The financial crisis crushed aggressive funds that focus on smaller stocks. During the downturn that began in November 2007 and lasted into March 2009, small growth funds lost more than 54 percent, according to Morningstar. But since then it has paid to bet on riskier stocks. From March 2009 through September 2013, small growth funds gained 171.3 percent. Mid growth did almost as well, returning 154.7 percent in the rally. During the past five years, small growth funds returned 9.3 percent annually, topping the S&P 500 by two percentage points.
But after the big gains, small stocks no longer sell at bargain prices. The average small growth fund has a price-earnings ratio of 22, compared to 17 for the S&P 500. With prices at those levels, small stocks are not likely to continue producing outsized annual returns. Still, there are good reasons to hold some aggressive funds. At a time when the emerging markets are slowing, the U.S. is steadily growing. That is providing a boost for small U.S. stocks, which depend heavily on domestic sales. “In the next five years, U.S. small-cap earnings should grow faster than the rates in the emerging markets,” says Richard Bernstein, a former equity strategist for Merrill Lynch who is now portfolio manager of Eaton Vance Richard Bernstein All Asset Strategy (EARAX).
Bernstein is particularly keen on small-cap industrials. Those are gaining market share as they become more efficient and win business away from foreign operators. He also likes small banks, which are faring better than large institutions. Struggling to comply with new regulations, large banks are shrinking their balance sheets. But small institutions have survived the turmoil and adjusted to changing conditions. “Loan growth is accelerating at small banks,” says Bernstein.
To bet that the bull market can continue, consider a solid growth fund that has thrived in recent years: Buffalo Emerging Opportunities (BUFOX). Since the market trough, the fund has returned 322 percent. The Buffalo managers focus on early-stage companies that seem poised to benefit from growing industries. “We like markets that can be substantially larger in three to five years,” says portfolio manager John Bichelmeyer.
Most of the Buffalo fund’s assets are in microcap stocks with market capitalizations of less than $500 million. The portfolio has a price-earnings ratio of 30. A holding is SPS Commerce (SPSC), which offers cloud-based software that manages sales orders. Companies pay monthly fees for systems that make it possible to connect efficiently with customers. The software company’s revenues have been increasing at a 30 percent annual rate.
Another strong fund is MFS New Discovery (MNDAX), which is up 245 percent since the market trough. Some of the fund’s holdings seem likely to grow more than 20 percent annually for the next three years; such rapid growth can justify high valuations. Other holdings sell at lower multiples because they operate in unloved industries.
Recently the managers began focusing on shipping companies. With global growth weak, profits have slipped. Second-tier companies have been forced to sell vessels and cut shipping prices. A holding is Diana Shipping (DSX), which transports dry bulk cargoes, including coal, iron ore and grain. “This will be an attractive growth business if the industry normalizes back to historical norms,” says institutional portfolio manager Andrew Boyd.
William Blair Small Cap Growth (WBSNX) holds a mix that includes contrarian choices as well as some reliable growth names. Because the fund often has big stakes in volatile microcaps, the portfolio can sink in downturns. During the turmoil of 2008, William Blair lost 46.9 percent and trailed 88 percent of small growth competitors. But in 2009, the fund bounced back, returning 69.6 percent and outdoing 99 percent of peers.
Portfolio manager Mike Balkin scored big gains with Nu Skin Enterprises (NUS), which relies on an army of 1 million independent distributors to sell anti-aging products. The Nu Skin shares sank after Herbalife (HLF)—another direct seller—was accused of being a pyramid scheme. The stock rebounded as fears about the company waned. “Some people thought it was a scam, but the company was beating its earnings estimates and raising the guidance,” he says.
