Small-cap growth cycles are among the most volatile in the equity markets, and this can create an especially strong temptation to change one’s style stripes when times get tough. Some managers try to smooth out the fluctuations inherent to the asset class by migrating toward holdings with lower growth and valuation profiles, or with larger capitalizations. The thinking is that the shift toward stocks perceived to be safer is a sound risk control.

But managers who drift do so at their own peril. Volatility works in both directions, and unless one is particularly skilled at the difficult and unlikely task of timing a market cycle, the only way to benefit when the run-up kicks in is to have been true to one’s investment approach all along.

The Allianz OCC Opportunity Fund seeks capital appreciation with no consideration given to income. To succeed in this asset class, we believe market downturns must be viewed as a time of opportunism, not flight. Our philosophy has enabled us to repeatedly benefit in the aftermath of market inflections. We attribute this success to three core tenets of our investment approach: (1) active management of position sizes around risk/reward profiles, (2) style purity and diversification across multiple metrics, and (3) managing through the multiple phases of a small-cap growth cycle.

Figure 1: Small-Cap Growth Index Performance Cycles

*3 Months After Trough Past performance is no guarantee of future results. Small-cap growth performance is represented by the Russell 2000 Growth Index. Market troughs were 10/9/02, 7/21/06 & 3/9/09. Being positioned to fully participate in the asset class rebound can significantly impact a manager’s long-term results. Source: FactSet.

Risk/Reward Opportunism

We build the Allianz OCC Opportunity portfolio and set position sizes based on our view of a stock’s risk/reward profile, which reflects where its share price trades relative to our upside and downside price targets for the stock. The ratio represents the expected return of a stock if our investment thesis proves correct versus the expected downside exposure if it does not.

Average Annual Total Returns as of 6/30/09

(Fund Inception 2/24/84**)

Performance quoted represents past performance. Past performance is no guarantee of future results. Current performance may be lower or higher than average annual returns shown. Investment return and the principal value of an investment will fluctuate. Shares may be worth more or less than original cost when redeemed. For performance current to the most recent month-end, visit our Web site at www.allianzinvestors.com. MOP returns take into account the Class A maximum initial sales charge of 5.50%. The Fund’s expense ratio is 1.31%.

**This is the inception date of the oldest share class, which for this Fund is the C share class. The returns presented are for Class A shares, which were first offered in 12/90. Returns measure performance from the inception of the oldest share class to the present, so some returns predate the inception of Class A. Those returns are calculated by adjusting the C share returns to reflect the A shares' different charges and expenses.

Several recent examples provide context for the type of ratio we have been able to exploit in times of market duress. In early 2003, following an economic recession and deep, multiyear bear market, our bottom-up research revealed upside/downside ratios of 3- and 4-to-1, the most attractive return/risk opportunities we had ever seen to date. We experienced a similar phenomenon in mid-2006: Following monetary tightening that caused small-cap growth stocks to decline 18% in less than three months, our research again uncovered 3- and 4-to-1 return/risk opportunities. For the calendar year 2003, the Allianz OCC Opportunity Fund (Class A) posted a 60.1% gain and for the calendar year 2006, the fund posted an 18.6% gain.

More recently, from October 2007 to March 2009, small-cap growth stocks endured a 58% peak-to-trough decline. This was as painful and trying a period in the small-cap growth market as there has ever been. But as it had in prior, less severe dislocations, our discipline remained clear: Rather than seek refuge from the risk that comes with the territory in small-cap growth investing, we instead sought to identify the highest-potential opportunities for the given level of risk. We repeatedly tested our investment theses and applied especially conservative estimates to our analyses. Ultimately our research uncovered return/risk ratios of 5- and 6-to-1 — an extraordinary opportunity set that further reinforced our discipline.

Style Purity & Diversification

In an effort to help the Allianz OCC Opportunity Fund perform well at inflection points, we maintain style purity in all market environments. We have no proven ability to time the market by betting on sector rotation or other systematic risk factors. We therefore do not shape-shift into a defensive shell or withdraw from risk just so we can sleep better at night — in our view, sound sleep is not the domain of a small-cap growth manager. We look to pick great stocks, and we aim for stock selection to account for 80% or more of our tracking error.

To demonstrate that we’re pursuing outperformance with a consistent approach, we expect to produce a style-pure portfolio whose characteristics are aligned with our benchmark, the Russell 2000 Growth Index. The best way to achieve this, in our view, is to diversify our investments across a variety of dimensions.

The traditional view of diversification focuses on sectors or industries. But varying a portfolio’s constituents by these criteria alone can still produce holdings with cross-correlation. So we go beyond industry and look to diversify our holdings across factors such as market capitalization, earnings growth, valuation levels, company quality and others.

By maintaining exposure across these areas, we believe we will be well positioned to succeed both when the market changes direction and when only certain segments of the asset class are in favor. For us, this varied exposure has resulted in a high r-squared vs. our benchmark as well as a pure holdings based style profile. In addition, as demonstrated by our performance attribution, we have been able to add value over time across a broad cross-section of portfolio characteristics.

Managing Through the Cycle

Since the economic cycle drives the business environment in which small-cap companies operate, we aim to build a portfolio that is capable of weathering a downturn and ultimately thriving as the economic cycle progresses.

The primary way we do this is by focusing on secular growth. We favor companies with growth prospects that are longer-term in nature and less dependent on the economic cycle. In the course of analyzing companies, we are typically able to identify longer-term trends in our economy or society that can provide a tailwind to growth irrespective of economic conditions. We can then aggregate these insights into broader investment themes (see Figure 2), which in turn enable us to identify other stocks that stand to benefit from the underlying growth trends. The end objective is to assemble a portfolio of companies that have sustainable and diversified growth prospects.

Figure 2: Investment Themes

The list above includes five representative investment themes among more than two dozen that we’ve identified and from which our companies are benefiting. A company need not have an identifiable secular trend to enter the portfolio; additionally, there may be investment themes that we follow but are not exposed to at any given time.

Other attributes we prioritize include companies that have fully-funded business models; cash flows to reinvest; an appropriate capital structure to weather a tightened credit environment; sustainable competitive advantages in product, cost structure or business model; optionality with diversified business lines; downside valuation protection (e.g. net asset value or private market value); and a strong value proposition to its customers in any economic environment. Finally, we emphasize seasoned management teams that have guided a company through past economic cycles to emerge stronger and leaner on the other side.

In addition to the economic cycle, we actively manage through the market cycle. Our approach entails adding to and trimming position sizes depending upon a stock’s movement relative to our upside and downside price targets. In doing this we attempt to lock in much of the upside, even if we sit out the eighth or ninth inning of a stock’s rally. We remain disciplined with our price targets, and always maintain a robust list of investment candidates waiting to enter the portfolio.

Conclusion

Since we cannot limit the innate volatility of small-cap growth investing, we design our investment approach to use the volatility to the Fund’s advantage. The flight from risk that usually accompanies a declining equity market typically creates terrific opportunity for the calm, disciplined investor. By embracing the nature of the asset class, we can construct a small-cap growth portfolio that may be resilient through a downturn even as we plant the seeds for strong alpha generation when the cycle turns.