Small and Obscure Is Beautiful

Small and Obscure Is Beautiful

When searching for strong asset managers, big is not always best. But finding a good small fund can be difficult.

Investment researchers have long known about the virtues of tiny funds. A study by Morningstar found that small funds beat their large competitors by more than a percentage point annually. The gap occurs because small funds can trade nimbly, while bloated portfolios must struggle to buy and sell without moving the market.

To appreciate the difficulties that the giants face, consider Fidelity Contrafund (FCNTX), which has $50 billion in assets, ranking it as one of the world's largest funds. Portfolio manager Will Danoff recently had 1.3 percent of his assets — $724 million — invested in 10 million shares of Colgate-Palmolive. The average daily trading volume of the stock is 2.8 million shares. So if Danoff decided to sell his Colgate position, it would take days or weeks to unload the shares. During a downturn, the portfolio's losses would mount each day as the fund waited for trades to be executed. In contrast, a smaller rival might be able to dump a position in seconds.

Nimbleness can be especially important in the kind of manic markets that investors have faced lately. But finding a good small fund can be difficult. When a fund turns hot, it can quickly gain a large following — and become bloated or close its doors to new investors.

The Elusive Good, Small Fund

To spot a good small fund, it is sometimes necessary to go off the beaten path, considering offerings from boutique firms or companies that don't excel in marketing. Such little-known funds can sometimes offer unusual returns or risk controls that may not be available from the giants. For financial advisors, boutiques often provide special services. “When you want to find out the details of a boutique fund's strategy, you may be able to talk directly to the fund manager, instead of going through a wholesaler,” says Dan Sondhelm, a partner with SunStar, a marketing firm that advises fund companies.

What is the optimum fund size? That is hard to pinpoint, but Morningstar has developed rough guidelines by examining the size of closed funds. Among small-cap funds that barred the gates to new investors, the average size was about $800 million. When assets reached that mark, managers apparently began worrying about bloat.

To avoid concerns about unwieldy portfolios, we searched for top-performing funds with less than $200 million in assets. Our list includes little-known funds that distinguished themselves during the downturn. These undiscovered managers have demonstrated their ability to trade nimbly under harsh conditions.

One fund that consistently shines in downturns is Becker Value Equity (BVEFX). A dedicated contrarian, the fund ignores Wall Street research and looks for solid companies that face temporary problems. When financial stocks were climbing in 2006, Becker became concerned about mounting default problems. To avoid trouble, the fund dumped soaring bank shares and began buying stable consumer companies, such as General Mills, which was then seen as a boring blue chip. The move enabled the fund to outdo 90 percent of its large value competitors during the downturn of 2008.

Lately the fund has been buying Emerson Electric, a maker of industrial motors. With the recession hurting sales and earnings, the stock has become cheap, says portfolio manager Marian Kessler. “This company has a superb balance sheet and a wonderful franchise,” Kessler says.

Another contrarian is Croft Value (CLVFX), which has outdone 93 percent of its large blend competitors during the past decade. Portfolio manager Kent Croft buys stocks of all sizes, including unloved growth companies and value shares that have been crushed. One of his favorite sectors these days is timber. At a time when the construction industry has collapsed, sales of lumber have sunk badly. But the long-term outlook for the industry remains solid, says Croft. “The timber companies aren't reporting any earnings these days, but their assets grow every day,” he says.

A favorite holding is Plum Creek Timber, the largest private landowner in the country with 7 million acres. A big producer of lumber and plywood, the company's sales are sluggish. But the business continues to report high returns on equity.

For a steady way to own small stocks, consider FBR Pegasus Small Cap Growth (FBRCX). Instead of searching for high flyers, portfolio manager Robert Barringer favors stocks that can record moderate annual growth of 12 percent for a sustained period. Seeking companies with high returns on equity and low capital costs, Barringer often buys service companies with established brand names. Such businesses can weather economic downturns. The approach shined during the downturn, enabling the fund to outperform 93 percent of its competitors during the past three years.

One holding is FactSet Research Systems, which provides data and analytics to investment professionals. Despite layoffs on Wall Street, FactSet has maintained rich returns on equity. “The company can continue growing because it is innovating and providing the kind of data that investment analysts want,” says Barringer.

Like FBR Pegasus, Frank Value Fund (FRNKX) excelled during the downturn by sticking with steady performers. Portfolio manager Brian Frank looks for solid companies that have strong market niches. To find the most compelling choices, Frank buys companies of all sizes. He is a tight-fisted bargain shopper, aiming to find stocks with good underlying businesses that have nevertheless fallen out of favor.

A big holding is GameStop, the videogame chain. Retailers face headwinds these days, but Frank says that GameStop has a large following of loyal customers. “Hardcore gamers love GameStop because it allows them to trade used games for new ones,” says Frank. “You can't do that at Wal-Mart.”

Among the top performers in 2008 was Pennsylvania Event-Driven Fund (PAEDX), which resembles a hedge fund. Portfolio manager Thomas Kirchner uses a variety of strategies, including investing in distressed debt and mergers. He varies the mix to take advantage of market conditions. With markets rising in 2006, he had 90 percent of assets in merger stocks and very little in distressed debt. These days he is finding plenty of distressed debt to buy.

Recently he bought bonds of General Growth Properties, a REIT that filed for bankruptcy. Kirchner paid 60 cents on the dollar. He says that the bonds have been rallying as it appears likely that the company will be able to make debt payments. Because returns on such troubled bonds don't necessarily track the stock market, the fund can help to diversify portfolios, delivering decent returns in years when most investments are heading down.

TAGS: Mutual Funds
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