global financial crisis, the May 2011-September 2011 slump, and the fourth-quarter 2018 pullback. Meanwhile, the fund has kept up in bull markets, capturing 97% of its index's upturns since January 2005. Overall, strong stock-picking has driven outperformance, since the strategy keeps close to its benchmark's sector weightings.

People Pillar:

Positive | Christopher Franz, CFA 01/09/2019 The fund's Positive People Pillar rating reflects the effective and stable leadership of comanagers Mark Burns and John Slavik. The team is among the category's most seasoned; Burns joined in January 2005 and Slavik in April 2005. Burns started at Loomis Sayles in 1999 as a small-cap analyst and had previously worked as a research analyst for New England Pension Consultants. Slavik came aboard following management stints at Westfield Capital Management and Harbor Capital Management. Burns and Slavik collaborate on all decisions, dividing sector coverage, with some overlap, among themselves and their analyst team. Burns focuses on healthcare, consumer, and industrials stocks, while Slavik has responsibility for energy, industrials, and tech. Both invest at least $500,000 in the fund.

This fund's four analysts have 16 years of industry experience on average. Chris O'Brien joined in September 2013. He covers the financials and consumer discretionary sectors. Nathaniel Roberts and James Lamb started in August 2007 and January 2008, respectively. The former covers consumer discretionary and industrials, and the latter consumer staples, industrials, and tech. In 2017, the firm hired Anand Vankawala, who had eight years of industry experience and was most recently a small-cap healthcare analyst, to replace Alex Galperin, who left to cover healthcare stocks for a hedge fund manager.

Parent Pillar:

Neutral | 08/03/2017 Paris-based Natixis Global Asset Management is the parent to a number of different asset managers globally, including Natixis AM in France and Loomis Sayles and Harris Associates in the United States. These affiliates have maintained a large degree of autonomy, both in operational terms and in terms of their investment philosophies. The quality of investment culture varies significantly from one subsidiary to another. The results of the teams at Loomis Sayles and Harris Associates, manager for the U.S. Oakmark funds, for example, are excellent, communications with investors are of high quality, and fund launches have been minimal. NGAM’s latest acquisition, DNCA, has also begun improving its funds’ fee structures since joining the fleet.

On the other hand, the results obtained by Natixis AM are more mixed, and its teams are less stable. Furthermore, in July 2017, the French financial regulator Autorité des Marchés Financiers imposed a EUR 35 million fine on Natixis AM for failings relative to its range of formula-based funds, arguing that the firm had overcharged investors and had failed to adequately disclose charges in the funds’ filings. The sanction on Natixis AM thus weighs negatively on our assessment of the group’s stewardship, but we recognize that strengths in other parts of the organization, particularly in the U.S.-based affiliates, partly compensate for this weakness, resulting in a Neutral Parent Pillar rating.

Price Pillar:

Positive | Christopher Franz, CFA 01/09/2019

The fund is reasonably priced by small-cap fund standards, earning a Positive Price rating. Driving this is its N share class, which contains 35% of assets and is priced low relative to similarly sold peers. Its institutional and advisor share classes look just average. The fund recently reopened to new investors in October with the strategy at $2.8 billion in assets.

Lower turnover than its small-growth category helps reduce trading costs and taxes