Trying on Small Caps

“Small companies” may bring up the image of family-run operations that make up the backbone of America, but many of the publicly held firms that comprise that sector are neither stable nor reliable.

Advisors often suggest “small-capitalization” mutual funds as a long-term investment and a good way to diversify an investment portfolio. But investors must be prepared for extreme short-term volatility. In fact, just in the last year, the small-company fund sector has seen very wide swings.

While there is always significant downside risk in these stocks, however, there is also the potential for large returns on the upside. Often the biggest stock gainers of all are the small-cap companies that grow to become blue chips. It is that potential that continues to attract investors to this sector.

This is especially true in the high-technology arena, where companies can grow very quickly--and can also go bust quickly too.

In fact, in the small-company stock fund sector overall, the average return on growth-stock funds (which tend to be heavily invested in tech shares) for the 12 months ended June 30 was a measly 5%--less than U.S. Treasury bonds, according to Morningstar Inc., the Chicago-based tracker of mutual fund data.

Still, this year has seen some improvement in the small-stock sector overall, with the Russell 2,000 small-stock index up 14.6% year-to-date, nearly equal to its full-year gain for 1996. Although that still badly lags the 28.3% year-to-date gain in the blue-chip Standard & Poor’s 500 index, small stocks have been outperforming blue chips in recent months. (See Street Strategies column, D1.)

“Investors might be interested in small caps because they’re so beaten up--cheaper than at any time in the past year-and-a-half. It could be a good time to buy,” said Bill Whitt, a Morningstar analyst.

But which funds do you buy? The accompanying chart shows the best-performing small-cap funds in the last 12 months, but past performance for any period is only a guide. There are other considerations, too.

“It’s important for people to pick funds that match their personalities,” said Kurt Brouwer of Brouwer & Janachowski, a San Francisco investment advisor. That means finding funds that match your appetite for risk.

For those comfortable with more risk, Brouwer recommends the Brandywine Fund (two-year average annual return: 22.6%; phone: [800]-656-3017).

Although the fund has slightly lagged the average small-stock fund this year, Brouwer likes it for investors who have a five-year to 10-year horizon. Brandywine has as much as 40% at one time in the more volatile small-cap tech stocks, and it invests in companies with high earnings-growth momentum.

“It’s got superb long-term performance,” Brouwer said.

For those looking for something a bit more conservative, he recommends the Baron Asset Fund (five-year average annual return: 24.1%; [800]-992-2766). The fund is known for its low turnover because the manager takes a buy-and-hold strategy toward high-quality growth companies.

And for real middle-of-the-roaders, Brouwer recommends what he calls “a real up-and- comer,” Rainier Small/MidCap Equity Portfolio (two-year average annual return: 30.5%; [800]-536-4640). The fund is run by four managers who adopt a team approach and own a blend of growth and value stocks.

For a young person who is investing for retirement and wants a small-cap index fund, Paul Merriman of Paul Merriman & Associates, a Seattle-based money manager, picks Vanguard Index Small Capitalization Stock Portfolio (five-year average annual return: 19%; [800]-662-7447).

“This gives people who believe in indexing a way to do this in the small-cap market,” he said. The fund currently owns 1,568 smaller stocks; it’s designed to mimic the performance of the small-stock market overall.

In a surprising recommendation, another Merriman favorite is Pennsylvania Mutual Fund (five-year average annual return: 13.7%; [800]-221-4268), a 34-year-old fund that once boasted of a stellar performance. Although Merriman says it has a “terrific long-term track record,” its recent lackluster performance has prompted many advisors to recommend investors sell their holdings in favor of better-performing funds. As a result, the fund has shrunk dramatically in recent years, from $1.2 billion in 1992 to as low as $500 million last year. Assets have since climbed back to $600 million.

Merriman finds Pennsylvania Mutual a good bet for long-term investors who think a stock market crash is coming and want a fund that may decline less than the broad market. The fund currently owns 204 smaller stocks that are mostly value issues--meaning they typically sell for relatively low price-to-earnings ratios, and may be out-of-favor with investors in general.

“When the big bear market comes, value stocks in general will have already gone through their own bear market,” he said. “So these value small-cap stocks will be a good place to be.”

What about small-company stocks in the rest of the world?

For those willing to roll the dice on international bets, Merriman likes Acorn International (two-year average annual return: 19.5%; [800]-922-6769).

Still, he cautions, the fund “is likely to lose 25% to 50% in a declining market” and that investors should be prepared for that.

(Indeed, it’s important for investors to remember that small-cap funds are just one small part of a diversified portfolio.)

Tim Kochis, a San Francisco-based fee-only financial advisor, said he likes Navellier Aggressive Small Cap Equity Portfolio (year-to-date return: 7.8%; [800]-887-8671). This fund is for aggressive growth-oriented investors.

On the value side, for investors who want something they can stick with, Kochis likes Heartland Value Fund (five-year average annual return: 22.7%; [800]-432-7856).

One warning: Small-company investors must remember that what appears to be the best-performing fund may not be the best investment.

Just look at the American Heritage fund ([800]-525-2406), whose return so far this year is an amazing 100% (but whose five-year average annual return is an anemic 5.3%).

Note that this fund has only $21.9 million in assets. What’s keeping investors away?

Well, for instance, Morningstar, which gives American Heritage a low one-star rating, says, “American Heritage fund might just as easily be considered a financial cult as a mutual fund.”

Morningstar notes that about 19% of the fund’s assets are in the stock of the drug company Senetek, which is still going through clinical trials with its male impotence drug. And former investors have sued the fund, which has an expense ratio of 3.7%, more than double the average.

“With small funds like this, it’s much harder to find out what the manager is doing,” Whitt said. “Especially for first-time fund buyers, they might get into one where the manager is doing something goofy.”

In thinking about the opportunities the small-cap sector affords, investors should keep in mind an important bit of market history: When they’re hot, small-company stocks can get very hot, beating the broad market. But they also tend to be hit much harder than bigger stocks when there’s a decline in the overall market.

“In general, if the large-cap market starts floundering, people will flee to quality and bail out of small caps. That’s something for every investor to keep in mind,” said Whitt.

Times staff writer Debora Vrana can be reached at debora.vrana@latimes.com