Ellenbogen Wins With Best Small-Cap Fund: Riskless ReturnCharles Stein
Henry Ellenbogen had a tough act to follow when he took over the T. Rowe Price New Horizons Fund in March 2010. His predecessor, John Laporte, had beaten three-fourths of peers in his 22-year tenure as manager.
Ellenbogen is doing even better so far. T. Rowe Price Group Inc.’s New Horizons had the highest total return over the past three years and the best risk-adjusted performance among small-cap funds that buy U.S. stocks, according to the BLOOMBERG RISKLESS RETURN RANKING. The $12.2 billion fund, which has more than doubled in size since Ellenbogen became its manager, had about average volatility among 57 small-cap funds with at least $2 billion in assets.
Ellenbogen won because of an unusual strategy for a fund that buys small-company stocks: He holds on to winners such as Netflix Inc. and Regeneron Pharmaceuticals Inc. long after they graduate into mid-sized or large companies. The fund, which was started in 1960 by Thomas Rowe Price Jr., founder of the Baltimore-based mutual-fund firm that bears his name, is based on a belief that wealth is created by finding the small companies that will become market leaders.
“The trick is identifying the companies and having the patience to hold on to them,” Ellenbogen, 40, said in a telephone interview. “Both parts are equally hard. Sometimes one of the best things I do is resist the desire to trade.”
The fund over its history has invested in Xerox Corp., Texas Instruments Inc., Wal-Mart Stores Inc. and Starbucks Corp., according to a 2010 regulatory filing.
Small-capitalization stocks are those defined by Chicago-based Morningstar Inc. as those with a market capitalization not exceeding $3 billion. The New Horizons fund’s willingness to stick with stocks even after they’ve grown above that threshold allows it to benefit from their expansion without taking on extra volatility. The Russell 2000 Index of small U.S. companies had volatility of 24.2 over the past three years, compared with 17.3 for the Standard & Poor’s 500 Index of large stocks.
The risk-adjusted return isn’t annualized. It’s calculated by dividing total return by volatility, or the degree of daily price variation, giving a measure of income per unit of risk. Higher volatility means the price of an asset can swing dramatically in a short period, increasing the potential for unexpected losses.
The New Horizons fund returned an adjusted 4.5 percent in the three years ended Aug. 2, with the highest absolute return of 104 percent during that period. The fund’s volatility of 22.9 compared with average price swings of 22.6 for the group, according to data compiled by Bloomberg.
The $2.4 billion Janus Venture Fund ranked second with a risk-adjusted return of 4.1 percent. It had the fourth-highest total return among the 58 funds with lower than average volatility. The $2.3 billion Brown Capital Management Small Company Fund had the third-best performance of 3.9 percent when adjusted for price swings, combining the third-highest total return with average volatility.
The top-performing funds in the ranking were growth funds, or those that invest in companies expanding profit faster than peers, while those with the poorest returns were value funds, or those that buy shares that the managers deem cheap compared with yardsticks such as earnings. The Russell 2000 Growth Index gained 77 percent in the three years ended Aug. 6, including reinvested dividends, compared with an increase of 61 percent for the Russell 2000 Value Index.
Ellenbogen, who has studied the history of the fund, said much of its outperformance can be attributed to a small number of stocks that successfully made the transition from small to large. That observation explains why New Horizons is willing to continue holding stocks after they have grown beyond the traditional small-cap category, he said.
Netflix, the largest individual stock position in the fund as of June 30, has more than doubled this year and has a market value of $15.1 billion. Regeneron Pharmaceuticals, a Tarrytown, New York-based biotech firm, has a market value of $25.4 billion after rising more than 10-fold over the past three years, according to data compiled by Bloomberg. It was the best-performing stock in the S&P 500 Index in that period.
In a 2003 interview with Bloomberg News, the fund’s previous manager warned investors not sell “great companies too early.” It makes no sense to sell a stock just “because it hits an arbitrary number,” Laporte said at the time.
Laporte, who oversaw a quintupling of assets at the fund during his two-decade career at the helm, was named Morningstar’s “fund manager of the year” after New Horizons climbed 55 percent in 1995, when the S&P 500 rose 38 percent.
Ellenbogen has benefited from some of Laporte’s picks. Regeneron has been in the portfolio since 2007. O’Reilly Automotive Inc., which has more than doubled in the past three years, has been a holding since 1999, according to Morningstar.
Ellenbogen trades stocks far less than his rivals. New Horizon’s turnover ratio, a gauge of how much the portfolio changes in a year, is less than half the average for small-cap growth funds, according to Morningstar Inc. in Chicago.
“The fund has been able to outperform without taking more risk than its peers,” Jeff Tjornehoj, an analyst with Denver-based Lipper said in a telephone interview.
Ellenbogen joined T. Rowe Price in 2001 after attending Harvard University in Cambridge, Massachusetts, where he earned three degrees: a bachelor’s degree, a law degree and master’s in business administration. From 2005 to 2009, he was a manager on the T. Rowe Price Media & Telecommunications Fund, which beat 99 percent of rivals in that period, Morningstar data show.
Ellenbogen has had his share of successes at the New Horizons fund as well. In the second quarter of 2012, he invested in Lumber Liquidators Holdings Inc., a Toano, Virginia retailer that specializes in hardwood flooring. The investment followed the appointment in January 2012 of Chief Executive Officer Robert Lynch, who according to Ellenbogen understood what it would take in terms of people, customer service and information systems to expand the company.
“One question we ask here is: Does management have the mindset to lead the company to a second act, which is what you need to become a billion-dollar company,” said Ellenbogen.
Lumber Liquidators last month boosted its revenue and earnings forecast for the year after same-store sales in the second quarter climbed 15 percent. The shares are up 82 percent this year.
Another winner in the portfolio is Los Gatos, California-based Netflix. New Horizons bought the stock in the fourth quarter of 2011, after the shares tumbled when management’s decision to raise prices cut the firm’s growth rate.
Ellenbogen said he liked the fact that Netflix executives owned up to their mistakes. He also concluded that the business could recover as Netflix invested in original programming. Netflix shares have quadrupled in the past year, according to data compiled by Bloomberg.
Some of the biggest contributors to the fund’s performance over the past three years have been biotechnology stocks, according to portfolio data compiled by Bloomberg. In addition to Regeneron, the fund has benefited by owning Cheshire, Connecticut-based Alexion Pharmaceuticals Inc., which has quadrupled over the period, and Pharmasset Inc., a Princeton, New Jersey-based company that was acquired in 2012 for $10.6 billion by Gilead Sciences Inc., according to data compiled by Bloomberg.
The fund relied heavily on Kris Jenner for biotech picks, said Katie Rushkewicz, an analyst with Morningstar. Jenner left the firm in February after more than a decade as the manager of the $6.7 billion T. Rowe Price Health Sciences Fund. The fund beat 82 percent of peers over the past five years, data compiled by Bloomberg show.
“His departure is a source of some concern, because biotech has fueled big gains in New Horizons,” Rushkewicz said in a telephone interview.
Ellenbogen said that while Jenner was an “excellent” investor, T. Rowe Price has talented professionals who analyze biotech investments.
“We feel good about our team,” Ellenbogen said.
In the short run, the fund’s performance will be driven by its larger holdings, said Ellenbogen. Over a longer period, the fund will succeed only if its investments in small fast-growing companies pay off.
Each year, Ellenbogen devotes a portion of his capital to early-stage companies, including some privately held firms. New Horizons as of June 30 had 0.7 percent of assets in Twitter Inc., the San Francisco-based microblogging and short-messaging company. The fund also invested in Angie’s List Inc., an Indianapolis-based Internet company, when it was still private. The shares have climbed more than 75 percent since its 2011 initial public offering.
The newer investments won’t have much impact on results in 2013 or 2014, said Ellenbogen.
“But you can be sure they will make a difference in 2015, 2016 and 2017,” he said. “We are hopefully planting the seeds for the future.”