Turmoil-Tested Small-Cap Funds

The market conditions of the past three years have whipsawed small-cap funds in a big way.

From the Russell 2000's peak on July 13, 2007, to the market bottom on March 9, 2009, the typical small-cap fund shed 41%, whereas the typical mid- and large-cap funds shed 39% and 37%, respectively. From that bottom through the most recent peak on April 27, the typical small-cap fund surged by 89%, which outpaced its mid- and large-cap counterparts by several percentage points.

Those swings have wreaked havoc with small-cap funds' three-year record. The typical small-cap fund shed 5.7% annualized in the three years ending Aug. 16. That said, the challenge of navigating these turbulent markets was a virtual stress test that, when paired with longer-term performance periods, showed which funds lived up to their reputations and records during the crisis. Combining three- and 10-year results with other factors can help point to some interesting small-cap funds.

For this screen, we use Morningstar Principia to zero in on domestic small-cap funds with below-average expense ratios (below 1.3%) that are open to new investments of $25,000 or less.

Special Criteria = Distinct Portfolios Only
And ( Morningstar category = Small Value
Or Morningstar category = Small Blend
Or Morningstar categroy = Small Growth )
And Audited expense ratio < 1.30
And Purchase Contraints = Closed-New Investment
And Min Initial Purchase < 25,000
And Analysis not= NA

To stress-test the funds' records, look for options with three- and 10-year category rankings that are in the top quartile, and make sure the current manager has been around for at least 10 years.

And % Rank Cat 3 Yr  <  25
And % Rank Cat 10 Yr  <  25
And Manager Tenure (Longest) > 10

We ran the screen on Aug. 19. Here are a few funds that stood out:

Brown Capital Management Small Company BCSIX
This is one of a handful of small-cap funds to eke out a gain during the trailing three years. (It rose 1.6% annualized.) That's because its 30% loss in 2008 and 46% gain in 2009 were far better than most peers' showings. Longtime manager Keith Lee and his team search for small-cap firms with durable competitive advantages and sound balance sheets. This helped the fund hold up better than most as the markets plunged in 2008. Some excellent stock picks such as business software firm Rovi ROVI shone in this compact portfolio of around 45 names during the most recent rally. Over the past 10 years, the fund returned 3% annualized, while the typical small-growth fund was virtually flat.

It's important for growth managers to understand competitive advantages well, because they're often paying hefty sums of money for current or past earnings, so losses could be big if future profits don't pan out. For example, the fund's second-largest holding, Green Mountain Coffee Roasters GMCR, recently traded at more than 50 times trailing earnings. Nevertheless, the managers see outstanding growth in the future as the single-pod coffee-making trend gains momentum. Indeed, the firm has posted 60% revenue growth over the past year and returns on equity of more than 15% for every year except two for the past decade.

Holding firms with such high earnings multiples means this fund will court its share of volatility, even when its calls are ultimately right. Although its 30% loss in 2008 was tame in relative terms, it also clocked a 40% decline in 2002 when investors were fleeing growth stocks in droves. Altogether, though, this fund can add some zip to a portfolio, taken in moderation and with patience.

Royce Special Equity RYSEX
This fund arrived at its strong relative three-year record in a very different fashion. Veteran manager Charlie Dreifus is a stickler for clean balance sheets and gravitates toward cash-cow businesses and dividend- payers that he can hang on to for years. But it was the fund's large cash stake that helped even more in 2008. In a somewhat unusual move, Dreifus allowed cash to double to more than 20% of assets during the third quarter of 2008 given the uncertain market conditions, which provided some ballast. That slug of cash was a bit of a handicap in the rally that began in March 2009. The fund's 0.6% annualized gain for the three years ending Aug. 16 was better than 95% of its peers. Dreifus' focus on absolute returns has resulted in 11% annualized returns during the past decade, which is more than double the typical small-blend fund's result for that time frame.

Would-be investors need to be prepared for the cash and high-quality focus to result in some streaky relative returns. That has been a problem here in the past. After the 2000-02 bear market, the fund was flooded with new investors, who then headed for the exits when it went on to post bottom-decile rankings for three consecutive years. But this fund has proved that defending capital during the gloomy times can have a great long-term impact. During the past decade, its 12% annualized gains bested the typical peer's by 2 percentage points.

In the end, conservative and patient types have plenty to like here.

Wasatch Small Cap Growth WAAEX
By contrast, manager Jeff Cardon of Wasatch Small Cap Growth fills the portfolio with the stocks of small-cap firms that exhibit long-term earnings growth of 15% or more. He homes in on firms with little or no debt, which has caused the fund to lag its small-growth peers during previous rallies.

Not so this time around. The fund got an extra kick from its roughly 17% stake in foreign small caps including GlaxoSmithKline Consumer Healthcare Ltd. of India--Cardon thinks India's rising population and the upward mobility of some of its lower classes should continue driving growth in the stock for years to come. It has already given the fund a boost and is one of the fund's better performers in 2010 as some domestic stocks have struggled. While the fund shed 2% on an annualized basis during the past three years (still better than nearly 90% of its peers), Cardon's approach has resulted in a 5% annualized gain over the past 10 years, which outpaced its small-growth peers by a wide margin.

Cardon searches for the best high-quality growth companies, often owning stocks for years, as has been the case with Hibbett Sports HIBB. Cardon likes the stock because it's well run and has the potential to expand outside of the Southeastern United States, where it's based. Stocks with multiyear growth stories typically make up the bulk of the portfolio's top holdings, with more speculative fare, like biotech, playing a smaller role. That can hold the fund back at times, as has been the case during the trailing year, when the fund has lagged three fourths of its peers. However, the fund's stellar long-term record overshadows temporary lags and makes this Analyst Pick worth considering.

Karin Anderson is a mutual fund analyst with Morningstar.