The small cap stock universe is loaded with promising companies that seem to hold the potential to prosper and grow into mainstream market leaders. The challenge for investors is to ferret out the small cap stocks with the best chance of overcoming the inevitable economic downturns and growing pains that young companies face in order to realize that long-term potential.

The performance of small cap stocks tends to be less predictable and more volatile than that of the well-established large cap asset class. According to Morningstar, only six U.S. equity funds outperformed their benchmark each of the past five years through 2020 out of U.S. Equity Funds that had a 10-year history and current assets under management of at least $100 million.ⁱ  Thrivent Small Cap Stock Fund (TSCSX) is one of only four U.S. equity funds that have exceeded their benchmarkⁱⁱ for six consecutive years.

Much of that success can be attributed to a sound investment process focused on controlling risk and taking a long-term approach. According to Matt Finn, senior portfolio manager of the Thrivent Small Cap Stock Fund, “an important focus of our process is controlling risk, which means that fewer things can go wrong. For instance, we don’t try to time the market and hold too much cash, and we try to stay fairly well diversified across all sectors – although there may be times when we are overweight or underweight in a sector, depending on the opportunities we see in those sectors.”

The other key to the Fund’s success is the competence of the management team, adds Finn, who serves as the head of equity portfolio funds at Thrivent after more than three decades in the fund management arena. “Right now,” he says, “I have the best team that I’ve ever had.”

Fund management process

The management team adheres to a rigorous process in selecting stocks and managing the Fund, with a bottom up approach aimed at identifying quality companies at attractive prices. But while the team members are constantly searching for value, that doesn’t mean that low prices always catch their eye.

Jim Tinucci, a senior portfolio manager for the Fund, acknowledges, “some people ask us what it means to invest in quality companies at attractive prices.”  He explains that they can’t know everything, about every business, all the time. However, company managements typically have only two levers to improve their businesses – they can sell more per dollar of capital invested or they can generate more profit for each dollar of sales. The product of these two ratios is a company’s return on invested capital (ROIC).

“Cheaper stocks are not always the best investments,” explains Tinucci. A lot of stocks may look cheap, but there may be a reason for that. Paying up for a higher quality company may be a worthwhile investment for the long term.

Assessing the investment potential of small cap stocks is particularly difficult because many of those companies have no earnings or even negative operating profit, so the team needs to look beyond earnings to assess other factors.

The investment process begins by generating a list of potential investments through quantitative screening and in-depth proprietary research. “We want to focus our qualitative efforts on a small list of likely outperformers,” says Tinucci. The team is constantly searching for hidden gems. “We don’t want to fish in the same pond as everyone else.”

Their fundamental research process consists of three parts. The team looks for companies that:

1. Have 30 - 50% upside over the next two to three years
2. Are well-positioned to earn – or are on a pathway to earn – an ROIC above their cost of capital and have stable operating performance – or are expected to improve their operating performance
3. Are underappreciated, overlooked, or have a contrarian piece to the story.
   

Creating a thesis for each stock holding

Their portfolio maintenance and sell discipline use the same three parts as their fundamental research process: “When valuation is high, operating performance is above expectations, and sentiment reflects positive earnings estimate revisions or price momentum, we are generally reducing positions,” says Tinucci.

When an investment is made, they document the thesis. It summarizes what they believe will happen, what it would take to believe they are wrong, and how that translates into ROIC and valuation. They then track the thesis over time, updating their viewpoint as incremental information becomes available. When the thesis has played out or is no longer valid, they sell the company.

Risks of small cap stocks

“One reason to like small companies is that they have a large growth runway,” says Tinucci, “but fast growth can create growing pains.” Small cap stocks may also face less scrutiny than large cap companies. “Newer companies in the market often do not receive the same level of audit oversight as the larger established companies.”

Small companies tend to be more concentrated and less diversified. “Small stocks are very often newer and less proven, so that adds some business risk,” explains Finn. Another challenge with small caps is that the universe is constantly changing. “It’s a very dynamic asset class, with some stocks graduating to the mid cap sector while newer companies are coming in.”

Small cap stocks may be more volatile than larger companies, although Finn explains, “I don’t always see that as a problem. I see it more as an opportunity. I believe small cap is an asset class where active management can add value.”

Sectors of interest

The Fund seeks to maintain diversification across all sectors, with weighting similar to its Lipper peer group (Lipper Small-Cap Core Funds). But there are certain sectors the team believes offer more attractive opportunities than others.

Currently, the Fund has strong positions in several key areas:

Regional banks

Among the Fund’s top holdings is Triumph Bank (TBK), a regional bank that caters to the trucking industry. “Triumph offers a payment platform used by shippers and freight brokers to process, settle and manage carrier payments across all modes of transportation,” says Finn. “They also offer factoring, which allows truckers to get paid days sooner than shipping companies would typically pay them.”

Industrials

Another top holding is Raven Industries (RAVN), which operates in several sectors. “A large part of Raven’s business involves manufacturing composite films for the oil and gas industry, which gives our fund some exposure to the energy sector,” says Tinucci. While the Energy sector has recently suffered due to the decline in global travel, Tinucci points out that once travel returns to normal levels, the demand should rebound. Raven is also a leader in the precision agriculture market, including applications for tractors that provide GPS assistance and automation of seed and fertilizer application. “While the agriculture business is cyclical,” says Finn, “Raven has been increasing its penetration in that business.”

Other top holdings include:

• Manpower (MAN), a leader in providing companies with temporary and contract workers. “When the economy goes down, temp workers tend to be the first to go, but as the economy rebounds, the first workers to return are often temp workers,” says Finn. Manpower has a strong presence in France where temp staffing is particularly popular.

• QuinStreet (QNST), which focuses on modernization of outdated business systems and processes in online marketing, mostly in the insurance sector. It is a leader in customer lead generation and operates multiple fully integrated online sites with access to most carriers, enabling users to receive binding quotes and purchase insurance online.

• Agilysys (AGYS), which offers technology to help the hospitality industry manage contactless solutions for guest engagement, such as reservations, check-in and table management.

• Air Lease (AL), which focuses on leasing newer, energy-efficient aircraft. As air travel picks up and demand grows, the company could benefit if the airlines prefer to lease rather than buy new aircraft in order to allocate more funds to paying off the sizable debt they’ve incurred during the pandemic.
  

Despite their potential pitfalls, small companies help drive the economy, foster innovation, and offer investors the potential for solid long-term gains. While they may carry more risk than large caps, Finn believes they’re worth the extra risk for patient investors. “Small caps have outperformed large caps over the long term, and they provide a diversification benefit for a well-balanced portfolio.”

For more information about the Thrivent Small Cap Stock Fund and its current performance, visit Thrivent Small Cap Stock Fund.