Year in Review: What’s Driven Our Small Cap Fund’s Outperformance?

Posted by Dana Funds Investment Team on Nov 4, 2021 9:44:33 AM

The past 12 months have set up a favorable environment for active small cap managers, as company-specific fundamentals were rewarded by the market. Against that backdrop, Dana’s small cap Fund has delivered. The Fund has enjoyed a strong year of relative outperformance, returning 21.11% year to date and 56.28% for the 12 months ended Sept. 30. Those returns compare favorably to its benchmark Morningstar U.S. Small Core Index, which returned 12.98% and 42.68%, respectively, over the same time frames.

Dana’s small cap team attributes the outperformance to a few factors, but one of the biggest is the market’s renewed focus on earnings. In the first and second quarter of 2021, there was a wider than normal dispersion in quarterly earnings estimates, in part because many management teams had withdrawn earnings guidance, or admitted that guidance wouldn’t be precise, given economic uncertainty as the U.S. economy continued its path toward reopening.

When earnings came in, companies that beat both revenue and earnings expectations were rewarded by the market. In short, we believe understanding company-specific fundamentals and individual stock selection mattered. For Dana, stock selection has been a positive contributor to relative performance in every sector but one this calendar year, with health care and industrials sectors leading the way.

A Closer Look at Health Care and Industrials

Within the health care sector, much of the outperformance is due to stock selection among biotech companies. As mentioned in a prior blog, small-cap biotech stocks are often at risk of a binary outcome: the success or failure of a clinical trial for a drug under development. The small cap team has approached the sector by taking smaller positions in companies that are in the nascent stages of drug development and early earnings stage. These companies are more likely to be heavily penalized by the market when there is negative news about a trial. The team has also been opportunistic, adding companies when the market overreacts to news on a clinical trial.

The team has balanced its approach by also finding companies that are benefiting from broad innovation in the sector, but whose fortunes aren’t tied to a single clinical outcome. An example would be a company that provides technologies that help other biotech companies with established therapies be more effective or tolerable.

Within the industrial sector, the team has always focused on companies that have pricing power for their business. As firms navigate an inflationary environment, that pricing power has mattered more, as the market has rewarded companies that can pass rising prices on to their customers.

The market has also placed emphasis on industrial companies’ ability to navigate its supply chains with minimal disruption, and Dana’s small cap strategies hold several industrial companies that have done well in this regard.

Balanced Sector Exposures

A key feature of Dana equity strategies is that they do not take sector bets. For every sector, the fund’s weightings align closely with the benchmark. The rationale is that macro bets and sector calls are harder to predict and that it is preferable to keep the investment focus on finding the best individual stocks.

As part of that sector-neutral approach, the small cap fund has maintained an allocation to the energy sector at a time when many managers minimized their exposure. This helped performance during the year, as the energy sector massively outperformed other sectors in the index after commodity and energy prices surged in anticipation of an economic rebound.

Finally, from a factor perspective, Dana has benefited from valuation coming back into favor, and momentum and growth being less in favor.

Looking Ahead

For the broader small cap universe, we believe the outlook is improving. Some of the worst-case scenarios on the fiscal policy front have been avoided, which should benefit domestically focused small cap companies. As supply chain issues are worked out throughout the year, and if the COVID cases continue to ebb, we believe economic strength would also benefit small caps.

In terms of relative performance, if the market continues to show more breadth — with a greater set of stocks driving the market — and if it continues to reward companies that are consistently beating earnings expectations, then the backdrop should continue to be favorable for active management, and our investment process.

 

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The Dana Funds are distributed by Ultimus Fund Distributors, LLC. There is no affiliation between Ultimus Fund Distributors, LLC. and the firms referenced in this blog post.