Small Stocks, Big Potential

09/15/2009 11:39 am EST

Focus: FUNDS

Benjamin Shepherd

Analyst, Breakthrough Tech Profits, Global Income Edge and Personal Finance

Benjamin Shepherd, associate editor of Personal Finance, finds one value and one growth fund to give investors exposure to small-cap stocks.

Value funds have outperformed their growth brethren by a wide margin for more than a year. But growth funds are quickly regaining their dominance, with small caps leading the way.

T. Rowe Price Small-Cap Value (PRSVX) has performed extremely well. Management employs a blended strategy; some holdings are almost pure value plays, while others are better characterized as growth-at-a-reasonable-price (GARP) bets. The fund has outperformed its value peers, but not quite kept pace with pure growth funds.

But performance could lag. Based on the fund’s recently disclosed portfolio, the rally we’ve seen in small-cap stocks is closing the gap on the GARP plays, resigning manager Preston Athey to move more towards the pure value end of the spectrum. T. Rowe Price Small-Cap Value remains a Buy.

As a supplement to our value-focused holding, we’re adding Wasatch Small-Cap Growth (WAAEX) to the portfolio to gain more exposure to the growth side of the equation. Manager Jeff Cardon, who has helmed the fund for more than 20 years, seeks both foreign and domestic companies with market capitalizations of less than $2.5 billion.

The current average market capitalization of the fund’s holdings is $960 million. Eligible companies are then put through a series of fundamental screens designed to find consistent earnings growth (in the range of 15% to 20%), accelerating revenues, improving cash flows, and rising return on assets—both on an absolute basis and relative to peers.

Companies that make it through these screens are then subjected to rigorous management discussions and what Wasatch characterizes as “deep due diligence,” allowing Cardon to become comfortable with management and fully understand its strategy.

Once those hurdles are cleared, Cardon buys in and sticks with the investment until it no longer meets his fundamental criteria or he believes management has lost its way. He also keeps an eye on valuations, making sure he doesn’t overpay for growth potential. That keeps portfolio churn at a relatively mild 51%.

This strategy has proved highly effective, with the fund generating an average annual gain of better than 10% over the past two decades. All the while, Cardon has kept a lid on volatility by adding some slower-growth companies into the mix.

Ranked in the top 5% of small-cap growth funds, that long-term track record is one of the fund’s major attractions. With less that $750 million in total assets, the fund is extremely nimble and allows Cardon to move into positions with ease.

Over the past few quarters, the fund has benefited from a heavy weighting in information technology, which is still 27.1%. But Cardon has been mixing things up in recent months, adding names like HDFC Bank (NYSE: HDB), India’s largest nongovernment-owned bank, and MSCI (NYSE: MXB), the keeper of the MSCI indexes on which so many exchange traded funds are based.

With a tight focus on long-term growth and a time-tested strategy, Wasatch Small-Cap Growth is a Buy.

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