Small-Cap Funds with Dash, Not Trash

In general, risky stocks have enjoyed a much sharper rally than their stable-growth counterparts since the market's last bottom on March 9, 2009. Small-cap stocks in particular have enjoyed a big bounce. Even with the pullback in recent weeks, the average small-cap fund has gained 45% since the last bottom, putting it up 7% for the year to date ended June 29, 2009.

Whether or not the recent rally has been a "dash to trash," not all mild-mannered funds have been wallflowers. We zeroed in on some of these funds using the Premium Screener. First, we limited the screen to domestic small-cap funds that are open to new investments of $25,000 or less and which also sport below-average expense ratios. We also screened for funds that had lower debt/capital ratios than the Russell 2000 Index, a common small-cap benchmark, in 2008. This measure can help point to portfolios that had less exposure to debt-laden firms, and, therefore, these portfolios may have lagged those with riskier fare in recent months.

To stress-test the funds' performance, we required that the funds have top-third rankings next to peers for the trailing three-month period, which encompasses much of the recent rally, as well as for the year to date. Plus, we required minimum manager tenures of 10 years and top-third rankings for the trailing 10-year period. The screen turned up the following five funds as of June 29, 2009:

 Brown Capital Management Small Company (BCSIX)
Patience is the name of the game for the managers of this small-growth fund. Longtime manager Keith Lee and his team search for small-cap firms with durable competitive advantages and sound balance sheets. At times, this has caused the fund to lag its peers during sharp rallies. Not this time, though. The fund has gained a very respectable 42% since March 9, 2009. Over the long term, the team's process has produced a 6% annualized return over the past 10 years, which outpaced the typical peer by 4 percentage points.

 Columbia Small Cap Core 
The micro-cap investing experience of this fund's manager has served it well over the long haul. Peter Larson focuses on buying firms with market capitalizations of $500 million or less, and his goal of picking up long-term winners that are trading at bargain prices shows through in the portfolio's relatively low value measures. True, the fund's whopping 54% gain since March 9 owes much to the big bounce in micro-cap stocks recently. However, there is plenty of evidence that Larson's stock-picking has been solid over the long haul, as reflected in the fund's peer-beating 7% annualized return during the past 10 years.

 Heartland Value (HRTVX)
Veteran manager Bill Nasgovitz and his team look for stocks of micro- and small-cap firms that sport low price/earnings multiples compared with historical levels, as well as some catalyst for improving performance. Over the long term, management's clear and consistent approach has delivered the goods: The fund has posted an enviable 8% annualized return during the past 10 years. After last year's roughly 40% loss, the fund has come charging back with a 57% gain since the last market bottom. Certainly, the micro-cap focus has helped, but the performance is impressive given that the fund has a good deal of exposure to health-care firms--roughly 25% of assets as of March 31, 2009--which have generally lagged this year.

 Perritt Micro Cap Opportunities (PRCGX)
Of this group, this fund has the lowest average market capitalization--$130 million. Manager Mike Corbett has been successful at targeting tiny companies in the $10 million to $750 million range that he can hang on to for several years. He favors those that are operating in some kind of new niche, as well as those with little or no debt on the balance sheet. His valuation-conscious approach often has him buying during downturns. Recently, he has kept a roughly 8% cash stake in order to be able to add to his positions in the event of another sharp downturn. Investors here need to be prepared for an especially bumpy ride, and the fund rarely moves in step with its small-blend peers. The fund bounced back by 69% since March 9, 2009, and over the past 10 years, it has delivered a whopping 10% on an annualized basis.

 Wasatch Small Cap Growth (WAAEX)
Jeff Cardon has filled this portfolio with the stocks of stable-growth firms with strong cash flows for more than two decades. Long-term earnings growth of 15% or more is a focus, but more important is the tendency here to buy firms with little or no debt. Of this group, this fund's debt/capital ratio was the lowest as of March 31, 2009, and it was roughly half that of the fund's benchmark, the Russell 2000 Growth Index. Long-term holdings such as  O'Reilly Automotive (ORLY) and Copart (CPRT) have helped the fund bounce back by 47% since the recent market bottom. Over the long term, this small-growth Analyst Pick has produced an annualized return of 8% for the past 10 years.

Given the volatile nature of small- and micro-cap stocks, patience is required to do well with any of these funds, but we certainly think that each one would make a great complement to a well-balanced portfolio.

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