Best Small-Cap Mutual Funds
These six funds deliver the outsize of gains of small-company stocks while holding down the stomach-churning volatility.
Small-company stocks — and the funds that invest in them — can pack a punch. But they can leave some bruises behind, too. Over the past 15 years, for instance, the Russell 2000 index of small companies has gained an annualized 8.6%. That beats Standard & Poor’s 500-stock index of large companies by an average of 3.8 percentage points per year. But over the same stretch, the Russell 2000 has been one-third more volatile than the S&P 500. Ouch.
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For that reason, in our search for the best no-load small-company funds, we focused on funds that have consistently delivered above-average returns and have done so with below-average volatility. Here are our six picks, listed in alphabetical order (all returns are through November 21).
Baron Small Cap Fund Retail (symbol BSCFX). Since its 1997 launch, Baron Small Cap, a member of the Kiplinger 25, has returned an annualized 10.4%, trouncing the Russell 2000 index by an average of 3.3 percentage points per year.
The fund’s recent performance, although excellent on an absolute basis, has been so-so relative to its benchmark: Its one-year return of 38.2% lagged the Russell 2000 by 4 percentage points. Over the past year, the smaller a company, the more likely its stock was to perform better than stocks of larger firms. And manager Cliff Greenberg says part of the reason the fund didn’t beat its bogey by more was because of his penchant for holding on to winners, even if they grow into midsize companies.
The average market capitalization of Baron Small Cap’s holdings is about $3.1 billion — more than that of the typical small-company fund, which has an average market cap of $1.8 billion. And some of Small Cap’s holdings are substantially larger. For example, its top holding, wireless-tower company SBA Communications (SBAC), has been in the portfolio since 2004 and now has a market cap of $11 billion (the stock gained 27% over the past year). But some of the fund’s smaller holdings, such as Financial Engines (FNGN), an investment advisory firm, and hardwood-flooring maker Lumber Liquidators Holdings (LL), did far better, posting triple-digit advances over the past year.
Greenberg, who has run Small Cap since its debut, conducts his search for growth with an eye toward value. He looks at so-called special situations (including spinoffs and companies undergoing management changes) as well as fallen angels (once-great growth companies that have stumbled). Though the fund’s assets have grown to about $5.6 billion, Small Cap holds almost the same number of stocks (about 100) as it did when assets were closer to $2 billion. And Greenberg says he manages the fund the same way he did in the fund’s early days: “We are sticking to our knitting,” finding good, growing businesses trading at value prices.
Buffalo Emerging Opportunities (BUFOX). Long-term trends in technology, health care and demographics drive this fund’s stock picking — “simple trends that are simple to understand,” says John Bichelmeyer, who manages the fund with Craig Richard.
One such trend is the need to keep health care costs down. In other words, says Bichelmeyer, “What companies will give us efficient treatment at a lower cost?” Omnicell (OMCL) is a good example. The firm makes systems that allow a health care facility to track medications as they are moved to different areas within the building. Bichelmeyer followed the firm for a year before buying shares in 2009. “There’s continued monitoring of a drug, from the pharmacy to the cart on the nurse’s floor to the patient’s bedside,” he says. “Everyone knows where the drug is and has been. It’s a huge need.”
Business was weak back in 2008 and 2009 because spending plunged during the financial crisis. But Bichelmeyer and Richard believed spending would bounce back. The stock has climbed 61.2% over the past 12 months.
Bichelmeyer and Richard, with a team of 12 analysts behind them, focus on firms with market values of $700 million to $1 billion. The holdings in the fund are mostly single-product companies with small but growing sales, and they are often run by their founders. “They’re a little less proven, and by definition more risky,” says Bichelmeyer. But they’re financial stable. Of the 65 companies in the fund, 48 have no debt and generate positive cash flow (earnings plus depreciation and other non-cash charges). Those that aren’t cash-flow positive, says Bichelmeyer, “are choosing to be so — to grow by spending on sales and marketing.”
Bichelmeyer stepped in as manager in late 2007, when the fund was holding a bunch of “bad” and unprofitable companies. “It was a baptism by fire,” he says. He spent a year turning the portfolio around. Since then, Buffalo Emerging Opportunities has returned an annualized 9.6%, an average of 2.6 percentage points per year more than the Russell 2000.
Hancock Horizon Burkenroad Small Cap Fund (HYBUX). Why in the world would a fund manager ever limit his universe of potential holdings to companies based in just six states? David Lundgren and John Portwood get that question a lot because the small-company fund they run, Hancock Horizon Burkenroad Small Cap, invests only in companies based in Texas, Louisiana, Mississippi, Alabama, Florida and Georgia. But the benefits have outweighed any perceived limitations, says Lundgren. “This fund doesn’t look like or act like its peers or the Russell 2000, and that has been appealing to a lot of investors.”
What many investors see, most likely, is the fund’s high-return, low-volatility profile: Its ten-year annualized return of 12.8% outpaced the Russell 2000 by an average of 3.5 percentage points per year. And over that time, it was 10% less volatile than the benchmark.
Lundgren and Portwood whittle down their list of potential investment opportunities by using screens. “We’re a ‘quant’ fund,” says Lundgren. Scanning the 500 or so companies in the six-state area with at least $200 million in market value and a steady trading volume, they score firms on factors such as free cash flow (cash profits left after the capital expenditures needed to maintain a business), book value (assets minus liabilities), earnings trends and share-price momentum, among other things. They view the top 150 to 200 firms as potential “buy” candidates and start digging into the businesses from there. “We’re looking for reasons not to buy a stock,” says Lundgren.
Enter the “Burkenroad” part of the fund’s name. The fund has a licensing deal with a Tulane University business-school program called Burkenroad Reports, in which students analyze small companies in the region. “They’re looking for good stocks hiding under rocks,” says Lundgren. The fund managers don’t purchase reports or receive them directly from the Tulane program. “We pull the company reports from the Burkenroad Web site if one of the names is on our shortlist, and we use it as part of our research,” says Lundgren. The students’ work has helped to contribute about 20 stocks to the portfolio, out of 90 in all. One of them is Conn’s (CONN), a Houston electronics and home-appliance retail chain. The stock, a top-ten holding in the fund, has gained 115% over the past 12 months. (The reports are available at www.freeman.tulane.edu/burkenroad/companies.php)
Hodges Small Cap (HDPSX). Talk about digging under rocks. This fund’s team of four managers and five analysts made 2,200 contacts — including company executives, customers, suppliers and competitors — to research 700 companies over the past year. The team develops an investment thesis about their favorites. Sometimes the story is growth oriented; other times, it’s value oriented. But typically the team favors companies with high barriers to entry that are able to boost prices for their products and services. “If we’re seeing price increases, that typically means expanding profit margins, which means eventually a higher stock price,” says Eric Marshall, who runs the fund with Craig Hodges, Donald Hodges and Gary Bradshaw.
The fund came into being at an inflection point in the stock market: December 2007, just a couple of months after the start of the worst bear market since the Great Depression. After a fast start in early 2008, it began to trail in the second half of the year, so the managers retooled the portfolio. “We trimmed the holdings from 50 to 30 stocks,” says Marshall. “We stuck to our core discipline, but we concentrated on the stocks we liked best.” Although Hodges Small Cap finished 2008 with a 40.6% loss — which trailed 80% of funds that invested in small companies with a blend of growth and value attributes — it has finished every subsequent calendar year in the top 11% (or better) of all small funds, including so far in 2013. Since its launch, the fund’s 12.9% annualized return outpaces the Russell 2000 by an average of 4.5 percentage points per year.
With the market marching upward, the fund now holds more than 70 stocks. The managers work as a team but are free to make buy and sell decisions independently. “It helps avoid groupthink and fosters an element of individual accountability, which is important,” says Marshall.
Homestead Small Company Stock (HSCSX). The stocks in this portfolio have staying power. The fund, a member of the Kiplinger 25, has an average 1% turnover ratio, which implies that a stock stays in the portfolio for decades. (The typical small-company fund, by contrast, turns over 73% of its portfolio per year, suggesting an average holding period of roughly a year and a half.) Top holding Cracker Barrel Old Country Store (CBRL), the restaurant chain, has climbed 89% over the past year and has been in the fund since 2005.
Managers Mark Ashton, Peter Morris and Stuart Teach spend a lot of time on the road trying to find out-of-favor firms that have a catalyst to turn their businesses around. They prefer businesses they can understand. That means the portfolio is lighter on technology stocks (14% of the fund’s assets at last report) than it is on industrial companies (26% of assets). The strategy has worked well. Over the past five years, the fund has outpaced 96% of its peers, with a 30.3% annualized return.
T. Rowe Price Small-Cap Value (PRSVX). Longtime manager Preston Athey loves unloved stocks. He has run Price Small-Cap Value, a member of the Kiplinger 25, since 1991, and he has earned an enviable annualized return of 13.0%. That outpaced the Russell 2000 by an average of 3.0 percentage points per year. When Athey steps down this June, he’ll hand over management of the fund to associate manager David Wagner.
The transition has already begun. Wagner, who has been with Price since 2000, will spend the coming months shadowing Athey as they visit companies together. Until June, however, Athey has the final say on all buys and sells. Among Athey’s moves in 2013 was his decision to invest in beaten-down energy stocks, such as Northern Oil & Gas (NOG).
Wagner was in business school and a summer intern at Price when he first worked with Athey. Over the years, Wagner has worked with all of Price’s small-company managers, as well as 40 or so analysts who specialize in small firms. Plus, Wagner has a solid record of his own. As manager of a fund for European investors that invested in stocks of small and midsize U.S. companies, Wagner chalked up a five-year annualized return through September of 15.7%, beating the fund’s benchmark by an average of 4.6 percentage points per year. He has since stepped down as manager of that fund.