Back in the bubble days, many momentum investors focused on technology and dot-com stocks for a quick buck. Now, as the economy tries to emerge from recession, momentum investor Giles Knight of the ARK Small Cap Equity Fund (ARPAX) is betting on cyclical, small-bank, and consumer-discretionary stocks.
Knight says bailing out of tech stocks in the spring and summer of 2000, and staying out of the sector for the past two years, has helped his fund's performance. Now he says he's looking at technology stocks, but not the telecom group.
Knight's strategy has propelled the fund's performance much higher than its peers, helping it earn a 5-STARS
overall rank from S&P. ARK Small Cap Equity rose an average annualized 22.9% for the five-year period through February, compared with a 6.2% return for all small-cap growth funds. For the one-year period through February, the fund declined 1.7%, while its peers lost 13.3%.
Bill Gerdes of S&P's FundAdvisor recently spoke with Knight about the fund's investing strategy, top holdings, and recent portfolio moves. Edited excerpts from their conversation follow:
Q: Tell us about your investment approach.
A: We focus on aggressive, momentum-driven stocks in terms of earnings and revenue. We like growing revenue the most and avoid industries without favorable growth prospects. If we like a sector, we'll double our weighting relative to the Russell 2000 Growth Index, our benchmark.
Q: As a momentum investor, do you trade frequently?
A: We believe in the cockroach theory -- if there's one cockroach, there tend to be others. So if a company has a bad quarter, we'll bail out, since it can take three or four quarters before a stock comes back. Our turnover is fairly high, currently about 300%. We don't believe in "Waiting for Godot," sticking with a company until it rebounds.
Q: Do you have a maximum market-cap for a holding?
A: It's about $3 billion, although that's not a hard and fast figure. The average market cap for the fund currently is $1.19 billion. Normally, our targets range between $1 billion and $1.8 billion.
Q: What impact have the accounting issues raised by the Enron scandal had on small-cap growth investing?
A: Money managers now want to hear stories with lots of meat to them, not just hype. There's a lot of concern about the balance sheets of small-cap companies, but it's generally easy to track the operations of small companies, since they usually have only one or two products.
Q: What's your view of the balance sheets of small tech companies?
A: Many small tech companies don't have the scale of IBM or Hewlett-Packard, so it's easier to spot fraud. But that's not always the case -- if someone wants to defraud you, he generally can.
Q: How has the economic downturn affected your search for rapidly growing companies?
A: We've been holding more stocks for longer periods. For example, we currently have 60 stocks instead of our usual 50 positions. We're also holding lower
beta stocks and increasing our cash position to about 15% currently. But as the economy starts to look better, we're more likely to move into higher-beta stocks.
Q: How would you characterize the portfolio currently?
A: With the economy rebounding, we're focusing more on cyclical stocks and smaller bank stocks. We like consumer-discretionary companies because the average person, unlike dot-com workers or investment bankers, wasn't hurt in the recent downturn. The U.S. was able to get out of the recession because consumers weren't affected.
I've bought some family-restaurant stocks and some travel stocks, such as Royal Caribbean Cruises (RCL), Mesa Air Group (MESA), and SkyWest (SKYW). I think Americans will continue to spend, so the consumer-discretionary sector should grow for another six to nine months.
We're also looking at technology, but not telecom stocks since they aren't improving, despite some recent hype.
Q: So when do you think technology will come back?
A: Technology won't recover quickly. Some areas will do well, such as chip companies, but it will be a while before they reach their old highs. Telecom won't come back for at least two years because of the industry's debt overhang. Within technology, some defense and surveillance companies will do well because of September 11.
Q: Why do you like small banks?
A: Small banks look interesting because corporations are turning to them for funding since the IPO market is dead. Even if interest rates go up, loan volume at small banks should do well. Right now, we don't have many pure small-bank plays, but I'm sharpening my pencil in that area.
Currently, we have some financial stocks, such as Saxon Capital (SAXN), MutualFirst Financial (MFSF), Friedman Billings Ramsey (FBR), and Ceres Group (CERG). We also like small banks because there should be lots of consolidation. There are more than 5,000 banks in the U.S.
Q: This fund has held up better than most small-cap growth funds over the past three years. How come?
A: Cutting back on technology in the spring and summer of 2000 saved our performance. Then staying out of technology helped us for the past two years. Earlier in 1999, our overweighting in technology was a plus.
Q: What are your largest holdings?
A: Alliant Techsystems (ATK), a small-arms producer; Kulicke & Soffa (KLIC), a chip wire bonding company; and Crown Cork & Seal (CCK), a tin-can manufacturer. Crown Cork & Seal is a turnaround situation, which is unusual for a growth fund, but I like the flexibility of buying something with a little value. Up to 15% of the fund can be in special-situation companies.