Small Funds, Big Returns

Small-cap funds certainly trounced their bigger siblings last year: small-cap value funds returned 16.98%, small-cap blend funds gained 12.89% and small-cap growth funds lost 5.71% — handily beating each of their midcap and large-cap counterparts. Small-cap blend funds, for example, outpaced their large-cap brethren by almost 20 percentage points.

And small caps are still looking good so far this year. In the past two weeks, the small-cap Russell 2000 Index gained 5.7%, overtaking the S&P 500's 3.6% boost. Plus, fund flows into small-cap funds turned positive again last week, according to MSDW Small Companies Research, after eight weeks in the red.

Fund managers and analysts believe small caps could continue to post outsized returns throughout the year, in part because there still seem to be some big bargains in little stocks. Approximately 22% of the small-cap universe offers trailing price-to-earnings ratios below 10, according to the small-cap research department at Merrill Lynch. This last occurred in 1991, when the U.S. economy was in recession. (That makes the small-stock universe a lot more attractive to value-conscious investors than the big stocks of, say, the large-cap Standard & Poor's 500, which still has an average trailing P/E of 32.)

Managers who specialize in the small fry also argue that these stocks stand to benefit in an economic slowdown — especially in contrast to larger, more sluggish companies. For starters, those big companies are anxious to find ways to boost their own slowing growth rates. And many are likely to do that by gobbling up smaller fish, notes Sandi Gleason of the Kayne Anderson Small Cap fund (KASMX). Being a target of mergers-and-acquisitions ardor can obviously do wonders for a stock's price.

Small caps also have flexibility on their side, says J.B. Taylor, co-manager of the Wasatch Core Growth fund (WGROX). "Obviously, it's going to be tougher for companies this year, given a softer economy," he says. "But we think small-cap companies can sometimes do much better than their large-company counterparts because they can find small subsectors of the economy that are growing."

For Taylor, one such find was Rent-A-Center (RCII), an operator of rent-to-own stores. Because these stores supply appliances and furniture to customers who may not otherwise be able to obtain credit, they tend to do well in downturns. Taylor's top holding, Rent-A-Center returned a whopping 74% in 2000. A similar play is United Rentals (URI), another niche stock that Taylor has been buying more of lately. Although the stock price lost 21.5% last year, it's up 14% year-to-date and is selling at only seven times forward earnings.

The Wasatch Core Growth fund and the Kayne Anderson Small Cap fund were two of nine portfolios that emerged from this week's screen of small-cap funds. To find them (and the others profiled below), we searched Morningstar's database for no-load funds, looking for the best three-year returns, as well as positive one-year returns. We also sought expense ratios below the category average and an initial minimum investment of $5,000 or less. Notably, several fund families that specialize in the small-cap arena emerged from our search, including Royce Funds, Third Avenue Funds and Wasatch Funds.

Small-Cap Value
Two Royce funds took the two top seats in our list — the Royce Opportunity fund (RYPNX) and Royce Low-Priced Stock fund (RYLPX), which sport three-year annualized returns of 23.34% and 21.66%, respectively. The Third Avenue Value fund (TAVFX), a longtime top performer led by deep-value manager Marty Whitman, also made our screen.

Royce Opportunity manager Buzz Zaino looks for small-cap companies that are poised to capitalize on broader trends in the economy. He says he's looking to increase his 5% weighting in military and aerospace companies, for instance, since he expects the new administration in Washington D.C. to spend more on defense. The defense names already in Zaino's portfolio are EDO (EDO), DRS Technologies (DRS) and Herley Industries (HRLY).

Zaino is also eyeing retail stocks: He's betting on a stronger economy than the market expects once better earnings emerge. Although he doesn't own as many retail stocks as he'd like, Zaino does hold Spiegel (SPGLA) and Sharper Image (SHRP). Zaino expects Spiegel, which lost 37.6% last year, to improve its Eddie Bauer division through new management and merchandising direction. So far, so good, with the stock up more than 60% this year. Meanwhile, Sharper Image, which returned 21.2% in 2000, is down 11% this year, but fundamentals appear solid. The high-end chain reported a 10% increase in same-store sales this month.

Small-Cap Blend
In the small-cap blend arena, Wasatch Core Growth led the way with a three-year annualized return of 18.06%, helped considerably by a 37.29% gain in 2000. Other leaders included the UAM Rice Hall James Small Mid Cap fund (RHJMX) and Kayne Anderson Small Cap, which returned 15.24% and 13.89% over the past three years (annualized), placing them in the top 10% and 12% of their peer group, respectively, according to Morningstar.

Tom McDowell, part of the six-person management team at UAM Rice Hall James Small Mid Cap, says the fund is looking to increase its 16% weighting in technology up to about 20% of total assets. "The good news is they're cheap," says McDowell of tech names at the moment. "The bad news is they could get cheaper in the near-term." As a result, the team is looking to build smaller-than-usual positions in promising tech names, giving them more flexibility. Of the fund's existing holdings, McDowell cites Citrix Systems (CTXS), a turnaround play purchased in August 2000. The stock lost more than 63% last year, but is up 55% year-to-date after releasing better-than-expected quarterly earnings last week.

The fund also continues to follow business-services stocks, like Copart (CPRT), which McDowell says are not well tracked by Wall Street, allowing diligent managers to profit. He also likes F.Y.I. Inc. (FYII), a document-management company that he calls "an essential service" for the health-care and legal fields. The stock returned a modest 8.5% last year, although it's down 14.5% year-to-date.

Small-Cap Growth
Most growth funds suffered last year, and small-cap growth funds didn't escape unscathed. There were some exceptions, however, like the Wasatch Small Cap Growth fund (WAAEX), which climbed 16.8% last year, and offers a three-year annualized return of 22.78%. Its performance in 2000 was helped considerably by one of its largest holdings, Orthodontic Centers of America (OCA), which gained 161.8% in 2000. This fund has also proven itself over the long haul, with a 19.59% annualized gain over the past decade, besting the S&P 500's return of 17.45%.

Rounding out our small-cap growth picks are the PBHG Strategic Small Company fund (PSSCX) and the Meridian fund (MERDX), with three-year annualized returns of 21.01% and 15.24%, respectively. While PBHG Strategic Small Company lands in the growth category — its price-to-earnings ratio is just above the category average — half of the portfolio is managed by Jerome Heppelmann, a value-oriented stock-picker at PBHG. That helps to balance out the aggressive-growth names picked by James Smith. Meanwhile, Meridian's low tech weighting hurt it in past years — particularly 1999 — but it returned 28.2% in 2000, far outpacing its peers.