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Advisor select

Ralph Bassett is Deputy Head of North American Equities. Ralph joined Aberdeen in 2006 from Navigant Consulting where he worked as a management consultant providing client anal +

Aberdeen U.S. Small Cap Equity Fund
GSXAX (Class A)
GSXCX (Class C)
GNSRX (Class R)
GSCIX (Inst Class)
GSXIX (Inst Svc)
Fund Family
Aberdeen Funds
Fund Advisor
Aberdeen Asset Management Inc.

1735 Market Street, 32nd Floor
Philadelphia, PA 19103

T: 800-485-2294

Searching for Quality in Small Caps
Aberdeen U.S. Small Cap Equity Fund
Jun 1, 2017

Q: What is the history of the fund?

The Aberdeen U.S. Small Cap Equity Fund was launched in November 2008. We inherited the fund after our firm acquired 26 funds from Nationwide earlier that year, and I have been the portfolio manager ever since.

If anything, our evolution has focused on applying extensive, proprietary, and bottom-up research to gain deeper coverage and greater insight into the small-cap universe of companies included in the Russell 2000 Index. As buy-and-hold investors, we seek to identify those with a long-term and sustainable competitive advantage. We are not in the business of trading in and out of stocks – not on a daily, weekly or even monthly basis.

While other funds may have hundreds of holdings, our portfolio is far more concentrated, with just 40 to 60 companies. Our rigorous stock-selection approach ensures we pick what we believe to be the best stocks for our clients without overly diversifying away alpha. This strategy has allowed the fund to do well in a less risky way, whether in terms of standard deviation or tracking error.

Over time, our objective is to provide our clients with more consistency in performance and greater downside protection – the businesses in our portfolio may not be the most exciting, but neither are they deeply cyclical.

Q: What are the core tenets of your investment philosophy?

Our process is based around investment-quality businesses. Quality, especially in small cap, to us means businesses that are exhibiting sustainable competitive advantages and good business models. They are well-managed, which oftentimes is not the case in the small-cap world. 

This level of quality is characterized by certain measures, so in aggregate, our businesses tend to have better profitability whether looking at operating margins or returns on capital. They also tend to have lower leverage. 

Over time, our objective is to provide our clients with more consistency in performance and greater downside protection – the businesses in our portfolio may not be the most exciting, but neither are they deeply cyclical. Ultimately, we seek companies which will prosper and compound growth over a business cycle and not be as subjected to significant fluctuations in the market or the economy.

Q: Can you explain in a few steps how your investment process works?

Our universe includes companies with market capitalizations ranging from approximately $250 million up to $5 billion, and the process used to evaluate them is predominantly qualitative. To ensure the portfolio remains small cap, only companies below the upper level of the Russell 2000 Index are considered, and we sell out of them when they reach $5 billion. 

Much of our due diligence focuses on companies in the $500 million to $3 billion range because we want our holdings to deliver and grow over time. Were we to purchase a $4.5-billion company that grew to $5 billion in just a few months, the fund’s performance would benefit but we would still be disappointed because it migrated out so quickly.

Through extensive research, we whittle down 2,000 possibilities to a theoretical universe of 1,000. Our team of 13 has firsthand knowledge of much of the Russell 2000, especially companies deemed investable from a liquidity standpoint; we visit approximately 900 small companies a year. 

Going back to our measures of quality, key considerations are a company’s level of profitability and its ability to generate cash flow – eliminating many speculative energy and biotech firms from our purview. 

Our process is quite focused on what we own. Because we are buy-and-hold investors, we neither want to give a company too much credit nor pass by others of better quality. As a result, a great deal of time is spent on portfolio weightings and testing of our theses.

Even though the portfolio begins with such a big universe, only a handful of companies – roughly 50 – make it in, so it has high incremental barriers to entry. We always have a list of 10 to 20 fully-vetted names ready to go in, so we aren’t overly reliant on finding new ideas. It’s more a question of timing and portfolio construction for us.

Q: Would you give an example to illustrate your research process?

In the small-cap banking industry, we noted a great deal of consolidation taking place. While acquisitions certainly carry risk, they also create opportunities for companies that manage it well – like Glacier Bancorp, Inc., a Montana-based commercial banking services provider.

When we began researching Glacier in 2012, we found it to be an extremely skilled consolidator. Not only had the company taken share from larger peers that were distracted coming out of the financial crisis, it was creating value beyond that, so we added it to the portfolio last year.

  • Inception: November 2, 1998
  • AUM: $1.8 billion

Glacier faced little competition in its mostly rural territory, which put a competitive moat around its business. Often, Glacier is the only bank in town, so it forms deep relationships within local communities – communities which our research determined were growing, driven by agriculture, tourism, and commercial real estate lending. 

Moreover, Glacier has a good management team. When it acquires a struggling local bank, it minimizes the impact on the community so as not to disturb the strong relationships already in existence. There is no “shift in the banner” – Glacier doesn’t rebrand banks and it keeps their management personnel in place. 

Although Glacier is decentralized by the nature of its acquisitions, it is centralized in terms of underwriting, so we were comfortable with the risk it was taking. The company was also quite liquid, which was one of the issues we had flagged in 2012. Because it had a lot of its earnings coming from the securities book – capital it could deploy over time – Glacier wasn’t going to need to chase deposits or raise equity to grow.

Q: Can you cite another example?

Another company we have owned that exemplifies our research process is Fair Isaac Corporation (FICO), a data analytics company with a great business that has high incremental margins, and which has benefited from the expansionary credit environment we’ve been in for some time. 

However, our initial analysis revealed several hurdles, with this cyclicality being one. When the company walked us through how its business expands and contracts around the economy, we learned that in a contractionary environment, credit card companies and mortgage lenders tend to pull credit reports more frequently because they are worried about losses – so even though the business volume will fall, it is not nearly to the extent we thought. 

Additionally, after the appointment of a new CEO in 2012, FICO expanded its reach by entering software-related businesses like fraud protection, lending more stability to its model. The rollout of this product has been fairly successful, and over time, we think it will warrant a higher multiple.

Finally, we were concerned that its business could be replicated or negated by competitors. Our findings, though, revealed that FICO scores are built into many banking systems which are extremely difficult to change. Moreover, FICO scores cost very little, roughly half a cent to 1.5 cents. 

We like many things about FICO. Its business isn’t capital intensive and it generates exceptionally good free cash flow. Because the company is investing in a business, we need to be cautious, but our belief is it is investing for the right reasons and will continue to grow and still earn a good return.

Q: How much does price matter to you when buying companies?

Valuation is quite important and we look at things on the basis of absolute valuation as much as possible. Generally, we are sector agnostic, but because our goal is to find the best companies and opportunities, it’s all right if the fund is underweight or overweight a sector – even by a material amount – as long as it remains within our risk control parameters.

We stay disciplined regarding price. It is not unusual for us to monitor attractive companies for two to four years, waiting to buy until the valuation is palatable or lends enough downside protection. Managing risk in this way ensures there is enough relative upside in the company to deliver performance, and that we don’t overpay on a hiccup or cyclical turn in the economy which will burden us with a lot of share price compression.

Price targets are rarely set because it is difficult to use them effectively when operating in a market that can change quite sharply. Instead, we have valuation ranges that determine what we are willing to pay for a company, which is dependent on the level of growth it is delivering, the type of business it is in, and market valuation.

Rather than buying and selling companies outright solely for valuation, our tendency is to be more active in adding to and subtracting from positions – thinking about where in the business cycle it is, what its value should be, and overlaying that against all the companies in the portfolio.

Q: What is your portfolio construction process?

At any time, the portfolio has 40 to 60 companies. Risk controls include tracking error between 3% and 9%, so while we want to be active, we don’t go off the charts. 

Our maximum position is roughly 5%. At the sector level, it is plus or minus 10% relative to our benchmark, the Russell 2000 Index. For example, if financials are roughly 20% of the index, they could be anywhere from 10% to 30% in the portfolio.

Turnover is between 15% and 30%, and falls toward the higher end of this range when the markets are more volatile. Over the past few years, our turnover has been higher because small caps have generally been unidirectional, forcing us to sell companies that migrate into mid cap. 

Q: How do you define and manage risk?

To us, the most important type of risk is at the individual-security level. In order to have a basis for the convictions we build over time, we must understand the risks a company is taking and the opportunities available to it. This process begins with research and due diligence so we gain insight into its business-model risk, financial risk, and management risk. 

Beyond this in-depth analysis, we also step back and view the portfolio in aggregate. Is it really the best selection of companies when the risks – whether sector risk, valuation risk, or factor risk – are viewed in tandem? At this stage, we use weights and ultimately construction to ensure that we are comfortable with whatever risk we are taking.

From a more sophisticated perspective, we rely on access to internal and external systems. Though we want bottom-up stock selection to drive performance in names where we have conviction, this testing ensures no unintended risk is taken. For example, being overweight 10% in financials and being underweight REITs and utilities will lend a lot more interest rate exposure to the portfolio than we might appreciate, so we have to think about risk in that context.