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Meet the Small-Cap Specialists

These are four of the best.

Russel Kinnel, 03/22/2011

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When it comes to large-cap funds, the big fund companies dominate. But in small caps, they barely have a presence. If you're running $200 billion in large-cap funds and $5 billion in small-cap funds, clearly your priority is not small caps.

To fill that void, some other firms have focused their efforts on small caps. The stocks have less coverage from Wall Street, but the businesses are often simpler and easier to value. As a result, some firms have thrived with that focus. They actually have more analysts and managers looking at small-cap stocks than most of the giants. In addition, some are more willing to close their funds at a manageable amount.

Here, I'll take a look at four of the better small-cap firms and how they run money. I set a minimum of three small-cap funds to be included. Interestingly, each of the smaller firms has about 25 investment professionals--managers and analysts--working on small caps.

I've included a table showing how firms stack up on performance, manager investment, and expense ratios.

Royce is darn near synonymous with small caps. Who else would run 14 different small-cap funds? More important, who else could run them this well?

Royce dips a toe into growth, but really the firm leans toward the line between value and blend. The key thing to follow at Royce is the manager. Each follows a slightly different take on market cap and valuation. Whitney George leans a bit more toward growth and the smaller market cap. Chuck Royce tends toward the upper end of small caps and is rather value-oriented, while Charlie Dreifus has a deeper value bias and a greater emphasis on clean balance sheets.

The firm does quite well on nearly every data point that I've highlighted. It has strong long-term performance, low costs, and long manager tenure; and nine of its 14 funds boast manager investments in the $1 million-plus slot.

Third Avenue
New York-based Third Avenue lives by Marty Whitman's mantra "safe and cheap." Third Avenue believes in buying a company at a big discount to its value so that there's only a small chance of suffering a significant loss. It also does a lot of its shopping overseas. It is not a foolproof method, but it has been quite effective over the years.

So, how does Third Avenue find that margin of safety? By going the opposite way of the crowds to find companies under stress but where the balance sheets and business models are strong enough to survive. As Whitman says, "We buy stocks where the near-term outlook sucks." The best managers move in a different direction and have hard-to-replicate strategies. That describes Third Avenue to a T.

On the downside, Third Avenue instituted a stealth fee hike by raising the minimum investment on its existing share classes to $100,000 and introducing a new higher-cost share class with a 25-basis point 12b-1 fee tacked on for those who can't meet the $100,000 limit. They are excellent funds, but the cheap part applies only to the portfolio holdings, not the funds.

T. Rowe Price
More than most large fund complexes, T. Rowe Price gives small caps the proper respect they deserve. Its small-cap managers generally stay there for most of their careers. Jack Laporte just retired after nearly two decades at New Horizons PRNHX, and Small-Cap Value's PRSVX and Small-Cap Stock's OTCFX managers are working on their second decades. T. Rowe also closes its small-cap funds, albeit reluctantly.

T. Rowe is the place to go if you want to dial down risk. Compared with the other firms here, T. Rowe has less distinctive, more diversified funds. It also has heft, as three out of the four have around $6 billion in assets, and they're still open (though they've closed in the past). On the positive side, you get low costs and less risk at T. Rowe, so it's a pretty fair trade-off.

Salt Lake City-based Wasatch runs the least amount of any of the firms profiled here but has as many investment professionals as any listed here. That's good value.

Virtually every Wasatch fund looks for sustainable earnings growth. Wasatch tends to be a little more aggressive than Baron as it will buy tech and biotech, but it doesn't go off the deep end. Its emphasis on steady growth has limited its energy holdings, and that hurt the funds for much of the past decade, save 2008.

The funds have the widest diversity of tenure. On the one hand, there's Jeff Cardon in his 24th year at closed Wasatch Small Cap Growth WAAEX. On the other hand, you've got four funds in which the managers have less than five years at the helm. That may explain why Wasatch clocks in near the bottom for manager investment. Or it could be that Wasatch's high costs are scaring off the managers.

The plus side to those high expenses is that assets are always at a manageable level. Wasatch is more diligent than the others at shutting a fund before assets grow out of hand. While most of its funds have reopened due to a slump a couple of years ago, Wasatch has vowed to close its funds at even lower asset levels this time around so that it can avoid having to close the funds to existing investors the way it did a few years ago.

Russel Kinnel is director of mutual fund research with Morningstar.

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