Small-Cap Funds Appear Ready for Comeback

DURING THE CHRISTMAS season last year in Indianapolis, father-and-son team Bryan and Robert Auer launched their first mutual fund, Auer Growth (AUERX). At the same time, about 800 miles south, a similar situation was playing out in Dallas. There, Hodges Capital Management, a firm well-known for its namesake multicap offering, introduced Hodges Small Cap (HDPSX). Year to date both small-company stock funds have beaten the returns of the broad market.

In recent months more than a dozen prominent funds from competitors like Royce, Allianz, Third Avenue and Wasatch re-opened their doors to new money. Many of the managers at these offerings were dealing with asset outflows at the same time they were seeing an unprecedented amount of bargain stocks in the market place. In some cases, these funds opened for just a few weeks, took in the amount of money they needed, and then proceeded to close their doors once again. They had no problem attracting investors.

That's a lot of action for a fund category that had supposedly been left for dead the last few years. After a strong rally in small-company stocks earlier this decade started showing signs of fizzling out, investors segued into large caps instead in 2006 and 2007. Now, though, the category appears to be poised for a comeback. Managers are finding an abundance of well-run, strong-growth companies that are trading on the cheap. Advisors are ratcheting up their clients' exposure to these funds. Research also shows these stocks tend to lead the broad market out of recession-type periods. Indeed, that seems to be happening. According to Lipper, the average small-cap fund has lost about 10% in 2008. That's nothing to cheer about, but it is almost four percentage points ahead of S&P 500 index funds.

It just may be the time to give these funds another look. Small caps typically account for a minimal (10% or so) position in the average portfolio. The funds are there for diversification, but when they get going they can have a profound impact on overall returns. After the last bear market, small-cap stocks went on a five-year run. Indeed, FBR Focus (FBRVX), one of the top funds to center on small and midcap stocks, returned an average annual 10% between 2003 and 2008. That beat the broad market by three percentage points.

Small caps fell out of favor for several reasons. The sector's best stocks appeared to be fully valued (so much so that many small-cap funds found themselves listed as midcap offerings). When the economy slows, small caps run the risk of seeing the costs of finance escalate, if they can get it at all. At the same time sales of key products — in many cases these companies have just one product — can fall off a cliff. So when the market started to tank recently investors headed for the safe harbors afforded by the market's largest blue-chip stocks. Those shares have a history of weathering storms.

But let's get back to that bear market point. Data from Ibbotson show that dating back to the 1950s, in the months after a recession-type period, small-cap stocks tend to lead the broad market (although the gap starts to close after two years). That's a pretty strong data point to hang an investment decision on. The problem is that this current market may not be like any that have come before it. Indeed, investors are dealing with record energy prices, inflation, a virtual collapse of the financial-services and housing industries, the rise of emerging markets and a war overseas. All that could certainly spell trouble for any category of stock funds.

That's what gives Sam Stewart pause. Stewart founded Wasatch Advisors in 1975, and the company now has a lineup of 14 funds. The firm is known for its bottom-up approach and its knack of closing its funds long before they bulge with excess cash. Earlier this year the company took an unusual step by re-opening four funds. Two are still accepting new money, including its Small Cap Growth (WAAEX) offering.