Small Funds That Deliver Big Results

Westport, Conn., is one of America's richest towns, a suburban enclave that's home to celebrities like Don Imus and companies such as Playtex Products. But while most of us have heard of Playtex bras and Imus's radio show, the town also has a less heralded success story: Ed Nicklin and his mutual fund.

Nicklin manages the Westport Fund, a stock fund that has crushed 94 percent of its peers over the past decade, with an average annual return of 12 percent. If you've never heard of him, that's partly because he spends more time poring through annual reports than promoting his fund. His firm, Westport Advisers, operates out of a small wood-shingle building overlooking the Saugatuck River. His staff of seven is barely the size of a single research team at Fidelity. And his stock ideas? Nicklin says he finds them "anywhere and everywhere."

In a volatile market like this one, small may turn out to be beautiful. While no one tracks boutique funds as a category, analysts and other investment pros say there's a handful of tiny, out-of-the-way funds that have a long and rich history of little-noticed success in good times and bad. To be sure, even these funds have suffered double-digit declines in this year's painful bear market. But most are comfortably ahead of the wipeout in the market since the start of the year. Why they're not better known is anyone's guess, especially in an age with such intense scrutiny on fund performance. But the reasons they do well are more apparent, including the fact that patience and continuity of staff tend to be more of a virtue in the smaller shops. There's also less pressure to boost assets and market their funds. "These are people who want to spend their time picking stocks," says Russel Kinnel, director of fund research for Morningstar.

Giant funds that invest in small or midcap companies risk running up the price of stocks they're trying to buy and hammering down those they are trying to unload. In contrast, boutique managers can change their holdings without anyone noticing. Indeed, with $95 million in assets, the entire Westport Fund is smaller than just one stock position in a giant fund like Fidelity Magellan (FMAGX). All else being equal, "size erodes performance," according to a 2004 study in the American Economic Review. And over time the difference adds up: as much as one percentage point a year in returns, according to Harrison Hong, professor of economics and finance at Princeton University and a coauthor of the study. "Loss of nimbleness translates to a loss of performance," says Hong.

Here are four funds with a history of beating the market — in good times and bad.

Westport Fund (WPFRX)
While large funds typically have hundreds of stocks in their portfolio, Ed Nicklin, 61, has just 38. And that gives him time to study his companies inside and out and keep close tabs on them.

Working out of a cramped office — his workspace is a mound of papers and technical publications — and backed by just two analysts, he does almost all his own research. Most fund analysts comb through regulatory filings and talk to company management, but Nicklin does more than that. In recent years he's examined seismic maps and "well logs" to assess the value of oil-and-gas drillers, and he's steeped himself in bankruptcy law to find good businesses in firms that have gone bust. A few years back, that kind of digging led him to buy software company Peregrine Systems after it emerged from bankruptcy protection. The result: a gain of 70 percent, helped by a takeover of the company by Hewlett-Packard (HPQ).

Indeed, the portfolio manager has become something of an expert in sniffing out takeover candidates. Before investing in a company, he takes a close look at its assets and tries to calculate what a potential buyer would pay for them. Last year four of his stocks were acquired by other firms, including Claire's Stores and Caremark Rx.

With no fund bureaucracy to work through, Nicklin can focus on stock picking and make quick decisions. What he doesn't have with such a small shop is economies of scale. A $10,000 investment in Westport means $149 in annual expenses — nearly 30 percent higher than the average expense for stock funds with more than $1 billion in assets. And with such a compact portfolio, there's always the risk that a few bad picks could sink performance. This year the fund is down 34 percent, but that's beating the S&P 500 by about eight percentage points. "Nobody bats a thousand in this business," Nicklin says. With more than $1 million of his own money in the fund, however, he has good reasons to keep the strikeout ratio down.

Delafield Fund (DEFIX)
Visit Dennis Delafield at his office in New York City and you'll see a framed worthless railroad bond, circa 1860. "It's a link to the past," he says. For Delafield, comanager of the fund that bears his name, it's also a reminder that the markets are full of risk. "When a stock's prospects are favorable, we're likely to be sellers," he says. "Trees don't grow to the sky."

Selling stocks as they're on the rise might be contrary to the way many funds operate; after all, it can often mean leaving money on the table. But Delafield and his comanager, Vince Sellecchia, who have run the fund since 1993, have more than $5 million in the fund between them. That gives them extra incentive not to lose money — or be too greedy. "Dennis treats the fund like it's his own business," says Steve Roge, a financial adviser in Bohemia, N.Y., who has recommended the fund to clients.

One thing Delafield and Sellecchia look for is turnaround stories, or as Sellecchia puts it, "unloved and misunderstood" stocks. That's not unusual, but the pair layer on a cyclical strategy: buying and selling the same stock over the years as it swings from lows to highs. That's what they did with Gerber Scientific, which they repurchased after selling in 2005. The managers swung in and out of Foot Locker (FL) and Tyco (TYC), too. More recently, they invested in Kaiser Aluminum (KALU), an aerospace-parts supplier that emerged from bankruptcy protection with a clean balance sheet and new manufacturing plants. Weakness in the airline industry pummeled the shares, but Sellecchia says the firm has a big backlog of orders and should see stronger earnings as the industry revives.

After beating the market for much of the year, the fund fell behind recently, hurt by exposure to industrial companies like Kennametal (KMT), which have been slammed. "We've got companies trading at values we never thought we'd see," says Sellecchia, adding that the market's volatility is keeping him on the sidelines with the fund's cash. "We're not frozen," he says, "but we're not making a major push to be fully invested either."

Thomas White International (TWWDX)
Number-crunching is at the heart of Thomas White International, a foreign large-cap value fund with $233 million in assets. Unlike managers who travel the world for investing ideas, Thomas White, 65, relies largely on a team of six analysts who mainly stay in-house. Computers rank companies against competitors, using criteria such as price/book value, earnings growth and profit margins. The analysts then look deeper, assessing company management and digging into the accounting. Stocks rotate in and out of the fund, with cheap names replacing pricey ones. "It's like a summer camp," says White. "We'd buy it in winter, when it's cheap, and sell in summer."

Don't look for household names in this portfolio. One recent addition, Chaoda Modern Agriculture, listed in Hong Kong, contracts with farmers in China to produce crops for export and domestic consumption. Profits rose 28 percent in its fiscal year, yet the stock trades at just nine times earnings. White also likes Julius Baer Holding, a Swiss asset-management firm, and AU Optronics, a Taiwanese maker of flat-screen panels that has bright prospects in China.

The fund trailed the market in 2003, when White stuck with defensive names and market sentiment shifted to more growth-oriented tech stocks. This year it has been hammered along with other international funds by having holdings in energy and emerging-market stocks. But over the long run, the fund's patient approach has paid off. It has beaten its benchmark by an average of three points a year over the past 10 years.

Stratton Small-Cap Value (STSCX)
Stratton Small-Cap Value has beaten 82 percent of its peers over the past 10 years, racking up an 11 percent average annual return. It gained almost 25 percent during the 2000–02 bear market, and this year is down 32 percent — about 10 percentage points better than the S&P 500. Those kinds of numbers ought to make fund manager Gerald Van Horn, 35, a star. But as his boss Jim Stratton says, "We're not marketers." The bare-bones approach helps keep costs well below those of most equity funds — the fund's expenses are $870 for every $100,000 invested.

Van Horn likes to keep things small and simple. The fund holds only around 65 stocks, and with $764 million in assets, it's not so large as to be unwieldy — a critical edge in the small-cap space, where large-fund managers can't easily build a stake in a stock without driving up the share price. Van Horn starts with a screening process that evaluates stocks based on criteria such as free cash flow, earnings-estimate revisions and share-price momentum. He then looks for developments like a new product or restructuring that sparks the shares. He bought GameStop (GME) in 2005, for instance, just as a new generation of video-game consoles was coming out; the stock went on to increase 250 percent.

Van Horn also likes companies that aren't widely covered, because the market may be missing key developments. Few investors may have heard of Amedisys (AMED), a provider of home health care services. The firm is mainly covered by boutique investment banks, and research on it tends to be "stale," says Van Horn. But he noticed that it was buying up competitors and increasing earnings 28 percent a year. And it's been a winner, gaining 25 percent since he bought it two years ago. Of course, some of his bets have gone awry. In 2006 his consumer-discretionary and energy picks flopped, and he missed a big run in real estate investment trusts. "The markets took a defensive turn, and we were left holding the bag," he says. This year he's faring better, thanks in part to avoiding most financials. If he beats the market again, his fund may even get a little bigger.