3 Solid Small-Cap Funds

WHEN YOU'RE PART of a scrum, it's good to be scrappy. And if history is any guide, as the markets emerge from their protracted struggle with a falling dollar, a credit crunch and the skyrocketing price of oil, scrappy is what will be leading the pack.Small companies are leaner and nimbler than big corporations, making them faster at adapting to a changed economy. On average, the Russell 2000, an index of small-company stocks, gains more than 30 percent between the midrecession trough and the end of a recession, while large companies return 20 percent on average, according to Citigroup strategist Lori Calvasina. Of course, small companies are also often the first to be crushed in an economic downturn — which is

why, after a six-year tear, small stocks officially entered bear market territory, falling 25 percent since the economy hit the skids a year ago. In February the Russell 2000 hit its lowest price/earnings ratio since November 2000. But all this may be part of the good news: Many of these stocks are starting to look like bargains, and now may be the time to go shopping.

What's more, some of the best small-cap mutual funds, which had closed during the run-up, are reopening, in large part due to the $18 billion investors have yanked out since small stocks started underperforming. But now these managers are seeing a change in their corner of the market. The Russell 2000 has rallied 8 percent from its March bottom through July 18, while the S&P 500 is up 5 percent. One sign favoring a turn is the yield curve, a measure of the gap between short- and long-term interest rates, which has gotten steeper. While the "inverted" yield curve of 2007 portended a downturn, the steeper curve of today signals economic expansion ahead. "There's a bit of a stealth bull market going on in small companies," says Brad Evans, a portfolio manager of Heartland Value Plus.

That said, it's early in the rebound, and not all small firms are bargains. Plus, today's economic environment is still rife with wild cards. Your best bet? Invest with seasoned fund managers who understand the landscape. "That's where the real opportunity is," says Morningstar analyst Bridget Hughes. One example: The recently reopened Wasatch Small Cap Growth fund. One of the firm's flagships, it shies away from cyclical sectors, and in the tough 2000-02 market, it held up well thanks to having next to no dot-com holdings — evidence of remarkable discipline. Manager Jeff Cardon — who has a 22-year track record with the fund — looks for "consistent growers," firms with expected annual earnings growth of at least 15 percent over the next five years.

Small Funds, Big Returns?

Royce Low-Priced Stock (RYLPX): 13.0%*

Third Avenue Small Cap Value (TASCX): 12.9%

Wasatch Small Cap Growth (WAAEX): 5.4%

* 5-year return.
Data as of July 22, 2008.

Since small stocks are less liquid — fewer available shares can make for tricky trading, plus big shareholders can send stock prices up or down simply by buying or selling their lot — they're also subject to wilder swings. Third Avenue Small Cap Value and Royce Low-Priced Stock, however, are known for producing above-average returns with low volatility. Third Avenue Manager Curtis Jensen has been on the fund since 1997 and has created a somewhat eclectic portfolio by sticking to a deep-value approach, finding cheap stocks that don't have as far to fall when the markets tumble, Hughes says. Jensen looks for companies with "impregnable" finances and "businesses we can understand," regardless of geography. The fund's largest recent holding was Japanese beermaker Sapporo Holdings.

Royce Low-Priced Stock is more aggressive than some of the shop's other funds, but it has held up in choppy markets. Portfolio Manager Whitney George, who has been on the fund since 2000, is known for being a stickler about good balance sheets. The fund's largest holding at the end of the first quarter, Trican Well Service, was just 2 percent of net assets.

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