A Strategy That Yields Results
Although most small-cap funds are down sharply this year, small-cap value funds have fared better. For some, such as PIMCO Small Cap Value Fund/A (PCVAX ), the sun is starting to shine again.
Year to date through Oct. 18, the fund, which until recently carried a Standard & Poor's Select Fund designation, managed to return 7.8%. The Russell 2000 Value index, against which the portfolio is often compared, dipped 0.9%, while the S&P 500 fell 18.3%.
Lead manager Cliff Hoover believes that an unwavering policy requirement that all companies in the portfolio pay dividends is a key reason for the fund's relatively strong performance this year. He stresses the importance of dividends as a fundamental indicator of corporate health.
This dividend requirement -- along with other value measures applied to companies in the portfolio -- kept performance in check in 1998 and 1999, when investors embraced growth at all costs. Following three consecutive years, 1995, 1996, and 1997, when the fund returned 26%, 28% and 35%, respectively, PIMCO Small Cap Value lost 9.2% and 6.5% in 1998 and 1999.
"Those were difficult years," said Hoover in a recent interview at Standard & Poor's. "It was hard to convince our clients that things would turn around," he added. The long-awaited turn finally came in 2000, when the portfolio returned 21.2%, nearly matching the Russell 2000 Value's 22.8% return and the beating S&P 500, which fell 9.1%.
Why is this insistence on dividends so critical to the investment process for PIMCO Small Cap Value Fund? The requirement is unusual, "especially for a small-cap portfolio," admits Hoover, but it is important, he said. "We want to align ourselves with historical factors that work," Hoover explained. These include not only traditional value flags, such as low price-to-earnings and low price-to-cash-flow, but also indicators that suggest long-term growth of an investment.
"We have studies that show that higher-yielding stocks have outperformed non-yielding stocks in the small-cap arena" over extended periods, said Hoover. To Hoover and other members of NFJ Investment Group, who manage this fund, "dividends are the only assured part of growth." Hoover said the other component of growth is p-e expansion, which may or may not occur.
Citing data from Ibbotson Associates, Hoover noted that dividends have constituted about 43% of total returns going back to the 1920s, softening market declines and enhancing returns in the good years.
In addition to the dividend, the managers also look for specific valuation criteria, including low p-e, quality of earnings, and a healthy balance sheet. Companies that pass these initial valuation screens are a "fishing pond" from which portfolio selections are eventually made. Further investigation focuses on fundamental analysis, including the sustainability and growth of the dividend.
The portfolio has 100 holdings, which are all approximately equally weighted. The addition of a new investment is always triggered by a decision to sell an existing holding or by its removal through acquisition or merger. Although some companies are removed because they exceed the small-cap size limitation -- $400 million to $1.5 billion -- this is a rare occurrence.
As of Sept. 30, the fund's top ten portfolio holdings were: Homestake Mining Co. (HM ) and Ball Corp. (BLL ), each representing 1.2%, followed by AmerUs Group (AMH ), Vectren Corp. (VVC ), Susquehanna Bancshares (SUSQ ), Health Care Properties (HCP ), Dean Foods (DF ), Sturm Ruger (RGR ), Dentsply International (XRAY ), and Washington Federal (WFSL ), each representing 1.1%.
The fund is diversified by industry to reduce volatility, but there is no attempt to mimic the industry weightings of any index. The fund does not invest more than 10% in any one industry. Absolute and relative valuation tend to act as governors, limiting exposure to industries that are becoming overvalued.
In other words, absolute valuation rules preclude the addition of stocks trading above their industry p-e ratio. Relative valuation generally comes into play during screening. If the screen uncovers an alternative to one of the fund's holdings with equally strong fundamentals but a substantially lower p-e or a substantially higher dividend yield, a substitution may be made.
The fund has been team-managed by Dallas-based NFJ since November 1995. NFJ, founded in 1989, consists of six portfolio manager/analysts and an equity trader. The manager/analysts average nearly 25 years of experience and nearly nine years with NFJ. Team compensation is tied to investment and business success. About 40%-50% of the team's 401(k) plan is invested in the small-cap value portfolio that it manages, Hoover noted.
From Standard & Poor's FundAdvisor