Small Growth Packs Risk After Rally

This article was published in the October issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor here. 

The small-cap growth category has had a fantastic run so far in 2013. Averaging a 30.4% return through Sept. 30, it is the top-performing diversified-domestic category by a mile. In second place, the small-blend category is trailing well behind with a 23.8% return. (Meanwhile, large-cap funds are averaging around 20.0%.) Fueling these returns are high-flying small-cap technology names such as Angie's List (ANGI) (up 87.6%) and Zillow (Z) (up 203.8%).

Jeff Cardon, manager of Gold-rated  Wasatch Small Cap Growth (WAAEX), told us in late August: "Such companies are valuation-stretched. It's not an Internet bubble, but it is pretty close." While Cardon is a low-turnover manager who buys stocks and hopes to hold them for five years, he has been trim­ming picks added earlier this year. His fund is also trailing most of the rest for the year to date, with a 24.3% return. (That's not cause for concern: The fund sometimes lags in rallies, but Cardon has produced one of the best records in the category during his tenure of more than 25 years, and the fund is notable for its low Morningstar Risk ratings.)

Not surprisingly, the top-performing funds in the category this year tend to have healthy slugs of technology and correspondingly high price/earnings ratios. (The P/E ratios mentioned here are based on trailing 12-month earnings.)  Brown Capital Management Small Company (BCSIX) is an example of price risk. Indeed, that fund's P/E of 33 is the highest in the small-growth category, which averages a P/E of 22. At the end of August, the fund had more than 60% of assets in tech stocks; its top position was cloud service provider Medidata Solutions , which was up 152.5% through Sept. 30. Brown Capital Management Small Company was also one of the top-performing small-growth funds, with a 38.1% return.

A look at other high-average P/E funds, and it's the same story:  Artisan Small Cap (ARTSX),  Buffalo Small Cap (BUFSX), Loomis Sayles Small Cap Growth (LCGRX), and  Conestoga Small Cap (CCASX) have P/Es of 29 or higher. They also have tech stakes greater than a fourth of assets and are up more than 30% for the year. While this rally is a broad one and each portfolio is distinctive, Medidata Solutions pops up in several of these funds, as does Angie's List.

High P/Es aren't necessarily a sell signal. Four of the five funds are Morningstar Medalists, which means Morningstar analysts believe they are likely to outperform over the long run. (Loomis Sayles Small Cap Growth has not been rated.) What's more, none of them has been riskier than the average small-growth fund, and Conestoga Small Cap has low risk ratings. That fund's managers and the Brown Capital Management team follow deliberate, low-turnover strategies. (Turnover for both was around 15% at last count, compared with more than 80% for the category.)

Average valuations and sector weightings aren't a perfect guide to risk. Some top-performing small-growth funds, such as William Blair Small Cap Growth (WBSNX) (up 42.1%), have relatively small tech stakes and more reasonable valuations. William Blair Small Cap Growth has a P/E of 24. This fund, however, also has above-average risk ratings and suffered steeper losses than the others in 2008.

That said, lofty P/Es are a reminder that for most investors, small-growth funds fit into a relatively small "aggressive" slot in a diversified portfolio. If you have a fund that's been riding the small-cap Internet rally this year, it's time to revisit your risk tolerance and perhaps rebalance your portfolio.