The Problem of Success

Small-cap mutual funds have attracted so much attention that the best ones are closed. What no? Can you say 'smids'?

If you overweighted clients' small-cap stock funds exposure a few years back, you're looking like a genius. Small-cap stocks have posted an incredible run since April 1999, having jumped by nearly 70 percent through January 2006 as measured by the Russell 2000. Not surprisingly, investors have raced into small-cap funds. That flood of cash has overwhelmed hundreds of portfolio managers, forcing them to stop taking new investors. But what now? Anyone seeking a small-cap choice faces a hard problem: Nearly all the top candidates have been closed. Of the 20 small growth funds with the best five-year records, 14 are either closed or focus on institutional investors. In small value, 15 of the top 20 are out of reach for retail investors.

Unable to use their first choices, some advisors have turned to also-rans or index funds (create a five-year chart of the iShares S&P Small Cap Index fund, for example, and you'll see a pretty picture). But there is another alternative — funds that hold both small- and mid-cap stocks. These funds tend to stay open because mid-cap stocks can absorb more assets. Because of their flexibility, small mid-cap funds are gaining more popularity and a new name: smid. Increasingly, institutional managers talk about seeking smid funds. In response to growing demand, several companies have opened small mid-cap funds, including Munder and William Blair.

Graduating From Small to Mid

Besides being able to avoid closings, smids may have certain advantages over funds that own strictly small- or mid-cap stocks. “A small-cap fund has to sell its winners when they become mid-caps,” says Joseph Candela, an advisor in the New York office of broker/dealer Ameriprise. “A smid manager can keep riding his best stocks, even after their market capitalization increases.”

According to data from Ibbotson Associates, small stocks outperform mid-caps over the long term. But, recently, smid funds have outshined pure small-cap portfolios. During the decade ending in January 2006, the Russell 2500, a smid index, has returned 12.3 percent annually, two percentage points ahead of the small-cap Russell 2000. Besides delivering competitive returns, smid portfolios may be more tax efficient because they are not forced to sell when small-caps become medium-sized.

Some smids range widely, focusing on small stocks one year and mid-caps the next. Security Mid Cap Value shifts holdings in search of bargains. When small stocks seemed cheap in 2002, the fund had most of its assets there. Currently, portfolio manager Jim Schier has most of the fund in mid-caps. “In the late 1990s, small stocks were significantly undervalued compared to mid-caps, but since then the valuation gap has closed,” Schier says.

Avoiding deeply troubled companies, Security aims to find solid businesses with limited debt. Schier likes companies that can increase their earnings for the next three years. A successful holding has been Coldwater Creek, which sells women's apparel through a catalog and retail outlets. The stock dipped several years ago after a disappointing sales report. But Schier figured the company would revive as it rolled out new stores and Internet sales began to grow. Sales soon revived, and the stock climbed.

Another flexible choice is Hodges Fund. While Morningstar lists the fund as a mid-cap blend choice, about half the holdings are typically in small caps. Run by the father-and-son team of Don and Craig Hodges, the fund holds an eclectic mix of growth and value choices. “We try to make money by buying whatever can work,” says Craig Hodges.

Hodges owns troubled companies that seem poised for turnarounds as well as strong companies with rapidly growing earnings. A current turnaround choice is Palm Harbor Homes, a maker of modular homes that should enjoy demand from hurricane victims. Another holding is Burlington Northern, a railroad that is reporting rising earnings because of the growth in coal shipments.

Investors seeking a steady growth specialist should consider Rainier Small/Mid Cap. The fund buys moderately priced stocks that seem likely to surprise Wall Street with strong earnings gains. Rainier limits risk by staying broadly diversified. Portfolio manager Jim Margard aims to keep the fund's sector weightings roughly in-line with the holdings of the Russell 2500. Because Rainier does not overweight any industries, its success depends on picking individual stocks. Most often the choices have proved on target: During the past five years, Rainier has outdone 96 percent of mid-cap growth competitors.

Margard likes companies that are benefiting from favorable business trends. His largest holding is currently Joy Global, a maker of equipment used in mining coal and copper. “Joy does not face many competitors and demand is growing from emerging markets,” says Margard.

Like Rainier, Oppenheimer Small- & Mid-Cap Value focuses on picking individual stocks instead of overweighting sectors. “We don't spend a lot of time trying to forecast the price of oil because we are always going to hold some oil companies,” says portfolio manager John Damian. “We want to find those oil companies with the best track records for managing their capital.”

Damian starts by focusing on the low-priced half of his investing universe, which includes stocks with market capitalizations of up to $13 billion. Then he looks for companies with the best valuations in relation to their earnings prospects. He will take a company with a relatively high price/earnings ratio — provided the earnings outlook is strong. A winning holding has been Chicago Bridge & Iron, an engineering and construction company. When Damian began buying the stock in 2004, the company had a P/E ratio of about 18. But the portfolio manager figured that earnings would double in the next three years because the company was seeing strong demand for energy projects. His bet proved correct, and the stock rose sharply.

Heartland Value Plus focuses on small stocks, but the fund keeps about one-third of assets in mid-caps, according to Morningstar. Portfolio manager Rodney Hathaway looks for stocks with below-average P/E ratios that seem to be poised for big improvements. He aims to hold down risk by mainly owning dividend-paying stocks. “Because they can afford to pay a dividend, the businesses tend to be mature companies with good cash flows,” he says.

A favorite holding is Stride Rite, the maker of children's shoes. The stock had been hurt when sales of Keds languished. But Hathaway says the company has been turning around the business and maintaining a strong balance sheet. That kind of performance will enable the company to remain a healthy small-cap — and perhaps advance into the ranks of medium-size stocks.

Funds That Hold a Mix of Small- and Mid-Cap Stocks
Fund Name Ticker 1-year Return 3-year Return 5-year Return Category 5-year % Rank in Category Maximum Name Front-End Load
Heartland Value Plus HRVIX 1.3% 22.1% 18.8% small value 12% 0%
Hodges HDPMX 17.3 38.0 16.6 mid blend 5 0
Oppenheimer Small- & Mid-Cap Value A QVSCX 11.7 27.9 16.0 small blend 10 5.75
Rainier Small Mid Cap RIMSX 17.5 26.4 9.2 mid growth 4 0
Security Mid-Cap Value A SEVAX 15.7 30.6 16.1 small blend 8 5.75
Source: Morningstar. Returns through 12/31/05.
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