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Unearthing hidden gems: small-cap star Hatton's micro machines

Unearthing hidden gems: small-cap star Hatton's micro machines

With nearly 33 years’ experience as a US small-cap fund manager, Gary Hatton isn’t easily swayed by the twists and turns of the market.

At this moment in time the Boston-based co-founder of asset management boutique Granahan Investments is not overly concerned with headlines about small companies struggling as investors flock to blue chips and household names.

‘I don’t sit around thinking too much about where small caps are going,’ says the Citywire AA-rated manager. ‘I run a small to micro-cap strategy and it pretty much stays in that vein, I don’t try and predict things too dramatically.’

His reassuring calm is underpinned by two years of very strong returns.

‘In 2012 and 2013 it was a very good time to be in small stocks. During 2013 in particular, it was a case of the smaller you went, the better you did in terms of performance.’

Hatton’s convincing track record on the Dublin-domiciled Vanguard US Discoveries fund goes back further than this.

Along with co-managers Jane White, Robert Granahan and John Granahan he has delivered 205% over the past five years to the end of October 2014 in US dollar terms, outstripping the benchmark Russell 2000 Growth TR, which rose 134.7%. The fund has also beaten the benchmark by nearly 20% over the past three years.

This outperformance has been driven by shrewd stock picking within a rapidly changing investment landscape, Hatton says. ‘There are only a few companies that have been in the micro-cap spectrum for an extended period of time.

‘I have known a couple for 10 years that are really strong businesses and we have looked to purchase them opportunistically.’

Hatton says the portfolio doesn’t change a lot, but his team are not averse to opening positions in partially unknown or under-researched companies to capitalise on potential.

‘We recently launched a Focused Growth fund for Drew Beja and as the name suggests, the difference between this fund and the Discoveries one is that Drew concentrates on 40 or 50 names, while I will go into 70 or 80.

‘The primary reason our fund looks at more is because when I buy something, I have a good idea about what it can achieve but I am not always 100% sure in terms of the potential risk and reward. So I tend to start with a smaller position until I know what I own.’

His colleague Beja adds: ‘The Discoveries fund lives up to its name too. So it is more micro and small cap, and has built a terrific record over the years from this mix.’

Three-pronged search

Hatton’s fund currently holds 69 stocks split across three broad themes, defined as: ‘special situations’, stocks which may have disappointed in the past but have a catalyst for change; ‘pioneers’, innovative firms showing long-term potential growth; and, ‘core growth’, meaning stocks with proven and sustainable returns.

At present the largest allocation is to the special situations portion, which accounted for 37.7% of the fund’s exposure at the end of September 2014.

Hatton identifies MarineMax, a Florida-based boat company, as a prime example of a business fitting this category, which represents 1.6% of the fund.

‘This is a really good supplier of Sea Ray boats in Florida and is a name I have known for at least 10 years,’ he says.

‘Like other funds at our company, I look for businesses that can grow over long periods of time, but I also home in on those that maybe have stumbled and because I am familiar with them over a longer time frame I know I can get a good valuation.’

Meanwhile, when it comes to the ‘pioneer’ class, Hatton points to Zeltiq Aesthetics, a specialist healthcare company which makes up 2.8% of the fund and is among its top 10 positions.

‘Zeltiq develops a product which dermatologists and plastic surgeons use to cool and reduce fat. It’s proven to be a really popular story,’ says Hatton.

‘It has been in the portfolio for two-and-a-half years, it came to the market in 2011 and, to begin with, it disappointed investors. I became involved when new management took over because I knew the incoming CEO was a good guy. I had a feeling from talking to people that the products actually worked.’

Owning the strategy

The Granahan Investments team draws on long experience. Hatton, together with Jane White and John J Granahan, established the investment boutique in 1985. These three managers – along with Robert Granahan who joined in 1995 – all remain active practitioners.

The venture was devised as a 100% employee-owned firm which would focus its expertise on small-cap stock selection. Over time, both the staff numbers and assets have grown, and the group now comprises an eight-strong portfolio management and research team which oversees $3 billion.

Broadening the expertise

Hatton believes in a team approach to idea generation. Healthcare is his area of expertise and this currently makes up 37% of the fund’s sector exposure, but despite this bias and the outperformance it has generated, Hatton is mindful of becoming too specialist.

‘I spend plenty of time in healthcare but I am also interested in other areas like industrials and financials. When it comes to technology, I rely on the other fund managers like Drew to some extent and also our technology team to point me in the right direction.’

Technology is the third largest sector weight at 12% of the fund, while consumer goods – staples and discretionary – accounts for more than 30%. ‘We draw on our consumer team in this field but we are all consumers in our day-to-day lives and we can sometimes come across something interesting.

‘A newer name which I think has potential is restaurant company Kona Grill,’ he says, which combines sushi and traditional American food and has just begun to expand into territories beyond its native Arizona. ‘I also happen to love that restaurant, it is a very recent addition and, for me, it is a good opportunity and a strong company.

‘You could say I’m a personal fan but I have also done my homework on the figures. It has a strong financial model which can grow in a self-sustaining way for a long period of time.’

Merger mania and selection success

Hatton realises he isn’t the only one hunting for small companies with bigger prospects. Merger and acquisition activity is on the up and this has had some bearing on how the Granahan team has gone about its business.

‘While it is not something we are looking to predict, it is a validation of what we are doing. We buy businesses with attractive assets and when other companies make a move for them it endorses our line of thinking,’ he says.

‘Last year we had a lot of buyouts, while this year there have been fewer, probably because valuations got so rich at the end of 2013. I don’t see it as a driver but it is a thumbs-up.’

Hatton cites Durata Therapeutics, a 1.5% position in the fund, as an example of a stock on the cusp of a takeover. Actavis was granted permission at the start of November to complete an acquisition of the pharmaceutical company.

‘It will get taken over and I will either hold onto it to get the cash, because it is a cash takeover, or I will sell it. This move backs up the work I have been doing in the antibiotics area.

‘It has also prompted me to increase a position in Tetraphase – a bacterial infection specialist – which operates in a different area of the antibiotics market.

‘So, I can take some of the proceeds from the Durata deal and add it there.’

The Obamacare effect

Hatton’s interest in the healthcare sector means he has kept a sharp eye on the impact of the Affordable Care Act, colloquially known as Obamacare, which was rolled out in 2010.

‘It has affected certain areas of the healthcare sector, primarily hospitals, because it is creating more volume per hospital as more people are able to go than before.

‘It hasn’t impacted biotech companies as much, which we hold, because, for the most part, I own companies which are creating drugs for which there is no alternative. These businesses can generally price these products as they see fit, because they are not “me too” drugs.’

However, Hatton is watching for new opportunities and is monitoring the potential in the sector. ‘For example, increased patient volumes have encouraged me to look more closely at nurse staffing companies,’ he says.

‘Generally, it has been pretty steady and I can continue to run it as I want to,’ he says.

Keeping it new

Hatton’s outperformance has not gone unnoticed. The Vanguard US Discoveries fund leapt from $25 million in assets at the end of 2012 to $160 million one year later, prompting the company to impose investment restrictions.

For Hatton, this was a vital step to ensure the fund’s micro-focus remained intact.

‘We wanted to continue managing the fund in the way we always have. It has ebbed and flowed with the existing holders taking some out and some putting more in.

This article originally appeared in the December issue of Citywire Global magazine

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