These Small Caps Could Have Big Potential

Small cap funds have outperformed large cap funds year to date, 2.05 percent to 1.90 percent respectively, and could continue to do so as investors seek stable growth.

Bridgette Hughes, Associate Director of Fund Analysis at Morningstar, said small caps outperformed mid and large caps from the March low to Russell 2000 peak in June with value stocks performing the best.

The low-quality rally saw companies with questionable balance sheets and revenue streams rally the most, she said. But in the past month, growth funds have held up better than blend and value funds.

“More stable companies are being appreciated again,” Hughes said.

Eric Cinnamond, manager for Intrepid Small Cap fund, a five-star Morningstar rated fund up 12.02 percent this year, said he is not terribly disturbed by the correction. Cash comprises only 13 percent of his portfolio and he’s “finding things to buy right now.”

Cinnamond prefers companies with strong balance sheets that are generating lots of cash. Petsmart, a holding in his fund, has reduced new store openings.

“Slowing down growth will generate free cash flow,” he said. Cinnamond finds the stability of the business attractive: “people will spend on pets rather than children.”

Core-Mark, a leading distributor to convenience stores and grocers, is part of the Intrepid fund. Cinnamond said while sales are up nearly 8 percent annually, the company has “volatile earnings” from using last in, first out accounting treatments. Core-Mark has “improved its balance sheet considerably, but has not gotten credit for it, “he said.

Cinnamond said risk control is very important for small cap investing. “There is more concentration of risks.”

Eytan Shapiro, who manages the four-star Morningstar rated JPMorgan Small Cap Growth Select fund which is up 6.39 percent year to date, said small cap stocks typically lead the economy out of a recession, with growth stocks being at the forefront. He remains positive on small cap stocks even with the recent correction and increased volatility.

“Second half of 2009 should be pretty positive for small cap growth stocks,” he said.

Shapiro selects companies that dominate their industry with sustainable growth and good barriers to entry. Nuance Communications, a holding in the fund, provides speech and imaging solutions. Shapiro said Nuance Communications is a dominant market player with expanding margins and strong cash flow.

He likes Blackboard, Inc., an enterprise software provider for colleges and K-12 institutions, also held in the JPM Morgan Small Cap Growth fund. Shapiro said there are still growth opportunities in the U.S. and abroad. Blackboard has a “strong record for integrating acquisitions.

MedAssets, Inc., a holding in the fund, provides revenue and supply chain management technology and services to help hospitals improve profit and cash flow. Shapiro said MedAssets has an extensive client list which serves as a competitive barrier to entry. The company benefits from “proprietary data” it has accumulated over the years.