JPMorgan SMID Cap Equity A PECAX

JPMorgan SMID Cap Equity benefits from a proven team and a disciplined approach, making it an attractive option.

Veteran managers Don San Jose and Dan Percella lead a small but stable team of three analysts. They have managed this strategy since April 2016 in separate accounts but inherited this mutual fund offering in November 2020. The managers know each other well, having worked together on sibling strategy JPMorgan Small Cap Equity VSEIX since 2008. Two of the group’s three analysts have worked on the team since 2015, while the third started in 2018. Although the team is small, it’s a plus that they are focused exclusively on small- and mid-cap investing. In addition, they occasionally collaborate with other J.P. Morgan Asset Management analysts for added support.

The team’s consistent investment approach centered on quality is key to its success. It focuses on companies operating in narrow niches that can leverage their competitive positioning to protect and grow their returns on capital at rates higher than the market foresees. These traits, along with a preference for earnings and free cash flow over top-line revenue growth, lead them to steadier business models. The team will ride winners from small- to mid-cap territory, but they will start to sell them once they hit the $20 billion market-cap range. Tolerating these stretched valuations courts risk, but the fund maintains a high-quality profile, as indicated by superior profitability metrics such as returns on equity and invested capital.

The strategy’s long-term record is solid, despite a recent rough patch. From the separate account’s inception in April 2016 through March 2024, the composite’s 12.2% annualized return (gross of fees) beat the Russell 2500 Index by 1.3 percentage points. Recently though, performance has been more challenged. Since the start of 2023 through March 2024, the strategy’s 21.9% cumulative return trailed its benchmark by 3.6 percentage points. Some mistakes with regional banks and poor picks in industrials and consumer discretionary largely drove the underperformance. Still, the strategy remains a great option, despite this recent hiccup.

The process here is all about finding great businesses priced as merely good ones. Don San Jose and Dan Percella scour the Russell 2500 Index for best-in-class companies with consistently high levels of profitability and management teams that have proved to be efficient capital allocators. They focus on companies operating in narrow niches that can leverage their competitive positioning to protect and grow their returns on capital at rates higher than the market foresees. These traits, along with a preference for earnings and free cash flow over top-line revenue growth, lead them to firms with steadier business models.

The team analyzes firms’ growth potential on a three- to five-year basis, but its view on margins tends to be the key differentiator. The team will happily own a company growing at a modest rate if it can expand its margins over time to produce strong earnings and cash flow that the market will reward. The managers build out new positions gradually, looking for validation of their investment thesis.

The managers trim holdings as they appreciate—few climb above 2.0% of assets—but tolerate higher valuations as long as their theses remain intact. They’ll hold onto their winners but will start to sell once they hit the $20 billion market-cap range.

While the strategy’s name implies a blend of small- and mid-cap stocks, historically the strategy has skewed more toward mid-caps. From inception through 2022, equity holdings classified by Morningstar as small-cap stocks never made up more than 40% of total assets. Recently though, this trend has reversed, thanks to 2022’s broad market selloff and the managers adding several smaller cap names like AssetMark Financial and Shoals Technologies to the portfolio. As of March 2024, roughly 56% of the portfolio was in small caps, while only 40% was in mid-caps.

The portfolio’s focus on quality is consistent. It scores higher than the Russell 2500 Index on metrics such as return on assets, return on equity, and net margin. Trailing earnings- and revenue-growth rates are roughly on par with the index, but that’s consistent with the managers’ preference for profitability over sales growth.

The strategy typically invests across all sectors, but the team completely sold its small group of energy stocks in 2020 as the coronavirus pandemic highlighted the difficulties in forecasting commodities-driven businesses. But the team’s views have evolved as it bought natural gas pipeline operator DT Midstream in early 2023, as well as exploration and production company SM Energy and pressure control equipment provider Cactus in early 2024.

Don San Jose and Dan Percella have run this SMID-cap strategy since the separate account’s April 2016 inception. San Jose is a J.P. Morgan veteran, joining the firm in 2000, while Percella joined several years later. They know each other well, having worked together on sibling strategy JPMorgan Small Cap Equity since 2008. There, the managers built an impressive record relying on strong stock-picking.

The managers primarily work with a team of three analysts. Two of them—Jon Brachle and Chris Carter—have been on the team since 2015 and have more than 15 years of industry experience apiece. Newest analyst Jesse Huang started working with the group in a junior role in 2018 but was recently promoted to analyst. The team sometimes collaborates with other J.P. Morgan analysts but largely works independently.

San Jose and Percella have added some new responsibilities in recent years. In October 2021, San Jose took over as CIO of J.P. Morgan’s Value Equity Division, while Percella served as a comanager on large-cap offering JPM America Equity from August 2022 through March 2024. That strategy is quite different from this one, but Percella had much less responsibility there. Fortunately, with Percella being taken off that strategy and San Jose settling into his new role, these workload concerns are not overbearing.

J.P. Morgan is a well-resourced, diligent, and responsible steward of client assets. Investment teams are seasoned and stalwart, especially in equity and fixed income, the latter of which has successfully undergone substantial transformation in recent years. The firm offers competitive compensation that is aligned with fundholders and shows strong retention at senior levels of the organization. It demonstrates a culture of constant innovation and willingness to evolve. For example, J.P. Morgan recently expanded its investment committee process through which senior leaders review various teams and strategies, and it continues to develop proprietary portfolio management and risk oversight tools. Some funds still face high fee hurdles, but the firm has generally lowered expenses as it has grown.

The firm isn't without its complications. J.P. Morgan's product offering is extensive, and some areas need improvement. For instance, its multi-asset business has faced some challenges as a result of complex investment processes. The firm continues to build out its footprint in China, but its efforts there remain unproven. Although not every strategy is the best in its class, J.P. Morgan remains earnest in the pursuit of excellence, and investors are well-served.

From its April 2016 inception through March 2024, the separate account composite’s 12.2% annualized return(gross-of-fees) beat its Russell 2500 Index prospectus benchmark’s 10.9% gain. Risk-adjusted results were even stronger, as the strategy's standard deviation(a measure of volatility) was well below the index’s.

Recently, performance has been more challenged. From the start of 2023 through March 2024, the strategy’s 21.9% cumulative return trailed its benchmark by 3.6 percentage points. The strategy’s exposure to several regional banks, including collapsed Signature Bank and Silicon Financial Group (parent of Silicon Valley Bank), hurt performance in early 2023, but picks in industrials and consumer discretionary were the main detractors over this 15-month stretch. The mutual fund’s record, which starts when Don San Jose and Dan Percella took over in November 2020, is less impressive owing to this recent rough patch.

The strategy’s broader performance pattern is a close match to that of its relatively defensive small-cap sibling, JPMorgan Small Cap Equity. The SMID separate account composite outperformed in a difficult 2018 and again during 2020’s coronavirus-induced bear market. However, its relative underperformance in 2022 stemmed from the strategy’s lack of exposure to the surging energy sector.

Based on our assessment of the fund’s People, Process, and Parent Pillars in the context of these expenses, we think this share class will be able to deliver positive alpha relative to the category benchmark index, explaining its Morningstar Medalist Rating of Bronze.