Published on January 5, 2022

Small cap growth stocks lagged for most of 2021 as the market simultaneously dealt with the pandemic, inflation, and tightening Fed policy. Given these challenges, we have been focusing on high quality companies trading at attractive valuations, and we have also been looking at non-technology businesses that are embracing digitization.

Although the worst of Covid-19 has hopefully passed, its impact on the markets remains front and center. The pandemic has been wreaking havoc on the economy for nearly two years, resulting in rising inflation and potentially higher interest rates, and it appears increased market volatility may continue in the near term as investors sort out the effects of new variants.

As a result, we have increased our focus on high quality companies trading at attractive prices, as we believe they are more likely to outperform even in challenging environments. Additionally, we have been looking at non-technology businesses that are successfully participating in the digital revolution, as we believe the market does not fully recognize their potential.

Small Caps Marked Time In 2021

As the below chart shows, small cap growth stocks began 2021 on the heels of an historic bull run, which largely explains their tepid performance last year.

Russell 2000 Growth 2 Year Returns

Source: RIMES


The rally eventually lost steam in February, as investors were confronted by multiple economic headwinds, including continuing Covid issues, rising inflation, supply chain disruptions, labor shortages, and shifting Fed policy. Given the uncertain backdrop and elevated share prices, sentiment never recovered in 2021, resulting in a sawtooth pattern of fits and starts for the entire year.

Nonetheless, the valuations of many small cap growth companies were slow to revert to attractive levels, despite their lackluster performance. For example, as you can see in the chart below, price/sales ratios for the SaaS industry skyrocketed during the pandemic and did not begin to fall until the end of the year. In 2015, average SaaS revenue multiples were as low as 3.6x, vs. a peak of 20.7x in 2021!

Cloud Software Sector Ratio

Source: Piper|Sandler


Although they are still above pre-pandemic levels, it appears the sector is beginning to rationalize as valuations have finally started to approach their historical norms. Periods of valuation rationalization combined with secular growth potential often create compelling buying opportunities.

Focusing On Quality At Attractive Valuations

With prices elevated for most of 2021, we were laser-focused on buying quality companies at attractive valuations. Of course, we always seek to invest in high quality businesses, but with the Fed expected to increase interest rates next year, it is vital that companies demonstrate their business models are durable and that their share prices are supported by fundamentals.

One area we have been emphasizing is profitability – surprisingly, over 40% of companies in the Russell 2000 Growth index are not profitable. We focus on profitability as a quality indicator because companies which can self-fund their growth are less exposed to the whims of capital markets or equity dilution. Additionally, profitable companies tend to have healthy cashflows, which make them more likely to weather short-term swings in the economy and less sensitive to changes in interest rates.

Beyond financials, we feel there are two other important measures of quality. First, we always look for companies with competitive advantages that are differentiated in their space, and second, we seek firms that are well-positioned within markets that are expanding. Companies with strong advantages that operate in shrinking markets will have trouble sustaining high growth rates despite their leadership position. Likewise, firms that are able to take advantage of strong secular growth trends have inherent advantages, but if their product is easily replicated they will have trouble increasing market share.

Examples of high quality, attractively valued firms currently in our portfolio include:

  • Onto Innovation: Onto sells critical semiconductor capital equipment used in process control and advanced packaging. Its process control equipment is critical to minimizing defects and boosting yields in the semiconductor manufacturing process which powers the building blocks of our increasingly digitized economy via cloud computing, e-commerce, and the proliferation of semiconductors across the economy, including in autos and the internet of things. Onto’s profitability is impressive, with operating margins approaching 30%. Furthermore, the stock trades at an undemanding multiple of 21x consensus 2022 earnings. The company is well on its way towards reaching its $1 billion revenue model, with more than $5 in earnings per share and we believe there is upside beyond this as well.
  • MaxLinear: MaxLinear is a semiconductor company that primarily serves the broadband and connectivity markets, where it sells chips that go into modems, gateways, and routers, enabling consumers to connect to the internet via cable and fiber networks. This market has favorable, duopolistic competitive dynamics and a strong, multiyear growth outlook due to increasing investment from cable and fiber operators. We are also excited by MaxLinear’s emerging infrastructure segment, which is projected to grow more than 50% this year, serving secular growth markets like cloud data centers, with Amazon as its first customer. The company’s operating margins are approaching 30% and yet it trades at an attractive price-to-earnings multiple of 21x 2022 earnings.

For both Onto and MaxLinear, we like the combination of high quality as evidenced by strong operating margins and attractive valuations. We believe moving out of software (trading at 20x sales) and into semiconductors (trading at 20x earnings), gives us exposure to secular growth trends, but at much more attractive prices.

Embracing Digital Transformation

In addition, we have been looking for opportunities with non-technology companies that are using technology to reinvent themselves. As we noted in a previous blog, these types of firms have always been of interest to us, but they are particularly attractive right now as they generally do not command the same lofty valuations as true software companies but can offer similar upside. They generally outperform their competitors by creatively deploying technology to decrease their operating costs and/or increase their revenues.

A classic example is Domino’s Pizza. When Patrick Doyle became CEO in 2010, he was determined to deliver a better customer experience. This included not just improving the quality of the pizza, but also upgrading their online presence. Domino’s created innovative apps with popular features, including one that lets customers track the progress of their order. The combination of high quality pizza and customer-friendly software powered the company to become America’s biggest pizza chain, and its stock price has risen by more than 10x since 2012, outperforming Apple and Google!

Two examples of innovative companies outside the technology sector following a similar approach are:

  • Wingstop: Wingstop is an international restaurant chain specializing in chicken wings, fries, and sides. The company is primarily a take-out business, so it has fared remarkably well during the pandemic. While many of their competitors have been struggling with the decline in in-person dining, their business has been booming – largely due to their substantial digital presence. 65% of the company’s total sales currently come through online channels (which carry a $5 higher check on average) versus just 35% pre-Covid. With over 1,500 restaurants worldwide and a skilled management team, we believe the company has plenty of runway for additional growth.
  • Floor & Decor: Floor & Decor is a nationwide retailer offering a broad assortment of in-stock hard-surface flooring, including tile, wood, laminate, vinyl, and natural stone. The company operates similarly to Home Depot – each location is a warehouse-sized showroom, except that the entire space is dedicated to flooring and related accessories. Business has been strong during the pandemic, particularly for online sales, which have increased from 10% of total revenues pre-Covid to 15% currently. The company provides a rich online shopping experience that has been particularly helpful for customers looking to avoid in-person shopping, and we expect it will continue to drive business in the future as consumers get more comfortable making large purchases online.

Final Thoughts

Covid-19 is a once-in-a-generation event that continues to impact the financial markets as much as it impacts our daily lives. With more uncertainty likely in the near term, including inflation and potentially higher interest rates, we think the best approach is for small cap growth investors to focus on the highest quality businesses at attractive valuations, including companies that are embracing digital transformation in traditional areas of the economy.


James Callinan

Chief Investment Officer – Emerging Growth

James Callinan

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. He is also a Portfolio Manager for the growth & income and flexible balanced strategies.

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

Vice President & Portfolio Manager

Bryan Wong

Vice President & Portfolio Manager

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). Mr. Wong holds the CFA designation and is a member of the CFA Society of San Francisco.

Morningstar Rating

★★★★★ Ratings Information
The Emerging Opportunity Fund is rated 5 Stars Overall in the Small Growth Category

Related Insight

Invest With Us

For more information about this strategy, please send us an email or call us at (800) 700-3316.

The Fund was rated 5 Stars against 574 funds Overall, 4 Stars against 574 funds over 3 Years, 5 Stars against 529 funds over 5 Years in the Small Growth category based on risk-adjusted returns as of 12/31/22.

The Morningstar Rating for funds, or “star rating,” is calculated for mutual funds, variable annuity and variable life subaccounts, exchange-traded funds, closed-end funds, and separate accounts) with at least a three-year history. Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. It is calculated based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a managed product’s monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of products in each product category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Overall Morningstar Rating for a managed product is derived from a weighted average of the performance figures associated with its three-, five-, and 10-year (if applicable) Morningstar Rating metrics. The weights are: 100% three-year rating for 36-59 months of total returns, 60% five-year rating/40% three-year rating for 60-119 months of total returns, and 50% 10-year rating/30% five-year rating/20% three-year rating for 120 or more months of total returns. While the 10-year overall star rating formula seems to give the most weight to the 10-year period, the most recent three-year period has the greatest impact because it is included in all three rating periods. The Osterweis Emerging Opportunity Fund does not have a 10-year Morningstar rating at this time.

© 2023 Morningstar. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance does not guarantee future results.

Opinions expressed are those of the author, are subject to change at any time, are not guaranteed and should not be considered investment advice.

The Osterweis Emerging Opportunity Fund’s top 10 holdings may be viewed by clicking here.

Holdings are subject to change at any time. References to securities are not a recommendation to buy or sell. Domino’s Pizza was not held by the Fund.

The S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance.

The Russell 2000 Growth Index is a market capitalization weighted index representing those stocks within the approximately 2000 smallest companies in the universe of U.S. equities that exhibit growth characteristics.

The Russell 2000 Index is an index measuring the performance of the 2,000 smallest companies in the Russell 3000 Index.

Cash flow measures the cash generating capability of a company by adding non-cash charges (e.g. depreciation) and interest expense to pretax income.

Price-to-Sales (P/S) ratio is calculated by taking a company’s market capitalization (the number of outstanding shares multiplied by the share price) and dividing it by the company’s total sales or revenue over the past 12 months.

Price-to-Earnings (P/E) multiple is Price-to-Earnings (P/E) ratio is the ratio of the stock price to the trailing 12 months diluted EPS.

Earnings per share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock.

Mutual fund investing involves risk. Principal loss is possible. The Osterweis Emerging Opportunity Fund may invest in unseasoned companies, which involve additional risks such as abrupt or erratic price movements. The Fund may invest in small and mid-sized companies, which may involve greater volatility than large-sized companies. The Fund may invest in IPOs and unseasoned companies that are in the early stages of their development and may pose more risk compared to more established companies. The Fund may invest in ETFs, which involve risks that do not apply to conventional funds. Higher turnover rates may result in increased transaction costs, which could impact performance. From time to time, the Fund may have concentrated positions in one or more sectors subjecting the Fund to sector emphasis risk. The Fund may invest in foreign and emerging market securities, which involve greater volatility and political, economic and currency risks and differences in accounting methods. These risks may increase for emerging markets.

The Osterweis Funds are available by prospectus only. The Funds’ investment objectives, risks, charges and expenses must be considered carefully before investing. The summary and statutory prospectuses contain this and other important information about the Funds. You may obtain a summary or statutory prospectus by calling toll free at (866) 236-0050, or by visiting Please read the prospectus carefully before investing to ensure the Fund is appropriate for your goals and risk tolerance.

Osterweis Capital Management is the adviser to the Osterweis Funds, which are distributed by Quasar Distributors, LLC. [OSTE-20211227-0402]