Top small-cap funds of 2017 focus on healthcare, tech in year ahead

NEW YORK (Reuters) - Healthcare, technology and Japanese small-cap stocks look poised to outperform the broader market in the year ahead, according to some of the best performing U.S.-based stock fund managers of 2017.

Small-cap stocks should be among the largest winners of the newly-signed Republican-led tax law, which slashed corporate taxes at home and made it cheaper for companies to bring back their profits from overseas. Yet small-cap fund managers from Loomis Sayles, Federated Investors and Wasatch Advisors whose funds are up 30 percent or more for the year say that a bigger factor in the year ahead will be continued global growth.

“The tax bill is going to make some balance sheets look better on the margin, but we think the larger factor is that the recovery is still going on internationally,” said Kenneth Korngiebel, a co-portfolio manager of the $335-million Wasatch Micro Cap fund, which is up 36.1 percent year-to-date. That performance makes it the 13th best small-cap fund of the year, according to Lipper data, which tracks about 1,800 small-cap funds.

As a result, Korngiebel is shifting more of his portfolio into international stocks, which often trade at lower valuations than their U.S. counterparts and have better growth characteristics, he said.

Korngiebel is adding to stocks like Japanese outsourcing company UT Group Co Ltd, whose shares are up 243 percent for the year to date, and which he expects to grow its revenue by more than 30 percent in the year ahead. He is also adding to his position in U.S.-based Tabula Rasa Healthcare Inc, which helps doctors screen for potential drug interactions. Shares of the company are up 97 percent in 2017.

“The percentage of the population who take five or more medication is going up and adverse drug events are expensive and can lead to loss of life. What we see here is opportunity to take advantage of an under-covered company that is unique and meets a large need,” he said.

Overall, companies in the small-cap benchmark Russell 2000 index pay a median effective tax rate of 31.9 percent, while the larger, multinational companies in the S&P 500 pay a median effective tax rate of 28 percent, according to Thomson Reuters data. The median for the 30 mega-cap stocks in the Dow Jones Industrial Average is 23.8 percent.

Some of the benefits of the tax cut are already reflected in stock prices. The iShares Russell 2000 ETF, which tracks the benchmark Russell 2000 index of small-cap shares, is up 14 percent for the year to date, with about half of that gain coming over the last three months as Republicans rolled out their tax plan.

John Slavik, a co-portfolio manager of the $18-million Loomis Sayles Small/Mid Cap Growth fund, the 16th best performing small-cap fund this year, said that industrial machinery companies such as Gardner Denver Holdings Inc should benefit if corporations reinvest part of their tax windfalls into improving their factories.

The fund’s largest position is in supply chain company XPO Logistics Inc, which Slavik expects to gain from both corporate capital reinvestment and global economic growth. Shares of the company are up 78 percent for the year, and now trade at a trailing price to earnings ratio of 65.9, but Slavik said that he expects its revenues and cash flow to accelerate as the global manufacturing sector continues to expand.

“The valuation of the stock has been more challenging but we still thinks it works into the future,” he said.

He has also been selling his position in clear-braces maker Align Technology Inc, whose shares are up 135 percent this year and now trade at a market value of more than $18 billion, making it too large for his fund.

“This is a company that has done very well for us but we are looking to start to redeploy that cash elsewhere,” he said.

Stephen DeNichilo, a portfolio manager of the $872 million Federated Kaufmann Small Cap fund, the 9th best small-cap fund this year, said that fund holdings such as plastics molding manufacturer Milacron Holdings Corp will benefit from a pickup in capital spending because its products help improve a factory’s efficiency. “This kind of investment pays for itself very quickly,” he said.

Yet he has a larger position overall in biotech companies, which have greater growth potential, he said. He has been adding to his position in Nektar Therapeutics, which is developing in abuse-proof opioid medication, and gene-therapy drug maker Spark Therapeutics Inc.

He also added a position in retailer Floor & Decor Holdings Inc shortly after its initial public offering in April as a play on consumer spending on home renovation. Shares of the company, which makes high-end floor tiles, are up 37.8 percent for the year.

“This a traditional brick and mortar retailer that has built a better mouse trap,” he said.