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The Market’s New Sweet Spot: Small-Cap Growth Funds

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Stocks of fast-growing small companies have finally moved center stage after spending most of the nine-year bull market trailing much larger companies. These “little” companies (with market capitalizations up to $2 billion) have the potential to expand rapidly, and their stocks returned an average of 10% in 2018 as of August 15 versus 6.7% for the Standard & Poor’s 500 stock index. And that outperformance seems likely to continue.

Many investors avoid this asset class because Wall Street analysts don’t pay much attention to relatively small companies…the companies often rely on just one product or service or a few major customers for their revenue…and their stocks can be very volatile. Top mutual fund analyst Todd Rosenbluth says that for investors who can stomach the ups and downs, small-cap growth stocks are worth the risk now because they diversify a portfolio that is heavy in big companies and they are likely to be the leaders in the next leg-up in the stock market.

Bottom Line Personal asked ­Rosenbluth to explain why the little guys can continue to do well and which funds that invest in these stocks are most attractive now…

Three Factors Stand Out

An unusual confluence of factors has come together to create an almost ­perfect playing field for small, fast-growing companies. These factors ­include…

The domestic economy is taking off. Annual growth in US gross ­domestic product (GDP) is likely to hit 3% for 2018—its highest level in 13 years—as consumers see bigger paychecks, thanks to wage increases and tax reductions. While this boosts US companies in general, profits at small companies are much more leveraged to periods of rising US growth because they tend to generate most of their revenue domestically, while companies in the S&P 500 derive roughly half of their revenue, on average, from foreign countries.

Trade wars. US trade tensions continue to rise, not just with China but also with our economic allies including Canada and France. Small companies look more attractive to investors than multinationals because their comparative lack of foreign sales helps insulate them from foreign tariffs.

Corporate tax cuts. Again, this means much more to small companies than large ones. Before tax reform, large companies rarely paid the highest corporate tax rates because they had many more loopholes to reduce their tax bills. Small companies have seen their real tax rates drop dramatically and now are in a position to execute new capital spending and expansion plans.

One risk to watch out for: If inflation suddenly spikes and the Federal Reserve is forced to raise interest rates very quickly to quell it, the entire stock market would be hurt—but ­especially small-cap growth stocks. Unlike larger companies, they often don’t have deep cash reserves or exposure to overseas markets that could help make up for shortfalls in domestic revenue. However, I think this scenario is unlikely.

Because it is more difficult to do research on small companies, individual investors would be wise to invest through mutual funds. Here are five attractive no-load mutual funds that focus on small-cap growth stocks and that have outperformed the S&P 500 over the past decade…

For Very Aggressive Investors

These funds invest in companies that have very strong earnings growth but whose stocks can be extremely ­volatile…

Hodges Small Cap (HDPSX). Manager Craig Hodges has been executing the same contrarian strategy for nearly three decades, hunting for overlooked or misunderstood companies with solid balance sheets that can dominate their market niches. He prefers technology and consumer-discretionary stocks that have strong brand awareness and are poised to benefit from industry consolidation. The fund can be “streaky,” often underperforming both its category and the broad market for years before it roars back to life. Over the past year, the fund gained 24.4%, which ranks in the top 12% of its category. Top holdings: Software maker Nutanix, which helps companies set up and oversee their own data centers and cloud storage…and American Eagle Outfitters, a casual-apparel retailer for teens and young adults.

Oberweis Micro-Cap (OBMCX) focuses on 90 to 100 of the tiniest companies in the stock market, those with market capitalizations of $600 million or less. It looks for firms growing earnings by 30% or more annually, thanks to innovative and transformative products and services that allow them to create new markets or take significant market share from larger competitors. This daring fund can soar in good times—it’s up 27.6% over the past year—but it has been 25% more volatile than the S&P 500. Top holdings: Intersect ENT, a drug-device company that develops products for ear, nose and throat conditions…and Adesto Technologies, whose semiconductor chips run health monitors and “smart” appliances using far less energy than competitors’ chips.

For Moderately Aggressive Investors

These funds tend to be more conscious of valuations than most funds in this category, and they tend to lose less than their more aggressive peers when markets grow volatile.

Conestoga Small Cap (CCASX) favors manufacturing and technology-related companies and tends to hold them a long time. All holdings must be “high-quality” companies, which means steady earnings growth from year to year, little debt and high returns on equity, a measure of how much profit a business generates with the money that shareholders have invested. Despite a focused portfolio of just 50 names, the fund has weathered market pullbacks well. Top holdings: Neogen Corp., which sells kits to food producers and processors for detecting harmful substances in human food and animal feed…and Blackbaud, which makes financial-management software for the nonprofit and higher education markets.

T. Rowe Price QM US Small-Cap Growth Equity (PRDSX) is an actively managed “quant” (quantitative) fund. The managers oversee a portfolio of 300 stocks picked by computer software that weighs factors such as historical valuations, cash flow, quality of earnings and recent share-price movement. That has helped keep fees low and has led to remarkably consistent performance. The fund doesn’t make big sector bets. Health care and technology each recently made up about 20% of the portfolio, but no single position accounts for more than 1% of overall assets. Top holdings: Align Technology, which manufactures innovative dental equipment such as transparent braces…and video game publisher Take-Two Interactive Software.

Wasatch Core Growth (WGROX). Lead manager J.B. Taylor has run this fund for 17 years. He looks for companies that can grow earnings by at least 15% annually for the next five years, and he is willing to pay a premium for them. Taylor invests with conviction. The largest individual positions can take up as much as 8% of assets, although 3% to 4% is more common. And he often hangs onto stocks as the companies get bigger, so the average market capitalization of the fund’s holdings skirts the line between small-cap and mid-cap. Assets can cluster in any sectors where Taylor finds opportunities. Right now, that’s information technology, health care and manufacturing. Note: This fund may be better for tax-advantaged accounts than for taxable accounts because, despite its low portfolio turnover, it has issued taxable capital-gains distributions in each of the past five years. Top holdings: Cantel Medical, which makes supplies for infection prevention in hospitals and doctor offices…and online automotive auctioneer Copart.

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Source: Todd Rosenbluth, senior director of mutual fund and ETF research at the financial research firm CFRA, New York City. CFRAResearch.com Date: September 15, 2018 Publication: Bottom Line Personal
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