With large-company stocks hogging the limelight in recent years, managers of mutual funds specializing in small-company stocks have toiled largely in darkness.
Among the shining lights, however, has been Patricia A. Falkowski, who has chalked up an impressive record in tough times.
Until Aug. 2, she was president and chief investment officer of Fiduciary Management Associates in Chicago, where she also managed the UAM FMA Small Cap Fund, which fund research firm Morningstar Inc. had described as “a great but forgotten fund.” (Its three-year annualized return, as of June 30, was 25.62 percent–outpacing the 18.86 return on the Russell 2000 index, the benchmark for small-company stocks.)
She has since departed for the Chicago Trust Co., where on Nov. 6 she launched the Alleghany/Chicago Trust SmallCap Value Fund, comprising bargain-priced domestic companies with market capitalizations between $50 million and $1 billion.
A daunting task for anyone, given the market’s recent volatility and the poor performance of small-company stocks this year.
Over a lunch of creamless herbed tomato soup and Chinese chicken salad at the tony Seasons restaurant in the Four Seasons Hotel Chicago, Falkowski recently discussed her outlook for the fund and for small-cap stocks in general. An edited transcript follows.
Q–Obviously, small caps have had a rough time for several years. Looking ahead, what do you see for small caps and for your fund? Is this a good time to be starting that kind of fund?
A–I think it’s a good time for an active manager with a real strong fundamental and research orientation, because in ’96 and ’97, that was not a good time for small caps, but I was able to get really strong numbers and I beat the S&P (Standard & Poor’s 500 index) in those years. I don’t think the passive management, like index, and the momentum style is going to work for the next few years.
Q–You have had a lot of success in what you do because you have certain macroeconomic theories that you use when you’re making your stock selections. And I wondered, looking ahead, if there are certain macroeconomic (trends) you see that will affect small caps.
A–Well, we’re taking the philosophy that the 1999 economic scenario is not easy to determine right now, and so what we’re looking for are companies that we think have relatively strong earnings dynamics so that they can swim upstream.
And we also have created a couple of themes. I really wanted to take a look at what we could do in the defense area, with the idea that the government is going to be fine. We’re not going to have to worry about their discretionary spending. And the defense budget could, in fact, be increased because there have been issues about readiness.
We came up with this Newport News Shipbuilding company and we’re using Alliant Techsystems.
Another play that we’ve got going . . . was the big highway bill. The federal government is going to be putting out a couple (hundred) billion dollars in spending over the next few years that will be matched by state funds, so there’s an awful lot of money that’s going to be coming into the economy.
We looked pretty hard for equipment manufacturers, but we didn’t find anything that fit our valuation parameters. We also have cement plays going.
Q–Are there other areas that you’ve found lately that look appealing?
A–We think that anything that has to do with mortgages has just gotten so badly creamed by the market that we were doing a lot of valuation work there. We actually are buying this Amerin (Corp.) . . . the mortgage insurance company that is headquartered here in Chicago.
(Editor’s note: Falkowski was not alone in liking Amerin. On Monday, it agreed to be acquired by CMAC Investment Corp. of Philadelphia. Its stock closed Monday at $23.62, up 15 percent from Nov. 18, the date of this interview.)
Another thing we’re doing as a top-down approach is we’re doing a lot of screens for yield, because it’s an uncertain market and the one thing you can hang your hat on is dividends.
We’re doing some work with the natural-gas area. . . . They’re like utilities; they tend to have higher yields.
And we are buying Lance (Inc.). It’s a snack company down in the Southeast. They make cracker sandwiches. It’s got a 5 percent yield. . . . I always buy it when this happens.
We do these things all the time, like yield screens and discounted P/Es (price-to-earnings ratios) and that type of stuff, but never before, except in ’90, ’91, did we have . . . so many high-quality company stocks pop up on us. Small-cap stocks have just gotten hit so badly that we really have the opportunity to upgrade the portfolio. I think that reduces the risk, too, of a portfolio.
That’s what my whole style is meant to do, is just keep as much risk out of this volatile part of the market as you can. And what we try to do is beat the market really well on the downturns and to keep up on the upside.
Q–For an individual investor, are there good values out there, and also things to watch out for?
A–I think the one thing to watch out for is it’s going to be choppy. I really think the markets are going to continue to be highly volatile, in large part because institutional managers are not really the ones putting money into the market here, it’s the retail individuals, and so you have more of a risk that they get scared and that there’s a herd mentality to pull out. If that happens, we could see a return to the lows.
But I think it’s a big opportunity to look for really high-quality companies that have been unfairly treated in the whole wash of this market. So I really think that you should look hard at anything that has a high dividend. I mean if you think that a company can hold on to that dividend and you can beat a Treasury (debt obligation) with it, that’s a good bet, I think. Especially local companies (where) you know what the franchise is, you understand the business.
Q–What do you think needs to happen to have people feel more comfortable with small-cap stocks?
A– Well, I think small-cap stocks cannot do well unless you have a fair amount of confidence that, No. 1, the economy is going to be OK, because a lot of these companies are suppliers to big companies, and they have limited product distribution and limited products. They can’t pull a rabbit out of the hat.
I think if people get more comfortable that the (interest-rate) easing that is occurring by the Fed (Federal Reserve) will really re-accelerate the economy, or at least take away the fear of recession, I think these stocks are going to fly, absolutely fly.
Q–If you were speaking to a group of individual investors, is there any one bit of advice you would give . . . in relation to small-cap stocks?
A–Well, I think their expectations of what the market generally gives is too high. We’ve had abnormally strong years for the last couple of years and people who manage money know that, but people who buy the funds, I don’t think, understand that. I think they have to lower their expectations a little bit.
Q–Do you have any sense of where the market’s going, any gut feeling about it?
A–As soon as we get confidence that Asia is OK, I think we’re off to the races again. I think over the next year you could really see a tremendous resumption in confidence in the global economy, and if that’s the case, you’re going to see these small-cap stocks, in particular, do extraordinarily well. I don’t know if they’ll do great in January, but I do think, by next December, people will have some very fine rewards in the small-cap area.
