Published on June 18, 2021

Growth stocks have lagged cyclicals so far in 2021, but we remain steadfast in our belief that secular growth is the key to generating long-term returns. In this piece, we discuss how we find attractive opportunities in the small cap universe.

Why Secular Growth Matters Now

In 2021, secular growth stocks have been relative underperformers. Through May, the Russell 2000 Growth Index has returned 4.1% YTD, while the Russell 2000 Value index has returned 27.5% YTD. This is also reflected at the sector level of the complete Russell 2000 index, with growth areas such as Information Technology and Healthcare underperforming cyclical sectors such as Energy and Materials.

Russell 2000 Performance by Sector

Source: Jefferies, Factset


The trend makes sense, as cyclical stocks are more sensitive to changes in GDP, and the economy has been expanding rapidly throughout the post-pandemic recovery. Not surprisingly, investors have been aggressively rotating into cyclicals during this period, as they were hit hard during the depths of Covid and were available at attractive valuations.

We feel this rotation has created an unusual buying opportunity for secular growth stocks, as they are generally 30% - 50% off their 52-week highs. When combined with their underlying growth rates, which have remained robust despite their tepid share performance, valuations look reasonable, especially on 5-year projected earnings.

Perhaps more importantly, we believe the present situation is an anomaly, and we expect growth stocks will reclaim their leadership position when the economy reaches its post-pandemic equilibrium. The current reopening process is (hopefully) a once-in-a-century event that has been driven by a powerful combination of pent-up demand and generous government stimulus. These tailwinds are both transitory, and when they abate, we are confident cyclicals will revert to more modest growth patterns.

How We Find Secular Growth: Exploiting Inefficiencies

Our investment philosophy is laser-focused on finding secular growth, as we believe this is the best way to generate long-term returns. Our objective is to build a concentrated portfolio of quality, small cap companies with superior revenue growth at attractive entry points. The challenge, of course, is identifying stocks that meet our criteria.

In our experience, there are four major categories of inefficiencies that create our investment opportunities: 1) growth rate, 2) growth durability, 3) valuation multiples, and 4) misclassification (i.e., growth companies masquerading as cyclicals).

When we add new positions to our portfolio, our view on at least one of these dimensions differs from the broader market, contributing to upside that is not widely identified.

Non-Linear Growth Rates Are Key

First and foremost, we seek to identify superior growth companies, both on an absolute and relative basis, that follow classic S-curves of adoption. Such S-curves are often underappreciated because they follow non-linear patterns of growth, and it can be very difficult for analysts to project exponential expansion due to the human tendency to think linearly.

We seek companies that are breaking out along such S-curves because growth can be both rapid and durable. For example, on his decision to start Amazon, Jeff Bezos said in a 2010 speech: “I came across the fact that Web usage was growing at 2,300 percent per year. I’d never seen or heard of anything that grew that fast, and the idea of building an online bookstore with millions of titles — was very exciting to me.”

It can be extremely rewarding when we discover companies that are finding strong product-market fit before the market recognizes the trend. For example, Five9 (FIVN) sells cloud-based contact center software that allows service reps to interact with customers through a variety of communications channels. Before Covid-19, the company was already growing market share as a disruptive, next gen vendor displacing legacy, on-premise systems in a $24 billion market that was only 10-15% penetrated by cloud software.

When we first purchased Five9 in 2019, the company was growing 28%. Since then, growth has accelerated to 45% in its most recent quarter, driven by an accelerating on-premise-to-cloud transition, as well as Five9’s expanding product portfolio, which includes artificial intelligence (AI) modules. Five9 is signing increasingly large deals, which haven’t even contributed to revenue yet. As an analyst from Morgan Stanley wrote, “to us this means that the accelerated moves to the cloud haven't even started yet, and FIVN is in the best position to capitalize on them as they do, with new large scale proof points."

Growth Has To Be Durable

Second, when analyzing secular growth companies, we think critically about the durability of growth and long-term earnings power. As Peter Thiel said, “80-85% of the value of these companies exists from cash flows...very, very far into the future…the question is whether a company is going to be around a decade from now is what actually dominates the value equation.” When assessing durability, we spend a great deal of time analyzing a company’s competitive advantage, and we utilize our proprietary anchor point framework to assess management’s ability to sustain growth and earnings over the long run.

Durability can be misjudged, which creates opportunities for us. For example, a recent study of cloud software IPOs by Bessemer1 found that growth rates have been more durable than expected post-IPO.

Growth Durability

Source: Bessemer


As the above chart demonstrates, growth for both Shopify and Twilio has been much stronger and persisted longer than analysts expected.

Entry Points Make a (Big) Difference

Third, we seek attractive valuations by taking advantage of price dislocations due to 1) mystery (i.e., investors not yet appreciating a firm’s growth potential), 2) company mismanagement, and/or 3) general market corrections.

When successful, entry points for such investments can be quite cheap. This is because these stocks benefit both from the twin engines of sustained growth and multiple expansion over time. For example:

  • In 2017, Etsy, an online marketplace for independent sellers, traded at 5x sales. Since then, its sales have grown from $441 million to a projected $2.2 billion in 2021, a 5-fold increase. In other words, in 2017, Etsy traded at just 1x projected 2021 sales!
  • In 2019, Fiverr, an online marketplace for freelancers, traded at 3x sales. Since then, its sales have grown from $107 million to a projected $308 million in 2021, nearly a 3x increase. In other words, in 2019, Fiverr traded at ~1x projected 2021 sales!

To summarize, we strive to identify exceptional small cap growth companies that can grow both faster and longer than market expectations, and we look to buy when such companies are cheap and/or misunderstood.

Secular Growth Can Masquerade As Cyclical Growth

The last major type of inefficiency we try to exploit is the misclassification of companies that the market considers to be cyclical, whey they really possess secular growth characteristics.

For example, we believe the semiconductor/semiconductor capital equipment (semicap) industry is becoming more secular (vs. cyclical) for a few reasons. First, there are now multiple market drivers for semiconductor growth. From the 1990s through the early 2000s, the semiconductor industry was primarily driven by PC trends, and over the past decade, smartphones have become a major driver.

Today, we believe we are at a digital inflection point that will drive sustained growth across multiple areas, including data centers, the Internet of Things, 5G, and Artificial Intelligence. Second, the costs of manufacturing to drive Moore’s Law – doubling the number of transistors on a chip every year -- are significantly rising, requiring more engineering and processing, which benefits equipment companies. Third, countries are recognizing the critical importance of owning these crucial building blocks of the future and are increasing local investment. Along with other experts, we believe the semiconductor industry can double from $500 billion to $1 trillion in revenues by 2030.

A recent investment in this category is Onto Innovations, which sells critical semicap equipment necessary for manufacturers like Intel to accelerate development, increase yields, and reduce costs. Formed from the 2019 merger between Nanometrics and Rudolph, Onto is the fourth largest semicap equipment manufacturer in the U.S. and has an expanding product portfolio due to robust, complementary technology from the merger. The company currently generates strong growth and profits and expects to reach $1 billion in revenue over the medium term, which translates to >$5 in earnings power vs. the <$2 in earnings it earned in 2019. For the quality of business, it is also inexpensive, trading at ~20x 2022 price-to-earnings ratio.

Another example is Cerence, the dominant provider of conversational AI and voice technology used in cars and trucks, with >50% market penetration globally. A 2019 spin off from Nuance, Cerence is another example where the end market is cyclical (autos) but the majority of growth is secular, led by the increasing penetration of voice recognition/AI in passenger cars. Today, only around two-thirds of vehicles have this capability but over time that will go to 95%. At the same time, Cerence is adding new content/features that will double its revenues per car from $10 to $20. By 2030, Cerence could do $1.5 billion in sales and $10 in earnings, up from <$2 in earnings last year.

Why Secular Growth Matters In the Long Run

No matter the market environment, we find secular growth is overwhelmingly important to long-term value creation. In one 20-year study, the Boston Consulting Group (BCG) analyzed four drivers (revenue growth, margin, valuation multiple, and free cash flow) of S&P 500 returns over different time periods.

LT Drivers of Equity Returns

Source: Boston Consulting Group


Over one-year periods, no single factor contributed to more than 50% of performance, though the most significant factor was the valuation multiple. However, over 3, 5, and 10 years, revenue growth was the dominant driver of returns by far, contributing 50 to 74% of total shareholder return.


Final Thoughts

Regardless of the market environment, our philosophy has remained constant – we believe that secular growth is the key to generating long-term returns. We have established a rigorous, repeatable process for identifying high quality, attractively priced small cap growth stocks, and we find the current environment particularly favorable due to lower valuations and a growing number of innovative companies going public.

1 - “State of the Cloud 2021,” Bessemer Venture Partners, by Deeter, Robinson, D’Onofrio, Catlett, & Teng, 3/10/21.

James Callinan, CFA

Chief Investment Officer – Emerging Growth

Bryan Wong, CFA

Vice President & Portfolio Manager - Emerging Growth


James Callinan, CFA

Chief Investment Officer – Emerging Growth

James Callinan, CFA

Chief Investment Officer – Emerging Growth

Jim Callinan was the Co-Founder & Chief Investment Officer at RS Investments. He also co-founded the RS Growth Group LLC in 1996 and managed the RS Emerging Growth Fund from 1996 until 2010. In 1999 Mr. Callinan was named Morningstar’s Domestic Stock Manager of the Year.*

He served as portfolio manager for the Putnam OTC Emerging Growth Fund from 1994 to 1996 and began his career at Putnam Investments as an equity research analyst in 1987. He joined Osterweis Capital Management in 2016 and brought with him the Emerging Growth Partners, LP, a concentrated small cap growth strategy he founded at RS in 2006.

Mr. Callinan is a member of the Weatherbie Capital Advisory Board.

He is an equity owner in the firm and the Lead Portfolio Manager for the emerging growth strategy.

Mr. Callinan graduated from Harvard College (B.A. in Economics), New York University (M.S. in Accounting) and Harvard Business School (M.B.A.). Mr. Callinan holds the CFA designation.

*Morningstar Managers of the Year are determined by a combination of qualitative research by Morningstar’s manager research analysts; risk-adjusted medium- to long-term performance track records; and performance in the calendar year.

Bryan Wong, CFA

Vice President & Portfolio Manager - Emerging Growth

Bryan Wong, CFA

Vice President & Portfolio Manager - Emerging Growth

Prior to joining Osterweis Capital Management in 2014, Bryan Wong was a member of the investment team managing the endowment of the David and Lucile Packard Foundation. Before that, Mr. Wong was an Analyst at Wohl Capital Management, a long/short hedge fund.

He is an equity owner in and a principal of the firm and a Portfolio Manager for the emerging growth strategy.

Mr. Wong serves on the investment committee of the Asian Pacific Fund.

Mr. Wong graduated from Yale University (B.A. in Political Science and International Studies with distinction) and the University of California Berkeley, Haas School of Business (M.B.A., Investment Management Fellow). He holds the CFA designation and is a member of the CFA Society of San Francisco.

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Emerging Opportunity Fund Quarter-End Performance (as of 3/31/24)

Fund 1 MO QTD YTD 1 YR 3 YR 5 YR 7 YR 10 YR INCEP
OSTGX 4.46% 12.10% 12.10% 26.31% -0.87% 13.72% 15.68% 12.93% 14.65%
Russell 2000 Growth Index 2.80 7.58 7.58 20.35 -2.68 7.38 8.40 7.89 10.29
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