Small Cap Growth Fund (Class A)  (PNSAX)

The fund delivered a solid return for the quarter and outperformed its benchmark, the Russell 2000 Growth Index. I am pleased to report that the fund also outperformed its benchmark for the 1-, 3-, 5-, and 10-year periods ended June 30, 2020.

As growth investors, we don’t seek to build an overly conservative portfolio, so the severe market drawdown in the first quarter was a challenge. However, the fund performed very well relative to our benchmark due in large part to a solid base of high-quality businesses in our portfolio. Our investment approach was to focus the majority of the portfolio on companies with strong margins, solid returns, and cash-generating ability. This proved beneficial as global economies came under severe pressure. Fortunately, as we reassessed our holdings, we did not find many companies with debt levels that were high enough to hamper their future growth prospects.

As the virus evolved from an emerging threat to a global crisis, we implemented a three-step approach. Steps one and two were designed to seek downside protection for the portfolio, while the third step was aimed at finding growth opportunities. First, we focused analysis on the liquidity and debt levels of our holdings to determine which companies could weather this severe shock given it had an unknown duration. Next, we conducted deeper analysis to determine which companies might be structurally weaker in a year or two as a result of the pandemic. Step three in our process is finding companies that will be structurally stronger as a result of the pandemic.

It is worth noting that fewer companies declare bankruptcy than is commonly believed. However, future returns on capital and growth prospects can be diminished if liquidity and debt levels force a company to cut costs too deeply. Here, we focused on areas such as brand power and competitive market positioning, and we tried to forecast the future spending behavior of corporations and consumers.

For example, if an airline cannot fly its planes, which were acquired through loans, the business faces serious challenges. However, in many cases, the long-term impact is not as obvious. Will a regional casino operator, for example, be able to successfully conduct business with fewer patrons? If “yes,” then this could present a compelling opportunity. Many restaurants could be weakened as they are forced to permanently shut locations, but a select few with strong technology and delivery offerings may actually become stronger during this tough period.

While the nature of every crisis is different, they do have one thing in common. Crises tend to accelerate the pace of change that was already occurring — often out of necessity. In our fundamental research, we always consider disruptive change, as it is often the force that enables small companies to compete against their larger peers. We are already finding that the Covid-19 pandemic has enhanced the growth potential of many small companies, and we are seeking to add them to our portfolio.

Among the beneficiaries are companies that specialize in remotely connecting patients and health-care professionals. We believe the adoption rate of telemedicine has advanced by several years as a result of the sudden COVID-19 lockdowns and the need for social distancing. Changes brought on by the pandemic should also benefit businesses with cloud-based software offerings. Examples include companies that provide online learning services and those that enable financial institutions to offer mobile banking services.

We look for small companies that we believe can grow their earnings and cash flows at a rapid pace for many years. Ideally, we seek small-cap companies that can grow into large-cap businesses over time. We are not typically attracted to companies that have been small for a while and are likely to remain small. We are attracted to businesses in big addressable markets that have products or services that enable them to take market share from peers.

The small-cap asset class can be volatile, especially when targeting the fastest growing companies. For this reason, it is important to note that the largest portion of our portfolio consists of stable, well-established companies that we believe are mispriced by the market. We believe these companies, which typically comprise 60% to 80% of the portfolio, can grow at much higher rates and the market is not pricing in their full profitability potential.

The remainder of the portfolio is invested in emerging growth and cyclical growth companies. We define emerging growth companies as those that offer disruptive products, services, or technology that will enable them to grow rapidly. They are typically early in their life cycles, and their quality metrics, such as return on capital or margins, may look weak today. However, if they grow at the rates we are projecting, they could mature into high-quality growth leaders. We put less emphasis on cyclical growth companies, but we will add these to the portfolio if we believe the companies are competitively positioned and offer durable growth prospects.

While it is well-established that the COVID-19 pandemic is a global health crisis, we are just beginning to see the economic toll it is taking on businesses. For many small-cap companies, the near-term outlook remains highly uncertain. However, we are optimistic about prospects for the asset class over the longer term. We believe the negative shock of the pandemic will reveal the strengths and weaknesses of many business models. At the same time, it should also accelerate the pace of disruptive change that many small companies help to promote.