Small cap growth stocks are typically considered to be at the riskier end of the investment spectrum, but with that risk may come great potential.

For instance, the Russell 2000 Growth Index, which measures the performance of the small stock growth sector, was up over 30% in 2020. (See Thrivent Small Cap Growth Fund performance)

“The growth prospects of the small cap market can be summed up in one word,” explained David Lettenberger, Thrivent Small Cap Growth Fund Senior Portfolio Manager (TSCGX), “and that one word is ‘innovation’.”

While established blue chips with global customers and a history of success are considered less risky than the upstart small caps, many young firms tend to be more innovative, offering new ideas and sometimes creating new marketplaces.

“Change creates opportunity,” Lettenberger noted, “and entrepreneurial individuals, and companies, seize upon these opportunities to create new businesses. Over time, they can create a tremendous amount of value for their stakeholders.”

Ferreting out prospects

Finding tomorrow’s winners in the evolving universe of small cap growth stocks requires a solid research process and a well-measured investment strategy.

“Our strategy,” said Lettenberger, “is to identify companies that have large and growing end markets, and then to determine if they have a competitive advantage that would allow them to win in those markets.”

As part of the research process, the Fund’s managers, in collaboration with Thrivent’s experienced team of research analysts, formulate an estimate of a company’s future revenues and cash flows, then discount those cash flows to present value to establish a fair current value for a particular stock.

“This approach is important given that many of these companies are very early in their growth trajectory,” explained Lettenberger, “and much of the current value of a stock is tied to how long the company can sustain high growth rates into the future.”

To help formulate their estimates, the team goes into the trenches, making visits to meet with management or see the facilities – either by air or by Zoom. With the pandemic upending normal travel and in-person visits, the Fund team replaced onsite visits with virtual meetings – and found it far more efficient. “In the last year, our company contacts have gone up by a multiple of at least two or three times,” Lettenberger said.

When a stock on their radar meets their approval – and their target price range – that’s when the Fund would typically establish a position in the stock.

As they track each holding, the team assesses how the company’s performance is stacking up with their analysis. If their projections for the company are holding up, they may add to their position. But if their expectations have played out or are no longer valid, that’s when they would likely sell or reduce their position.

Sell strategy: Happy trails to you

Lettenberger characterizes the sell strategy of the Fund as either “the happy sale, or the unhappy sale.” The former includes companies that become so successful they outgrow the fund’s cap range – which tops out at about $6 billion for new purchases. The latter are typically companies that disappoint when they fail to execute on their strategy or their revenue projections. “In a lot of cases, you have management teams that are at their first rodeo – they haven’t run a public company before,” Lettenberger said.

While not every pick works out when building a portfolio of unproven prospects, other holdings may exceed expectations – particularly when aided by a sea change in market dynamics.

For instance, the Fund bought shares in Bandwidth (BAND) in late 2019 based on their projections that the company could sustain annual growth in the range of 25%. But the cloud-based telecommunications provider – used by such applications as Zoom and Microsoft Teams – experienced accelerated growth in 2020 when the pandemic fueled a surge in virtual communications in nearly every phase of life – from schools and businesses to churches and social clubs.

Similarly, the Fund entered 2020 owning software companies whose products and services targeted both e-commerce and call center applications. While Lettenberger was already confident in the growth prospects of these holdings, Covid-19 lead to an even stronger growth trajectory and outsized equity returns.

Mitigating risk

While small caps carry more risk than the more established companies, Lettenberger explained that risk can be mitigated by investment managers with the discipline to:

• Identify the most promising emerging companies and apply a consistent, disciplined research approach to every prospective investment,
• Diversify broadly among industries and sectors,
• Take profits when successful holdings outgrow the small stock cap range,
• Take losses and move on when an investment disappoints.

The Fund owns, on average, about 100 names, and each of the 10 largest positions represent about 1.5% to 2.5% of total assets. Portfolio turnover was 56% as of March 31, 2021 – which is well below the industry average – as the management team employs a long-term investment approach.

The smallest positions – less than 1% – are apt to be taken in the riskiest areas, such as biotechnology. This is a field where companies can bet everything on an individual drug or therapeutic regimen, creating what Lettenberger terms a “binary risk.” “That’s when a single event, such as failing to get FDA approval, could destroy the growth assumptions for that company.” On the other hand, a small biotech that succeeds can see exceptional stock growth.

Searching for growth opportunities

Recent economic events, including the wholesale changes wrought by the Covid-19 pandemic, have thrown a spotlight on how Lettenberger and his colleagues navigate an ever-changing stock market.

After a banner year in the market, like 2020, some fund managers pivot to value stocks, but Lettenberger tries to maintain a consistent focus on growth stocks regardless of the market cycle. However, the Fund may opportunistically stretch its allocation in sectors that the team considers undervalued.

For instance, when the manufacturing sector suffered setbacks in the early months of the pandemic – as supply and distribution channels were disrupted – the Fund shifted its weighting in that sector from underweight to overweight, with particular emphasis on cyclical companies that tend to do well when spending revives.

“Importantly, even investments made in these more cyclical industries are focused on companies that are growing relatively faster than their peers,” noted Lettenberger.

Although the Fund is not a technology fund, it does invest heavily in that sector – and in industries that are affected by evolving technology. “Innovation happens everywhere,” Lettenberger explained. “It’s not just isolated to technology and healthcare. It’s happening in the financial sector. It’s happening in the industrials.”

Its leading holdings  as of March 31, 2021 include LHC Group, a provider of home health services; Middleby, a manufacturer of commercial and industrial food preparation equipment and residential appliances; Five9, a provider of cloud contact center software; Inspire Medical Systems, a developer of sleep apnea treatment products; and Natera, a leader in DNA testing and women’s health.

“I think small cap growth stocks have tremendous potential going forward, led by innovation that is impacting all industries” said Lettenberger.

But to take advantage of that potential, it’s important to stay focused on changes in technology and market dynamics. “When things change,” said Lettenberger, “you need to put your learning hat back on and figure out how you can benefit from that change.”