One sign of a good leader is commitment. In the business world, that often means someone who puts their own money on the line and sticks with a company through good times and bad. Few fund managers are as committed as George Smith and Chris Pearson of
Davenport Small Cap Focus.
Both have worked their entire careers at parent firm Davenport & Co., a Richmond, Va.–based broker and financial advisor in business since 1863.
Looking for that same managerial commitment in the companies they hold is key to the duo’s investment strategy. They seek small companies with executives who act as “owner-operators”—those with large insider ownership who behave more like the devoted founder of a business than a hired-gun executive who might cash in stock options and move on. This strategy has enabled the fund (ticker: DSCPX) to deliver an 19.4% five-year annualized return, besting 99% of its peers in Morningstar’s Small-Blend category. The fund’s 0.97% expense ratio is below average for an actively managed fund.
Smith, 45, got his start as an analyst at Davenport in 1997 right after graduating from the University of Richmond with a degree in finance. But his actual connection began even earlier. “I had a relationship with a broker at Davenport & Co. when I was in my teens,” he says. “I had maybe $500 in an account that my parents started for me. I was very interested in stocks, and I would call [my broker] and badger him incessantly. The size of my account was very misaligned with the amount of attention that he had to pay to me and the number of calls that I put into him.”
Pearson, 36, also went to the University of Richmond. He got an internship at Davenport working for Smith in 2006 and has been there ever since.
The two work with 10 long-tenured analysts, and everyone at the firm invests in Davenport’s funds through their retirement plan—roughly $25 million of which was in Davenport Small Cap Focus at the end of 2020.
“All of our employees continue to be invested alongside clients,” Smith says. “It creates an alignment of interests and accountability.”
Insider ownership can encourage executives to think long-term and not take unnecessary risks with their and fellow shareholders’ money for a transitory payout. The average stock in Davenport Small Cap Focus’ portfolio is currently about 16% insider-owned versus the Russell 2000’s 7%, Smith says.
Controlling individual-company downside risk is essential as the fund is concentrated—typically holding between 30 and 35 stocks—so any losses from company blowups are greater than in highly diversified portfolios. Having executives with skin in the game makes that less likely to happen. In fact, the fund has proven less volatile than its small-blend category peers and the Russell 2000 in the past five years, and its worst loss—a drop of 28.5% from Feb. 1 through March 30 in 2020—compares favorably to the average fund’s 34.3% loss and the Russell 2000’s 32.2% decline.
A typical investment for the fund is
Monarch Casino & Resort
(MCRI). “Insiders own 25% of the company and the CEO [John Farahi] 10%,” Smith says. “The Farahi family founded this company, and it’s the consummate owner-operator situation. They’ve done an excellent job building this from the ground up, essentially from a motor lodge into a billion-dollar enterprise that we think can grow from here.”
Smith is particularly excited about the prospects of a casino Monarch acquired in Black Hawk, Colo., in 2012, which it has recently renovated and expanded.
Nor is he concerned about Covid-19 killing the business. In fact, during the panic last March, he bought 200,000 more Monarch shares as the stock’s price fell to a 2020 low of $14. One reason for his confidence: The fund’s strategy favors companies with low debt and strong balance sheets that can weather market storms.
“Monarch has arguably the best balance sheet in the [casino] industry,” he says. Today Monarch stock trades at $55.
Note: Holdings as of Dec. 31; Returns through Feb. 1; three- and five-year returns are annualized.
Sources: Morningstar; Davenport Asset Management
Because the fund has a high-quality tilt, Smith and Pearson tend to avoid cyclical sectors like energy and mining, which depend on rising commodity prices. Yet they are also leery of overpaying for stocks in hot sectors. Perhaps the most surprising aspect of the fund’s strong longer-term performance is its minuscule 4% weighting in tech stocks and nonexistent health-care exposure—two sectors that have recently driven the market higher.
In comparison, tech stocks and health-care stocks make up 15% and 21%, respectively, of the Russell 2000. The small-cap index did outperform Davenport for the past 12 months, but its annualized return still lags behind the fund by more than two percentage points for the past three and five years.
“It’s not that we refuse to invest in technology,” Smith says, pointing out that the fund recently sold a highly profitable position in e-tailer
(ETSY). “We just find that in the world of smaller-cap technology, the business risk is elevated—the risk of failure, rapid change or obsolescence. There’s also a growth-at-any price phenomenon in tech that’s occurring [today] that may start to exhaust itself in the not too distant future.”
Health care is similar, especially in small-cap biotech companies dependent on government approval for new drugs to succeed, leading to “binary outcomes,” Pearson says.
The fund’s largest sector weighting currently is its 29% position in consumer-discretionary stocks. Historically, the fund’s allocation to the sector has been closer to 25%. “We feel good generally about the consumer right now,” Smith says. “If you just look at pent-up demand, savings, consumer credit metrics—all of it seems to portend healthy spending going forward.”
Besides Monarch Casino, the consumer category also includes
(OSW), a company that operates spas on cruise ships that has also suffered Covid lumps. The stock hit a low of $2.50 last March. But Pearson sees it as a safer way to play a recovery in travel.
OneSpaWorld “doesn’t put up any of the capital” for having spas on ships, he says. “They just manage the spas and take a fee for it, and they have a near-monopoly position.” Because it has a capital-light business, the company’s balance sheet is strong enough to face the downturn. The market agrees: Today its shares trade at $10.
A recovery in travel spending is part of the team’s thesis about pent-up consumer demand. “Think about all of those trips to Vegas that were deferred, trips to New York, spring breaks, cruises,” Pearson says. “People are going to be champing at the bit to get out there” once the pandemic ends.
And this fund will be ready for that surge when it happens.
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