Newsletter Watch: Small-cap funds
The recent extremes we’ve seen in market volatility may be causing some investors to lose some sleep at night, particularly those holding more speculative, small-cap stocks.
One way to maintain exposure to the long-term upside potential of small-cap stocks without the undue risk of individual small-cap companies is to consider mutual funds or exchange traded funds that in turn buy and hold small-cap issues.
While a small-cap fund will not be immune to a market setback, it does offer the benefits of diversification and professional money management, two valuable assets during a market swoon or period of high volatility.
This week and next, I will look at small-cap mutual funds that are currently on the buy list of financial newsletter advisors. We begin with Thurman Smith, editor of Equity Fund Outlook. Smith, who has been managing funds since 1982, focuses on isolating funds that have performed well in both up and down markets.
By comparing scores for upside performance and downside performance, Smith is able to determine an “Investment Skill Quotient,” allowing him to limit his buy recommendations to only those funds with the best risk to reward ratio for both bullish and bearish periods.
Among Smith’s current buys are several funds that focus on small-cap stocks. One is the Perritt Emerging Opportunities Fund (Nasdaq: PREOX). Managers Michael Corbett and Gerald Perritt, he notes, run one of the few funds that focus on the smallest stocks.
Smith points out that the fund’s annualized return of 23.6% over its 2.9 years looks very attractive against the 17.2% return for the average small-cap value fund. He adds that with a tax impact of only 1.0 and low risk it's useful for about any account.
Smith also recommends the Perkins Discovery Fund (Nasdaq: PDFDX) among small cap funds. He notes that over its 9.3 years, it has almost doubled the return of the average small-cap blend fund. At the same time, Smith cautions, its risk exposure is a third more than that of the market.
Smith explains, “Richard and son Daniel Perkins scout for smaller firms, especially ones in their upper-Midwest region, that they feel will appreciate in value.” He notes that a modest asset base of $36 million is a plus.
Another favored fund is the Kinetics Small Cap Opportunities Fund (Nasdaq: KSCOX). The advisor notes, “Kinetics Small Cap falls in the first percentile among its mid-cap blend peers for the last twelve months, and second and fifth percentiles for the last three and five years, respectively.”
This, he suggests, shows that the fund’s performance it is getting better with time. Smith also notes, “Managers, Peter Doyle and Murray Stahl pick stocks rather than sectors and aren’t afraid to make big bets.”
The fund managers, he explains, have several criteria for picking a stock. Smith notes that they like firms with a long product cycle, high barriers to entry and a sustainable business model. They also look for special situations, he observes, such as a battered stock with a good chance for a turnaround. Smith adds that a recent theme of the managers has been newly equitized stock exchanges.
Finally, Smith suggests, the stock has to show it can return 15% on equity (ROE) over a three- to five-year period. He adds, “The managers also focus on special situations, especially when a stock is down but there is a catalyst for a turnaround.”
The fund has 142 stocks, of which the top ten are 46% of the portfolio. Among big bets in the past, he points to energy stocks, including Canadian oil-sands operations. He notes that the fund also bought positions in distressed utilities, all of which had signed contracts with Enron.
The advisor states, “While the companies took a big revenue hit, their businesses were intact and recovered, as some got approvals for rate increases that will keep their ROE above 15%.”
Meanwhile, he notes that the managers sell when they feel a stock is at the end of its run-up. Smith explains, “Doyle and Stahl don’t jump in with big positions right away. Instead, they usually start a position by committing about 0.1% of assets to it. Once in, they monitor the stock. If it shows good price momentum, the stake goes up.”
Over its 7.3 years, Smith notes that Kinetics Small Cap Opportunities has returned 18.3% annualized. And while not suitable for conservative investors, he concludes, “The fund is tax efficient and a good choice for aggressive investors.”
