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Grand Opportunities for Small-Cap Stock Investors

After showing their mettle at Wasatch, the managers of the new Grandeur Peak funds get to strut their stuff with a much smaller asset base, a big plus.

Trying to find a good small-company stock fund is a bit of a Catch-22. You don't want to buy any fund until the managers prove their mettle. But by the time managers of small-cap funds do so, their funds have usually grown too large to excel. That's because small-company stocks are hard to trade in large quantities.

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Enter Grandeur Peak Global Opportunities (symbol GPGIX) and Grandeur Peak International Opportunities (GPIIX). Co-managers Robert Gardiner and Blake Walker, as well as six of the funds' seven stock analysts, each boast years of experience at Wasatch Advisors -- a first-class, small-cap shop whose long-term success has brought it an embarrassment of riches.

The Grandeur Peak funds are new, but they've gotten off to fast starts. From its inception on October 17, 2011, through November 19, 2012, Global produced a total return of 19.5% and International a return of 20.5%. The returns are nearly double those of each fund's benchmark.

But what really gets my juices flowing are the long-term results of Grandeur Peak's co-managers, Gardiner, 47, and Walker, 36. Gardiner, in particular, has a stellar record. He was lead manager of Wasatch Micro Cap (WMICX) from its inception in 1995 until early 2007. During his tenure, the fund returned an annualized 25.1% -- more than double the 10.8% annualized return of the Russell 2000 index, which measures the performance of small-company stocks.

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Gardiner stood out at another fund as well. Wasatch Small Cap Value (WMCVX), which he co-managed from late 1997 through early 2002, returned an annualized 24.2% during that period, compared with 7.3% a year for the Russell 2000 Value index. He also co-managed Wasatch Global Opportunities (WAGOX) with Walker from late 2008 until mid 2011, returning an annualized 39.9% -- an average of five percentage points per year better than the MSCI All-Country World Small Cap index, a measure of small-company stocks from all over the world.

As you'd expect given the small companies they specialize in, these funds were volatile. But they weren't off-the-charts volatile. In each case, the funds' returns more than made up for the volatility -- as long as you had the stomach to stay invested. In 2008, Walker's Wasatch International Opportunities (WAIOX), the most volatile of the managers' funds, plunged 54.7%, putting it in the bottom 12% among foreign funds that invest in fast-growing small and midsize companies.

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Most mutual funds steer away from small-capitalization issues because the stocks are hard to trade in large amounts. If you buy or sell a large number of shares of a small-cap stock, you're likely to push the stock price in the wrong direction -- up as you try to buy it, down as you sell it. Only relatively small funds can excel with small caps.

Because relatively few professionals pay attention to this segment of the market, it's a lot easier for talented managers, such as Gardiner and Walker, to generate superior returns. "We find huge inefficiencies in small caps," Walker says.

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There's no bad blood between Wasatch and Grandeur Peak. In fact, Spencer Stewart, son of Wasatch founder and chairman Sam Stewart, is a Grandeur analyst. "We're orthodox Wasatch investors," Walker says. "We're doing exactly what Wasatch is doing."

The difference is that they're doing it with a lot less money. Global has $250 million in assets and plans to close at about $400 million; International has $97 million and plans to close at about $300 million. (Wasatch, by contrast, has about $8 billion in small-company stocks, both domestic and foreign.) Gardiner and Walker insist that they want to maintain each fund's small-cap focus rather than see the funds invest in larger companies as the funds get bigger.

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Grandeur Peak's managers and analysts scour the globe for high-quality small companies. They run numerous quantitative screens first, looking, for instance, for companies with high profit margins. They ultimately visit almost all of the companies they invest in, regardless of where the companies are located. And they aim to buy these superb companies only when the companies are selling at steep discounts to the managers' estimates of fair value.

The funds come with two big negatives. First, they're costly. Annual fees are 1.5% -- and that's for the institutional shares, which you can buy from an online broker. I recommend the institutional class over the class used in no-transaction-fee platforms. The NTF funds charge 0.25 percentage point more.

Second, I don't think small caps are especially attractive today. I much prefer high-quality large-company stocks -- and funds that specialize in them. The global economic system still hasn't fully recovered from the aftershocks of the 2008 financial meltdown. High-quality large companies are more likely to stay afloat in such an uncertain environment.

But foreign stocks are certainly cheap -- pushed down to a large degree by the seemingly never-ending euro zone crisis. More important: Gardiner and Walker are good stock pickers. Too good to pass up, in my view.

Steven T. Goldberg is an investment adviser in the Washington, D.C. area.

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