Editor's Note: This article first appeared in the Q3 2022 issue of Morningstar magazine. Laura Lallos is managing editor of Morningstar magazine. Photography by Samantha Zauscher.
Nicholas Investment Partners’ roots predate the firm’s 2006 founding by many years, but the focus is something new.
Catherine Nicholas started her investment career as a small-cap stock analyst in 1987 at Nicholas-Applegate Capital Management. She went on to become the portfolio manager overseeing the firm’s domestic-equity strategies and helping build its international and emerging-markets efforts. When the firm was sold to Allianz Global Investors in 2001, it had grown to over $40 billion in assets under management.
In 2006, after her noncompete agreement had expired, she launched Nicholas Investment Partners, whose headquarters are in a converted equestrian center that was adjacent to Nicholas’ family property in San Diego.
“The intent of this firm is different,” Nicholas says. “At Nicholas-Applegate, it was the bigger, the better. The more products the better. This is a small boutique firm focused on small- and mid-cap stocks where we think there is a lot of alpha to be generated.”
To serve this interest, the firm plans to limit capacity for the flagship U.S. small-cap growth strategy at $2 billion; it’s currently approaching $400 million. It was available only to institutional investors until 2019, when the firm launched a mutual fund with a $5,000 minimum, Nicholas Partners Small Cap Growth NPSGX. The fund, which lands in the small-growth Morningstar Category, hit its three-year mark in January and had a 4-star Morningstar Rating as of June 30 (as did the separate-account composite, which has a record extending back to 2007).
Nicholas didn’t start from scratch when starting over. The partners include five former Nicholas-Applegate colleagues, including her husband Art Nicholas, who serves as an advisor to the firm. “It’s more than just a working relationship. We know everybody’s families,” she says.
Partner and portfolio manager John Wylie first met Catherine Nicholas when he, too, joined Nicholas-Applegate in 1987: “We sat right next to each other, literally six feet away.”
Wylie ran convertibles strategies there and now runs an institutional convertibles strategy at Nicholas Investment Partners, as well as the small-growth strategy. (He notes that there is a large overlap of companies in the convertibles and small-cap universes.) He’s been with Nicholas Investment Partners since the beginning.
“Catherine and I go back to the late ‘80s. We lived through the market correction and ‘93-’94 together, we saw Long-Term Capital together, the 2000 dot-com bubble,” Wylie says of his partnership with Nicholas. “When I had the opportunity to join Nicholas Investment Partners, I jumped at it because I’ve always loved working with Catherine.”
“The philosophy goes back over 30 years,” Nicholas says. “Basically, we are looking for companies where there’s something positive happening at the company level that will lead to an acceleration of revenues and earnings but is not priced into the market.”
After identifying an investment thesis, the team does due diligence on the company to ensure that growth will be supported by solid financials, strong management, and durable business models. The team buys only when the stock price is right, as indicated by factors such as positive relative strength, liquidity, and other market sentiments. Nicholas emphasizes that selling is just as important to the process; the team sells when a stock no longer meets its criteria or the growth catalyst has played out, or when a better prospect warrants a spot in the portfolio.
Nicholas singles out specialty retailer Boot Barn BOOT, added to the portfolio in 2021, which has benefited from an uptick in Western lifestyle wear. “This is a highly fragmented mom-and-pop niche, and this company has at least 3 times as many stores as their direct competitors and a long runway to open up more. Their sales have been much better than expected, and what’s smart is they have their own private label—they work with country-western musicians and put their labels on the shirt.”
She notes that a strong management team has been able to execute even in a challenging environment for retailers. Indeed, the stock is up for the year through June.
Wylie points to Switch SWCH, a technology company that operates large-scale data centers, which the managers added to the portfolio early this year after following it for some time.
“It’s a rapidly growing market, and these guys are growing revenues at low double digits with attractive operating margins. They’re very efficient operators,” he says. Research analyst Tony Pata had vetted management, but the team was initially put off by an unattractive dual-share-class structure. When the company switched to a more shareholder-friendly single share class, the team was ready to buy. The investment has been a success upon news that Switch will be acquired.
Switch won’t necessarily be replaced by another tech company. The team builds the portfolio from the bottom up and invests outside traditional growth sectors. It currently holds more in energy than the typical small-growth fund, for example.
Natural gas company Chesapeake Energy CHK is a recent addition here after it emerged from bankruptcy. “This company came out with a clean balance sheet,” Nicholas says. “They sold their properties that were not tied to natural gas—and natural gas is part of the solution to going green, so we saw that as a positive.”
That said, the portfolio overall consistently plots in the small-cap growth corner of the market.
The process has evolved as the market has changed, however. The portfolio is more concentrated than it used to be—one reason the strict sell discipline is necessary. Nicholas says that the explosion of exchange-traded funds has created more competition. In response, the strategy has more active exposure to improve its ability to outperform its benchmark, the Russell 2000 Growth Index. The number of holdings in the portfolio is generally between 60 and 70, and the top 10 holdings make up around 30% of assets.
Meanwhile, the rise of algorithmic trading has created opportunities. “You do see more volatility than you did, say, 15 years ago,” Nicholas says. “Trading that’s not fundamentally driven—whether by algos or retail investors—is an opportunity to cut back or buy.”
Another significant change: “The complexity of some of the companies we look at today is increased, particularly in some of the life sciences and technology spaces, like biotech and artificial intelligence,” Wylie adds. “The ability to manage the velocity of new information and the skill and depth to identify what is important and actionable are critical to success.”
One way the team adapted to that change was by adding healthcare and technology specialists to the portfolio management team. They bring actual industry expertise to their analysis.
Lisa Wheatley, who joined in 2014 and is now a partner in the firm, had previously run mergers and acquisitions for a large public life sciences company. “When we sold the company, I came to Catherine,” she says, noting that she had known Nicholas since befriending her stepdaughter as a teenager. “I’d always looked up to Catherine as a mentor. There were very few powerful females in the business that had risen to the ranks that she had.”
Wheatley says her previous experience integrating businesses provides insight into the companies she invests in today: “A lot of the time when things went wrong, it wasn’t that the drug or technology was bad; it was a result of poor execution of the business. Having that kind of real-world experience in how a public company actually operates brings a completely different perspective when I hear of something going awry at a particular company we are invested in.”
Wheatley grew up in San Diego and wanted to stay in the city where she and her husband and two children were established. She says the location is also an advantage because San Diego is a biotech hub.
In addition to working on the small-cap growth strategy, Wheatley runs NicHealth, a healthcare strategy available to institutional investors. “In mid-December 2016, healthcare had really pulled back, and I went to Catherine and said I think there’s a huge opportunity to invest in the space, not just for a couple of years but 10 or 20,” she says. “She was so supportive—the fund was up and running by Jan. 1.”
Says Nicholas, “If you want to keep good people, you need to provide a growth path for their career.”
Technology specialist Monika Garg joined the firm in 2019 with the understanding that she’d head up a tech fund of her own if things went well, and NicTech was launched in early 2020.
After earning an engineering degree in India, Garg moved to Silicon Valley and started a career in the semiconductor industry. She eventually decided to transition into investing: “Over drinks and dinners with my friends in equity research, it sounded much more exciting than what I was doing, and given my background in technology, I could provide a differentiated view on the research side.”
Garg moved with her husband and daughter to get an MBA at the University of Chicago and returned to the West Coast to work as an analyst at a sell-side boutique where Nicholas Investment Partners was a client. When Nicholas’ original tech analyst left for family reasons, Garg was eager to fill the opening.
“For me, working in a woman-led firm was very important,” she says. “And I knew that the way we look at investments aligned well.”
Garg still works from San Francisco in order to be in the center of the action: “I feel that if you do tech investing or tech research, you have to be in the valley, in the middle of where everything happens.”
Whether from San Diego, San Francisco, or Douglas, Wyoming—where Art Nicholas runs a working ranch—the team meets weekly about the small-cap growth strategy. The team members review the portfolio’s holdings and risk, guided by a quantitative research model developed for the small-cap space at Nicholas-Applegate and updated over the years. “We’ve been able to see how the markets and inefficiencies change,” Nicholas says, “and we’ve adapted to that change.”
As Wylie says, “It’s a multifactor model, each one representing a leg of the stool of our investment philosophy: How do you identify quantitative acceleration of growth, how do you identify quality, and how do you identify attractive valuation and timeliness of investment? There are multiple signals, but they’re aggregated up in those three buckets, and each company gets a composite score based upon all three of those combined.”
The model—which is maintained by head trader and director of quantitative analytics Alex Reison—ranks a universe of about 2,500 small-cap companies. It provides a fresh lens on current holdings and suggests prospects for further research. Garg takes the lead on tech names, Wheatley heads up healthcare, and Nicholas and Wylie divvy up the rest. The portfolio manager who does the due diligence presents the research to the team, and Nicholas makes the final decision.
Now may not seem like the best time to be a small-cap growth investor—the category was down more than 30% for the year to date through June, as was this fund. Wylie is philosophical: “Everybody’s stock prices are going down, but the best companies will manage through and come out the other side, stronger.”
Nicholas is setting her sights on the long-term possibility: “Rough patches in the market are where the opportunity is, like after 2008–09, or 1987. We’ve been through a lot of these crashes, John and I,” she says. “When it feels the darkest, sometimes that’s when you can generate the most alpha.”
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.