U.S. fund managers raise cash as small caps fall into bear market

[December 19, 2018]   By David Randall

NEW YORK (Reuters) - The shares of small companies in the U.S. fell into a bear market Monday, but several top-performing fund managers had already been acting as if it was inevitable.

Small-cap fund managers from firms including Needham Funds, Wells Fargo, and Hodges Capital Management have been trimming their winners, shedding stocks they think will not be able to weather an economic downturn, and raising cash, all in anticipation of more pain to come as the benchmark Russell 2000 <.RUT> dropped more than 20 percent below the record high reached in August.

The value of small-cap shares - generally those with market values of less than $5 billion - soared earlier this year as decades-low unemployment, a surging housing market, and the expectation that domestic companies would be immune from global trade wars drew investors into their stocks. Yet rising interest rates, falling oil prices and signs that small-caps were not as insulated from trade concerns as investors originally thought have upended the rally.

The Russell 2000 fell more than 2.5 percent Monday, leaving it 21 percent below the record high it reached on August 31.

"It's been awfully painful since September," said Gary Bradshaw, a portfolio manager at Dallas-based Hodges Capital.

As a result, Bradshaw has been lightening his portfolio, selling out of approximately 10 holdings to concentrate his fund into the 50 stocks that he expects have the strongest balance sheets and market positions to grow during slowing economic growth. His fund trimmed its position in financial stocks like LegacyTexas Financial Group Inc <LTXB.O> and instead is focusing on faster-growing companies like Goosehead Insurance Inc <GSHD.O> and restaurant chain Texas Roadhouse Inc <TXRH.O>.

"We're going into hunker-down mode, meeting with companies more, and doing more research. You work a lot harder during a downturn," he said.

There have been 15 bear markets - a decline of least 20 percent from a high - in the Russell 2000 since 1978, according to research firm Ned Davis Research, with the most recent occurrence in June 2015. The average bear market chops 31.5 percent from the benchmark's highs and lasts 213 days, the firm noted.

A trader works on the floor at the New York Stock Exchange (NYSE) in New York City, New York, U.S., December 4, 2018. REUTERS/Brendan McDermid/File Photo

Chris Retzler, portfolio manager at the Needham Growth Fund, said that his firm prepared for a bear market in small-cap stocks by building up what he would only call a "significant" cash position, done in part by selling some technology stocks. If it continues, the trade conflict between the U.S. and China will weigh heavily on small-cap shares, he said.

"The global economy has grown substantially from where it was 20 years ago and the interconnectedness of companies globally is much greater, so I'm not so sure that small caps provide that protection that they historically have," he said.

Even fund managers who remain bullish overall have positioned their portfolios more defensively in anticipation of more market volatility ahead.

Jim Callinan, portfolio manager at the Osterweis Emerging Opportunity Fund, said that the continued strong stock performance of high-flyers like the New York Times Co <NYT.N> and cloud computing company Twilio Inc <TWLO.N> shows that investors are not abandoning the small-cap market but becoming more selective.

He has been using the steep declines in the market to add to biotechnology companies like Ligand Pharmaceuticals Inc <LGND.O> that have fallen significantly. Yet is he is also adding to consumer-focused companies like gym chain Planet Fitness Inc <PLNT.N> that he expects will continue to do well even if the broad market stumbles and building up his cash levels.

"I'm not worried about the strength of the consumer," he said. "The only thing I'm worried about is that sell-offs of this magnitude tend to be self-reinforcing. If CFOs of small companies start to pull in their horns and cut their budgets because their stock is down, then this is going to last a lot longer than it should."

(Reporting by David Randall; Editing by Jennifer Ablan and Nick Zieminski)

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