JPMorgan Small Cap Equity A VSEAX

JPMorgan Small Cap Equity benefits from a proven team and a disciplined approach.

Veteran managers Don San Jose and Dan Percella lead a small but stable team of three analysts. After joining J.P. Morgan as an analyst in 2000, San Jose became a comanager here in 2007 and took the lead role in 2013, extending this strategy’s outstanding track record. Percella, who served as an analyst on the team since 2008, became a comanager in 2014. Two of the group’s three analysts have worked on the team since 2015, while the third started in 2018. Although the team is small, it’s a plus that they are focused exclusively on small- and mid-cap investing. In addition, they occasionally collaborate with other J.P. Morgan Asset Management analysts for added support.

The team’s consistent investment approach centered on quality is key to its success. It focuses on companies operating in narrow niches that can leverage their competitive positioning to protect and grow their returns on capital at rates higher than the market foresees. These traits, along with a preference for earnings and free cash flow over top-line revenue growth, lead them to steadier business models. The team will ride winners from small- to mid-cap territory, but it will start to sell once they hit the $10 billion market-cap range. Tolerating these stretched valuations courts risk, but the fund maintains a high-quality profile, as indicated by superior profitability metrics such as returns on equity and invested capital.

Under San Jose’s watch, the strategy has an excellent record. From his appointment to comanager in November 2007 through April 2024, the institutional shares’ 9.0% annualized return beat the fund's Russell 2000 Index prospectus benchmark by 2.1 percentage points. The strategy is coming off a challenging year, though, as its 11.9% return in 2023 lagged its benchmark by 5.0 percentage points. Some mistakes with regional banks and poor picks in industrials and healthcare largely drove the underperformance. Still, the strategy remains a great option, despite this recent hiccup.

The process here is all about finding great businesses priced as merely good ones. Managers Don San Jose and Dan Percella scour the small-cap universe for best-in-class companies with consistently high levels of profitability and management teams that have proved efficient capital allocators. They focus on companies operating in narrow niches that can leverage their competitive positioning to protect and grow their returns on capital at rates higher than the market foresees. These traits, along with a preference for earnings and free cash flow over top-line revenue growth, lead them to firms with steadier business models.

The team analyzes firms’ growth potential on a three- to five-year basis, but its view on margins tends to be the key differentiator. The team will happily own a company growing at a modest rate if it can expand its margins over time to produce strong earnings and cash flow that the market will reward. The managers build out new positions gradually, looking for validation of their investment thesis.

The managers trim holdings as they appreciate—few climb above 2.0% of assets—but tolerate higher valuations as long as their theses remain intact. They’ll hold onto their winners but will start to sell once they hit the $10 billion market-cap range.

Despite its small-cap moniker, the portfolio contains both small- and mid-cap stocks. Its average market cap as of March 2024 was roughly $5.2 billion, nearly double its Russell 2000 Index prospectus benchmark’s $2.8 billion but slightly below the Russell 2500 Index’s $5.8 billion. The managers’ preference for riding their best-performing stocks contributes to this skew, but they are cognizant not to drift too far off course. Recent sales to preserve the strategy’s small-cap profile include longtime holdings Generac and Aspen Technology, which were approaching mid-cap range.

The portfolio’s focus on quality is consistent. It scores higher than the Russell 2000 Index on metrics such as return on assets, return on equity, and net margin. Trailing earnings- and revenue-growth rates are roughly on par with the index, but that’s consistent with the managers’ preference for profitability over sales growth.

The strategy typically invests across all sectors, but the team completely sold its small group of energy stocks in 2020 as the pandemic highlighted the difficulties in forecasting commodities-driven businesses. Recently though, the team has gained more confidence in the sector as it bought natural gas pipeline operator DT Midstream in early 2023, as well as exploration and production company SM Energy and pressure control equipment provider Cactus in early 2024.

Managers Don San Jose and Dan Percella have impressed over their tenures. After joining J.P. Morgan in 2000, San Jose became a comanager on this strategy in 2007 and took over lead duties in 2013. Percella joined him at the helm in January 2014, after serving on the small-cap core team since 2008. The pair also comanages JPMorgan SMID Cap Equity, which has the same investment process but targets slightly larger firms.

The managers primarily work with a team of three analysts. Two of them—Jon Brachle and Chris Carter—have been on the team since 2015 and have more than 15 years of industry experience apiece. Newest analyst Jesse Huang started working with the group in a junior role in 2018 but was recently promoted to analyst. The team sometimes collaborates with other J.P. Morgan analysts but largely works independently.

San Jose and Percella have added new responsibilities in recent years. In October 2021, San Jose took over as CIO of J.P. Morgan’s value equity division, while Percella served as a comanager on large-cap offering JPM America Equity from August 2022 through March 2024. That strategy is quite different from this one, but Percella had much less responsibility there. Fortunately, with Percella being taken off that strategy and San Jose settling into his new role, these workload concerns are not overbearing.

As of 2022, this investment stalwart manages more than USD 2.5 trillion in AUM. Composed of various global cohorts and diverse asset classes, the firm has more tightly integrated its capabilities in recent years, notably through the development of proprietary analytical and risk systems. Investment teams are robustly staffed and helmed by seasoned contributors. The firm’s strategies tend to produce reliable portfolios, and several flagship offerings are Morningstar Medalists. Manager incentives align with fundholders'; compensation reflects longer-term performance factors, and portfolio managers invest in the firm’s strategies as part of their compensation plans.

The firm’s funds tend to be well-priced, but they aren’t as competitive as many highly regarded peers of similar scale. Recent product launches include thematic and single-country strategies, both of which carry the potential for volatile performance and flows, along with misuse by investors. The firm remains intrepid when it comes to developing an environmental, social, and governance-focused framework and continues to move into other areas such as direct indexing through its 55iP acquisition and China through its joint venture, but these complicated initiatives take time to assess any real and lasting effect.

From his appointment to manager in November 2007 through April 2024, the institutional shares’ 9.0% annualized return beat the fund's typical small-blend peer’s 6.4% and its Russell 2000 Index prospectus benchmark’s 6.9% gain. It also beat the 7.9% return of the Russell 2500 Index, a relevant bogy given the fund’s large average market cap. Risk-adjusted results were even stronger, as the strategy's standard deviation(a measure of volatility) was well below its indexes and peers.

The strategy’s outperformance has been consistent. Of the 163 rolling three-year periods since November 2007, the strategy topped its prospectus benchmark in 88% of them. Since the start of 2008, the strategy has beaten its benchmark in all but four calendar years and ranked in the Morningstar Category’s top third in nine of those 16 years.

Despite this stellar record, recent performance has been more challenged. From the start of 2023 through April 2024, the strategy’s 10.3% cumulative return trailed its prospectus benchmark and typical peer by 4.1 and 4.9 percentage points, respectively. The strategy’s exposure to several regional banks, including the collapsed Signature Bank, hurt performance in early 2023, but the team’s picks in industrials, consumer discretionary, and healthcare were the main detractors over this 16-month stretch.

Based on our assessment of the fund’s People, Process, and Parent Pillars in the context of these expenses, we think this share class will be able to deliver positive alpha relative to the category benchmark index, explaining its Morningstar Medalist Rating of Bronze.