Small Stocks, Big Profits

09/14/2010 11:16 am EST

Focus: FUNDS

Russel Kinnel

Editor, Morningstar FundInvestor

Russel Kinnel, editor of Morningstar FundInvestor, and analyst Jonathan Rahbar like a little-known small-cap-stock fund that has posted strong returns for quite some time.

Consistency and patience have paid off for Brown Capital Management Small Company Institutional fund (BCSIX).

The managers [of the five-star-rated fund, which is up 6.98% annually over the last five years—Editor] employ a growth-at-a-reasonable-price approach to picking stocks, focusing on relative values across companies that appear to have strong prospects in various industries.

Management targets firms with $250 million or less in revenue, which has given the fund a meaningfully lower average market capitalization than that of the typical rival. The managers hunt for companies with sustainable revenue growth, solid market share, good profitability, and low debt.

After attractive candidates are purchased, management hangs on for the long haul. The fund’s turnover averaged about 11% over the past decade, compared with well more than 100% for the category average. The portfolio typically holds around 50 stocks and can be concentrated in particular sectors, such as technology and health care, which recently made up more than 75% of the fund’s sector exposures.

Despite [that concentration,] the fund’s volatility has been right in line with the category average over the past decade, but its performance has been anything but average. The fund’s three-, five-, ten-, and 15-year trailing results land squarely in the category’s best quartile. In the 97 rolling ten-year periods since the fund’s inception in 1992, it has landed in the category’s top quartile 63% of the time and in its top half 100% of the time.

Management’s preference for quality companies can leave the fund susceptible to bouts of underperformance when the most speculative stocks rule. Also, because the managers like technology, the fund occasionally takes a hit, as was the case in 2002. However, in the most recent market collapse, it turned in one of the best showings in the pack, as it did in 2009’s rebound.

Since 2007, the fund has seen steady inflows, but, after shedding 30% during 2008’s financial crisis, expenses have continued to creep up on the margin and now stand at 1.24%. The average no-load small-cap mutual fund clocks in at 1.20%.

The fund’s fees could use a haircut, but on the whole, Brown is a strong steward of its shareholders’ capital. Firm founder Eddie Brown has [more than] $1 million in the funds he manages. What’s more, the fund’s management team is experienced. Keith Lee, who joined Brown Capital Management in 1991, has been the fund’s lead manager since its inception in July 1992. There are about 25 people at the firm in total, of which about half are focused on portfolio management. Turnover [among] managers and analysts throughout the past decade has been very low.

The fund has attracted more than $300 million since the beginning of 2008, so investors will want to keep an eye on the fund’s size, but the fund’s smaller positions and diversification across individual names should help mitigate those risks.

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