- The Alger Small Cap Focus Fund, managed by Amy Zhang, has gained 47% this year, outperforming its benchmark and all except one US fund tracked by Morningstar.
- Small-cap stocks, broadly defined as companies worth $200 million to $2 billion, provide a “fertile ground for active management,” she told Business Insider.
- In a recent interview, Zhang shared three stock picks that had helped drive her fund’s outperformance as well as what mattered most when deciding which companies to invest in.
There’s hardly any obvious link between playing the piano and investing.
But Amy Zhang, who does both activities, can spot a few, including the importance of consistency, creativity, and practice. She also recalls the looming deadlines before each time her teacher would show up to evaluate what was learned during the previous lesson.
“It forced me to be disciplined,” Zhang said of her piano-learning days. She said those skills had carried over into her management of the $2.2 billion Alger Small Cap Focus Fund.
As of Wednesday, the fund’s 47% year-to-date gain was outranked by just one US portfolio in Morningstar’s coverage universe. It also beat the best-performing large-cap growth funds, mirroring how smaller companies have gained more than their larger counterparts this year; the Russell 2,000 has rallied 11.5%, outperforming the S&P 500 by about 3.5 percentage points.
The small-cap space is “a fertile ground for active management,” Zhang told Business Insider in an interview on Tuesday.
For one, there are nearly nine times as many US small caps (worth $200 million to $2 billion) as there are mega-cap companies worth more than $50 billion. This means there are far fewer analysts available to cover small-cap companies, the stocks are less liquid, and institutional ownership is less.
This inefficiency means stock pickers who do the grunt work may find outsize opportunities that have fewer eyeballs.
“People ask me if I’m surprised by the performance, and I don’t want to sound arrogant, but I think it’s a testament to long-term stock-picking investors like us,” Zhang said.
Though market cap is widely used to separate small caps from mega caps, Zhang prefers to use revenue to define company sizes — specifically those with no more than $500 million in revenue as a starting point.
It’s all about data
From there, companies she finds attractive tend to have one thing in common: their ability to turn data into actionable information.
Veeva Systems fit that profile.
It’s essentially a tech company for the healthcare industry, providing content-management software. Pharma and biotech companies, for example, can use Veeva’s cloud-based software to scan documents securely from mobile phones or track data during a clinical trial.
Veeva’s clients include Merck and Biogen. The company had $512 million in cash at the end of the second quarter and earned $209.6 million in revenue.
Though Veeva is firmly in the life-sciences arena, it also creates software for companies in the consumer-goods and chemical industries.
“There’s still lots of room for growth,” Zhang said, notwithstanding the stock’s 88% surge this year and 135% gain since it went public in 2013.
“We always invest in companies that have long-term secular trends,” Zhang said, including another tech company called Cognex.
Zhang describes it as making “machines that can act like the human eye and the human brain, which is not easy.”
Cognex’s machine-vision products span from barcode readers to laser cutters and Zhang’s self-professed favorite: inspecting pizzas to ensure they’re adequately covered with cheese.
“It’s more precise,” she said, and taps into the longer-term trend of human tasks being reassigned to machines that can do them more efficiently.
What also makes Cognex attractive is that its core technologies can be applied — and are already being used — in various industries, which gives the company longevity, Zhang said.
The company’s total addressable market is north of $3.5 billion, she said.
A common thread that runs through these companies is that they have a healthy spend on research and development as a share of revenue. For Zhang, it’s a demonstration that they are investing in the future.
Cognex spent $27 million, or 13% of its revenue, on R&D during the second quarter. It reported $755 million in cash and investments and no debt.
Another characteristic Zhang looks for when picking stocks is companies that address a pain point for customers.
That’s partly why Apptio was a buy, and it remains a top-10 holding in her portfolio.
Apptio uses companies’ IT data combined with details of their finances to budget and plan their technology needs.
The company started with enterprises but is now gaining federal clients including Washington state.
“That’s opened up a whole new addressable market,” she said, adding that these tended to be sticky long-term contracts that are expensive to cancel.
Apptio is also net cash positive, with $255 million in cash and $143 million in debt at the end of the second quarter.
Its stock has surged 72% in 2018.