Goldman Sachs money manager digs into three themes for long-term growth

By Philip van Doorn

Greg Tuorto explains how smaller companies can use a narrow focus to make a lot of money for investors

Most exchange-traded funds are passively managed - they are designed to mirror the performance of stock indexes and typically have low management fees. They can work out very well for investors, which has been the case for funds that track the S&P 500. But in the world of small-cap stocks, active management can be worth the extra expense to identify innovative companies or those trading at low valuations when considering their potential.

During an interview with MarketWatch, Greg Tuorto, who co-manages the Goldman Sachs Small Cap Core Equity ETF GSC, described a bottom-up process through which he, his colleagues Raj Garigipati and Robert Crystal, and a team of analysts select companies for investment. He discussed how stocks are weighted and named examples of stocks within three themes the team likes in the current market.

"More than 50% of new ideas come from existing companies in the portfolio. We will hear of a competitor or someone a management team is emulating," he said.

The team maintains a long list of ideas and narrows it down to a group of 100 or fewer stocks. Tuorto said the portfolio is diversified and weighted by risk.

There is limited exposure "to companies that may be a bit further away from true profitability or free cash flow," Tuorto said. "As they get to the top of the portfolio, they are companies where we are intimately familiar with the management teams, the strategies and the long-term results."

He also said that the management team selects stocks with an outlook of three or more years in order "to make a significant return on our money."

"We hope they get so big that we have to sell them, because they are no longer small-caps," Tuorto said. For new positions, the fund managers select companies with market capitalizations below $5 billion. "We will let our winners run to $6 [billion] or $7 billion," he said, adding that the "sweet spot" for the fund is market capitalization of $2 billion to $4 billion.

When asked about concentrated portfolio strategies favored by some active managers, Tuorto said that he prefers to have a portfolio of close to 100 names without heavy concentration at the top because "things happen, even with high-quality companies." He added that the small-cap space represents "a different volatility stream than investing in large companies."

Investment themes

Tuorto discussed three themes he and his colleagues favor and provided at least one example for each.

Medical technology

It is reasonable to expect investors to overreact to any broad change in an industry, and this year's excitement over Ozempic, the weight-loss medication developed by Novo Nordisk A/S (NVO), and competing GLP-1 drugs may be a good example in the large-cap world. Among the 11 sectors of the S&P 500 SPX, healthcare is the second-worst performer this year, with a 1.6% decline, while the full index has returned 20.9% (both with dividends reinvested).

A recent GLP-1 development: Eli Lilly's Mounjaro three times more effective than Ozempic for weight loss, real-world study finds

"Many people felt medical technology would be a significant loser as everyone lost 100 pounds and there would no longer be hereditary diseases in cardio, as everyone took their GLP-1s," Tuorto said. But when many healthcare companies reported their third-quarter results, they were performing as expected, by "growing and expanding their clinical presence."

One healthcare stock Tuorto feels good about, regardless of the GLP-1 success, is Axonics Inc. (AXNX), which provides treatments for incontinence. There are various causes for this health issue, and the company "treats all those different things, with minimally invasive procedures for men and unique, topical products for women, to expand their clinical presence across all types of practitioners," he said.

The treatments are provided by medical professionals, but Tuorto expected Axonics eventually to provide medication directly to consumers. "By going after the doctors first, they have built up a significant amount of credibility," he said.

Tuorto expects Axonics to achieve a 20% annual growth rate for revenue, "with a meaningful capacity to build free cash flow ... because of the investments they have made."

He also said that Axonics provides a good example of the difference between small and large companies. A small company "can focus myopically on a specific need," he said. In this case, Axonics first developed treatments for male incontinence and then expanded "to the female market, post-birth and post-procedure," in a deliberate manner.

Another medical-technology example that Tuorto named is iRhythm Technologies Inc. (IRTC), which makes electrocardiogram monitoring devices.

"We think this company has been unfairly punished, as if the GLP-1 approach means we will never see cardio companies again," he said. He expects to see "a mid-teens" growth pace for iRhythm's revenue.

Cybersecurity

"Over past two years in software, there has been a big IT shakeout," Tuorto said. "Many companies that went public haven't stood the test of time."

But he expects the cybersecurity industry to continue to have "an enduring, underlying buying pressure from enterprise," because "we find out about data breaches much later than we should."

According to Tuorto, Tenable Holdings Ltd. (TENB) has "a unique approach to state and local government security." He noted that the federal government had selected a company with a market cap of less than $5 billion as "a preferred vendor to determine exposure to breaches or data-security loss."

"These companies are highly prized, with six to eight taken over by private equity alone," he said.

With "a really strong outlook for growth," Tenable "can fit in as part of a large public company or be a target for a takeover," Tuorto said.

Casual dining

Tuorto said the casual-dining industry "has gone through a re-evaluation of what customers will want and restaurants will provide."

He said that weaker performers, such as Sweetgreen Inc. (SG) and Shake Shack Inc. (SHAK), had "disappointed loyal customers by changing menus, not managing loyalty programs, or through a lack of consistency across restaurants."

Tuorto named two casual-restaurant companies held by the fund. The first is Cava Group Inc. (CAVA), which went public in June. Cava has built "a positive feedback loop" though its real-estate strategy and its consistent menu, he said.

Another of Tuorto's favorites in the space is Wingstop Inc. (WING), which has been successful in expanding its menu, he said.

A top holding

When asked about Meritage Homes Corp. (MTH), which is the fund's second-largest holding, Tuorto said he had been impressed with the builder's "ability to change its approach for the type of market it is in," which has helped with "earnings resiliency."

This could be especially important if the U.S. moves into a recession next year or if economic growth slows considerably. Then again, "there is a significant dearth of available housing stock," he said.

Here's a look at projected compound annual growth rates for sales, based on consensus calendar-year estimates among analysts polled by FactSet. The table also includes consensus EPS estimates for three years.

   Company                    Ticker  Two-year estimated sales CAGR through 2025  Estimated 2023 EPS  Estimated 2024 EPS  Estimated 2025 EPS 
   Axonics Inc.               AXNX    21.0%                                       -$0.14              $0.35               $0.73 
   iRhythm Technologies Inc.  IRTC    18.4%                                       -$3.18              -$2.23              -$1.23 
   Tenable Holdings Ltd.      TENB    14.1%                                       $0.70               $0.79               $1.02 
   Cava Group Inc.            CAVA    18.8%                                       $0.10               $0.14               $0.20 
   Wingstop Inc.              WING    14.7%                                       $2.39               $2.83               $3.41 
   Meritage Homes Corp.       MTH     4.5%                                        $19.70              $18.70              $20.34 
                                                                                                                               Source: FactSet 

Click on the tickers for more about each company, ETF or index.

Click here for Tomi Kilgore's detailed guide to the wealth of information available for free on the MarketWatch quote page.

A new fund, but an older strategy

The Goldman Sachs Small Cap Core Equity ETF is a new fund, with annual expenses of 0.75% of assets. It was established on Oct. 3 and only has about $10 million in assets under management. But it follows a similar strategy for stock selection and is managed by the same team as the Goldman Sachs U.S. Small Cap Equity Portfolio, which was established in June 2018, is distributed by Goldman to European clients and is rated four stars (out of five) by Morningstar.

There is no guarantee that the two funds' performance will match closely, because of differences in how the two funds time their trading activity and in how they are regulated.

The older fund's three-year average annual return (after expenses) through October was 7.3%, and its five-year average return was 6.4%. These haven't been very good periods for small-cap stocks, but the fund has outperformed its benchmark by a significant margin. In comparison, the three-year average return for the Russell 2000 Index was 3.9% and the five-year average return for the index was 3.3%, according to FactSet.

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-Philip van Doorn

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12-09-23 0628ET

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