Under-the-Radar Small-Cap Fund

It's tough nowadays to find solid small-company funds that are still accepting money from new investors. So sometimes, you have to look in out-of-the-way places. Our search led us to a promising no-load choice run by a manager mainly known for his firm's load funds.

David Dreman is one of the best-known practitioners of contrarian investing -- the idea that some of the best opportunities lie in some of the most widely despised stocks. He is the author of several well-known books, including the 1982 classic Contrarian Investment Strategies. His firm, Dreman Value Management, in Jersey City, N.J., manages nearly $8 billion in mutual fund assets under the DWS Scudder and SunAmerica labels. The stable includes DWS Dreman High Return, a large-company fund that has returned an annualized 14% over the past 15 years, outrunning 93% of all diversified U.S. stock funds.

The problem with the DWS and SunAmerica funds is that they impose sales charges. However, in early 2004, Dreman launched three value-oriented no-load funds -- one focusing on large-cap stocks, one on mid caps, and one on small companies. All come with affordable minimums of $2,500. We find the small-company fund, Dreman Contrarian Small Cap Value, intriguing. Although the fund (symbol DRSVX; 800-247-1014) is open to anyone, it is mainly meant for employees of Dreman Value Management and isn't actively marketed, says Dreman, 70. That explains why assets stand at a miniscule $11 million.

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In its nearly three years of existence, the fund has quietly built a terrific record. Since its launch on January 2, 2004, Small Cap Value has returned an annualized 21% through October 12. Over the same period, the Russell 2000 Value index gained 16% annualized. The fund's 19% gain in the first nine months of 2006 was better than all but one small-cap value fund (ABN AMRO River Road Small Cap Value, in case you're curious).

Dreman, along with co-manager Nelson Woodard, invests in out-of-favor companies selling at a discount to their intrinsic value. The duo seek stocks with low price-to-earnings ratios, low price-to-book ratios, and low price-to-cash flow ratios. "We look for reasonably strong companies on the whole," Dreman says. His checklist includes looking for companies with strong management teams and those with catalysts that could spur future growth.

Over the past two years, the fund has benefited from a sizable stake in energy stocks (now a bit more than 10% of the portfolio). A large position in financials -- specifically shares of small banks -- has also given the fund a boost. The portfolio, which contains 90 holdings, includes such companies as natural gas transporter Southern Union (SUG) and Foster Wheeler (FWLT), an engineering and construction firm. It's rare for a single stock to account for more than 2% of the fund.

Dreman and Woodard apply the same strategy to the $1.5-billion DWS Dreman Small Cap Value. The main differences between the two funds are size and sales fees. The DWS fund (KDSAX; 800-621-1048; 5.75% sales charge for the class A shares), which will close to new investors on December 29, holds 181 stocks. Dreman launched this fund in mid 1992 and ran it until 1993. What followed was a rocky few years during which the fund saw a slew of manager changes, a switch to a quantitative strategy, and a blow-up during the dot-com bust because it held a large slug of technology stocks. Dreman returned at the beginning of 2002 and restored the fund's value strategy. Over the past three years, the DWS fund returned an annualized 22%, placing it among the top 2% of all small-company funds.

Dreman has proven that his value strategy works on funds of all sizes. That's why we think Dreman Contrarian Small Cap Value is a fine choice for no-load investors who are seeking a promising small-company fund. Annual expenses, at 1.50%, are about average.