Top Small-Cap Funds: Consensus Stock Picks

Most investors would love to know which small companies are on a trajectory to eventually become an established large-cap name. After all, if you’re able to get into a stock before it’s started its long climb up the capitalization ladder, then that means you’ll have years of gains ahead of you.

But it’s difficult for the retail investor to find such companies amid the clutter. And many smaller companies are underfollowed by Wall Street analysts, so you won’t necessarily have the comfort of institutional affirmation. However, the information vacuum can create pricing inefficiencies, and that translates into the opportunity to find a promising small company before it’s been bid up by the Wall Street crowd.

So how can the average investor discover such companies? One of my favorite idea-generation tools is to use Morningstar’s Premium Fund Screener to find consensus picks among the top-performing mutual funds.

In the past, I’ve performed variations of today’s screen to intriguing effect, both here and here. One previous article examined consensus picks among top-performing funds regardless of style or category, while another looked at the stocks most commonly held among the subset of market-beating mutual funds I’ve profiled in the pages of Benjamin Shepherd’s Wall Street.

This time around, I altered my screening criteria to focus just on mutual funds that specialize in picking small-cap stocks. I then created what I consider an absurdly high threshold for performance. Although I prefer to only consider mutual funds that beat the market or their benchmark over a period of at least 10 years or longer, I also wouldn’t mind near-term performance that similarly outpaced the market. To that end, I screened for funds that beat both the S&P 500 and the small-cap Russell 2000 index over the one-, three-, five-, and 10-year trailing time periods.

But I’m also wary of excess volatility. And because smaller-cap stocks tend to exhibit higher volatility than large caps, I wanted funds whose performance data suggest they exploit risk successfully. So I looked for funds that beat both benchmarks on a risk-adjusted basis over the past three years, as well as funds that lost less than both benchmarks during the bear market year of 2008. That doesn’t mean the individual stocks we’ll uncover will necessarily reflect a fund’s general risk-averse approach, it merely increases that possibility.

Finally, I wanted funds helmed by a team in which at least one portfolio manager had at least five years of experience in running money.

Here is the list of the nine funds that made the cut:

• Consulting Group Small Cap Value Equity (TSVUX)
• Franklin MicroCap Value A (FRMCX)
• Fidelity Small Cap Discovery (FSCRX)
• Goldman Sachs Small Cap Value A (GSSMX)
• Hancock Horizon Burkenroad Small Cap A (HHBUX)
• ING JPMorgan Small Cap Core Equity Portfolio Advisor (IJSAX)
• JPMorgan Small Cap Equity A (VSEAX)
• T. Rowe Price Small-Cap Stock (OTCFX)
• T. Rowe Price Small-Cap Value (PRSVX)

Though all of these funds produced enviable returns, not all are suitable for the average investor’s portfolio. For instance, the funds denoted as “Class A” have sales loads of as much as 5.75 percent, which would be deleterious to long-term returns. Other funds have limited availability due to only being offered in certain plans or brokerages.

However, the Fidelity fund as well as the two T. Rowe Price funds don’t charge loads and are widely available. The one concern is that all three could conceivably suffer from asset bloat at some point. The smallest of the three holds more than $3 billion in assets, which is still a sizable amount of money for stocks that generally have limited liquidity.

I then used Morningstar’s Portfolio X-Ray tool to see which stocks were most commonly held among these nine mutual funds. I looked for names that were held by at least four funds. Here’s the list, with the number of funds that hold each stock listed in parentheses:

• Brinker International (NYSE: EAT) (5)
• EastGroup Properties (NYSE: EGP) (4)
• Proassurance Corp (NYSE: PRA) (4)
• Southwest Gas Corp (NYSE: SWX) (4)
• Texas Capital Bancshares (NSDQ: TCBI) (4)

The next step was to examine each fund’s portfolio to see when they purchased their initial position in the stock, as well as whether they’ve added shares to their existing holdings recently.

Ideally, I was hoping to find a stock that was either a relatively recent addition or had its holdings boosted significantly. The one stock that cleared those hurdles is Texas Capital Bancshares.

JPMorgan Small Cap Equity A established its initial position in the regional bank during the third quarter, with a 1.56 percent allocation, which makes it the 25th largest holding in its portfolio of nearly 70 stocks.

The three other funds that hold shares of the stock initiated their positions as far back as 2004. However, all three boosted their holdings in the stock by an average of 2.8 percent during the third quarter. And the stock is among the top 15 holdings in each of these three funds, which is noteworthy because the smallest portfolio of the three still has at least 220 stocks in its portfolio.

Texas Capital Bancshares was also the only stock out of the five aforementioned names that displayed strong relative strength against the S&P 500 over the trailing three-month and 12-month periods. Indeed, the stock has been on a tear this year, with a nearly 48 percent return year to date. Even so, it’s still down 12.9 percent from its 52-week high. And for those worried about how it might perform during a downturn, it lost more than 10 percentage points less than the broad market during 2008.

Furthermore, the company seems to have solid fundamentals underpinning its performance. Its revenue grew 24.4 percent annually over the past three years, while profits have average 46.3 percent growth over that same period. The bank has $88.2 million in cash and equivalents on its balance sheet and no long-term debt.

Of course, the next step in due diligence is to examine the bank’s history of loan losses to see how that’s trending. So additional fundamental analysis is warranted. But I think we’ve gotten a pretty good start.

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   Reply Leonard schutz November 18, 2012 at 2:20 AM EDT

   I am interested I your stock picks