Q: What is the history of the fund?
Launched on April 1, 1999, the Voya SmallCap Opportunities Fund has been consistently managed through many market cycles. With a sector-neutral approach, a diverse group of holdings, and a team of highly experienced analysts, we try to stay ahead of significant market moves.
We constantly look within out-of-favor industries so that when they begin to become more attractive, we can capture those initial moves and remain sector neutral - our investment objective. At the security level, we apply rigorous fundamental research to identify smaller companies with specific growth characteristics.
Unlike small-cap funds which become more concentrated and take greater risk, we have not deviated from a low-risk profile. This is partly driven by the number of names in the portfolio; by constantly holding between 130 to 160 names, we manage liquidity rather than being crunched by it.
We always want to be diverse enough to capture the upside. For example, as rates started to rise late last year and into 2017, we were neutral in the bank sector. This allowed us to capture moves early on while many of our competitors were underweight the sector.
Expertise also gives us an information edge that helps to stay ahead of the curve. Seven of the eight people on our team have more than 20 years of experience and the other has been in the industry for more than 10. Relative to peer funds which have younger and more junior analysts, our knowledge of sectors is much greater.
Our target client isn’t looking for a hyper growth manager. We are more diversified and more conscious of the preservation of capital than many peers, and our diversification has allowed the fund to participate in both up and down markets.
Q: What are the underlying principles of your investment philosophy?
In small-cap, bottom-up stock selection, we look for several key characteristics. The first is consistent management that delivers relatively strong results over time. Because liquidity is so important, it is critical we invest in companies managed by people we want to partner with.
Cash flows are another important characteristic. We seek companies which can generate cash flows while minimizing risk on their balance sheets because they know how to manage risk while also growing.
Finally, valuation helps determine whether an opportunity is one we’re interested in. But when looking at the sector/industry level, we can’t compare apples to oranges. Sectors have different characteristics and different risks; some have more debt, and some generate cash flows while others do not.
For example, we don’t compare leverage in a biotech company against leverage in a capital growth company. Instead, risk is analyzed and companies mirrored against their relative competitors. If we were looking at a biotech company with no cash flows, our focus would be on the cash on its balance sheet.
The fund is sector neutral because we want to be contrarian, owning stocks in sectors and industries that may be under siege in the near term, and for companies able to weather a variety of storms. Historically, this approach has proven to be quite good at preserving capital and has performed well in down markets.
For example, through February 11, 2017, when the market was down roughly 16%, we were buying companies in sectors that were out of favor – like industrials and energy – because they were pulling back significantly. We added to names with attractive valuations and balance sheets we felt comfortable with.
We want to take advantage of these market disconnects. If we think the market is oversold or overbought, there are things we can do on both sides. This is an important part of our process and ensures we aren’t missing anything. When a market is pulling back double digits, it takes a lot of work to stay on top of companies. Neither an ETF or a computer can capture this, however our experienced team of individuals can.
Q: Would you describe your investment process?
Our investment process starts by going back to what we care about most: finding companies that generate cash flows, have attractive balance sheets, and relatively strong valuations. Because the fund is sector neutral, we’re always looking for bottom-up opportunities within each sector rather than trying to make big macro calls.
A unique aspect of our process is that before investing in a company, we require each of our analysts to speak to its management, either through a call or an onsite meeting. Understanding the company and its business is a real driver for us.
We build an initial model to examine the terminal value of a company. It looks back a few years then forward to analyze how earnings may shake out, and based on that, determines valuation relative to its peers.
From there, it is my role as the head of the team to analyze risk and liquidities and ascertain where a name would fit in with the portfolio.
If the market turns unexpectedly, we are able to make near real-time decisions. By drawing on our team’s expertise and the long-term relationships we have with our companies, we can quickly make buy and sell determinations ahead of our competitors.
Q: Can you provide an example that illustrates your sector-neutral process?
When the Affordable Care Act (ACA) was passed, 30 million people gained health coverage. This created more volume in hospitals, which in turn generated greater demand for hospital-related products and services.
We began by identifying sectors that would benefit from the increased volume to the overall healthcare sector. Then, applying our bottom-up process, we looked for companies that met our criteria regarding balance sheets, cash flows, and valuations. Without this kind of strong base, we won’t initiate a position in a company no matter how advantageous a macro event might seem.
Q: How do you construct the portfolio?
The benchmark for our small-cap core strategy is the Russell 2000, and for our small-cap growth strategy, the Russell 2000 Growth. The maximum market cap we would consider at the time of purchase is roughly $5 billion.
Several thousand initial names are narrowed down to about 700, which are further reduced to approximately the top third. Among these, we look for companies that make sense within a specific sector or industry, which reduces opportunities significantly.
If we find a company attractive, we start to build a position while taking many things into account. Working with the analyst, I determine risk so we can maintain a position that is not only attractive in terms of potential upside, but also won’t impact us significantly should it pull back on a downside.
The way we view sector neutrality isn’t ultimately about the number of names in a sector – they aren’t limited – but more about weighting. A sector could be 3% of the benchmark, and the fund may have five names in it, depending on the level of associated risk. For example, we could take 3% weighting in biotech across roughly 20 names, versus a 3% weighting in hardware across four names.
No sector will be plus or minus 300 basis points over its relative GIC sector weight. An average position in the fund is approximately 65 to 70 basis points; the maximum position on an absolute basis is about 150 basis points; and a maximum active bet roughly 100 basis points.
Q: What drives your sell discipline?
When a stock is down, it is common for investors to want to buy it. However, our experience in small-cap has taught us that when these stocks are down, it is often for a reason. Such thesis breaks drive our sell discipline, which we have refined over the years.
Small caps don’t have the luxury of time that a company like Apple Inc. does. Should Apple sell fewer iPhones than expected, its stock will pull back but not go to zero. Investors may get nervous but they know Apple will be around for a long time.
Most small-cap companies are one-trick ponies lacking strong balance sheets and market share. If a product or service isn’t working, that means serious trouble – few can recover from a broken thesis.
Couple this with the increased volatility we have seen in recent years. In small cap, stocks have gone down 30% to 40% on bad earnings, which is considerably higher than anything we’ve seen historically.
Ultimately, we must decide whether a company can weather the storm. If it can’t, and we can no longer justify our investment, we move on.
Q: How do you define and manage risk?
Diversification of risk across the portfolio and within the sector is crucial. No one sector dominates; for instance, our top-ten holdings should be a mix of all sectors, including financials, healthcare, technology, and consumer goods. Also, every sector has to be treated differently because there is different risk associated with each.
Taking diversification further, if the fund has three names in one sector, they should have different active weights, and not have the same downside or same upside.
Liquidity is particularly important when investing in small cap. As a guidepost, we want to be able to liquidate about 20% of the overall portfolio in 10 days or less at 25% of the average daily volume.
