11
Morningstar FundInvestor
October
2013
The small-cap growth category has had a fantastic
run so far in
2013
. Averaging a
30
.
4%
return through
Sept.
30
, it is the top-performing diversified-domestic
category by a mile. In second place, the small-blend
category is trailing well behind with a
23
.
8%
return.
(Meanwhile, large-cap funds are averaging around
20
.
0%
.) Fueling these returns are high-flying small-
cap technology names such as
Angie’s List
ANGI
(up
87
.
6
%
) and
Zillow
Z (up
203
.
8
%
).
Jeff Cardon, manager of the Gold-rated
Wasatch
Small Cap Growth
WAAEX
, told us in late August:
“Such companies are valuation-stretched. It’s not an
Internet bubble, but it is pretty close.” While Cardon
is a low-turnover manager who buys stocks and
hopes to hold them for five years, he has been trim-
ming picks added earlier this year. His fund is also
trailing most of the rest for the year to date, with an
24
.
3%
return. (That’s not cause for concern: The
fund sometimes lags in rallies, but Cardon has pro-
duced one of the best records in the category during
his tenure of more than
25
years, and the fund is
notable for its low Morningstar Risk ratings.)
Not surprisingly, the top-performing funds in the cate-
gory this year tend to have healthy slugs of tech-
nology and correspondingly high price/earnings ratios.
(The P/E ratios mentioned here are based on trailing
12
-month earnings.) In August’s cover story on various
risk exposures in the Morningstar
500
, we mentioned
Brown Capital Management Small Company
BCSIX
as an example of price risk. Indeed, that fund’s
P/E of
33
is the highest in the small-growth category,
which averages a P/E of
22
. At the end of August,
the fund had more than
60%
of assets in tech stocks;
its top position was cloud service provider
Medi-
data Solutions
MDSO
, up
152
.
5%
through Sept.
30
.
It was also one of the top-performing small-growth
funds, with a
38
.
1%
return.
Rank the small-cap growth category in the Morning-
star
500
by P/E, and it’s the same story: The next four
on the list—
Artisan Small Cap Investor
ARTSX
,
Buffalo Small Cap
BUFSX
,
Loomis Sayles Small
Cap Growth
LCGRX
, and
Conestoga Small Cap
CCASX
—have P/Es of
29
or higher. They also have
tech stakes greater than a fourth of assets and are
up more than
30%
for the year. While this rally is a
broad one and each portfolio is distinctive, Medi-
data Solutions pops up in several of these funds, as
does Angie’s List.
High P/Es aren’t necessarily a sell signal. Four of the
five are Morningstar Medalists, which means Morn-
ingstar analysts believe they are likely to outperform
over the long run. (Loomis Sayles Small Cap Growth
has not been rated.) What’s more, none of them has
been riskier than the average small-growth fund,
and Conestoga Small Cap has low risk ratings. That
fund’s managers and the Brown Capital Management
team follow deliberate, low-turnover strategies.
(Turnover for both was around
15%
at last count,
compared with more than
40%
for the category.)
It’s also worth noting that the top-performing Morn-
ingstar
500
small-growth fund,
William Blair Small
Cap Growth
WBSNX
(up
42
.
1%
), has a relatively
small tech stake and a P/E of
24
. That fund, however,
also has above-average risk ratings and suffered
steeper losses than the others in
2008
.
That said, lofty P/Es are a reminder that for most
investors, small-growth funds fit into a relatively
small “aggressive” slot in a diversified portfolio. If
you have a fund that’s been riding the small-cap
Internet rally this year, it’s time to revisit your risk
tolerance and perhaps rebalance your portfolio.
œ
Contact Laura Lallos at
Small Growth Packs Risk After Rally
Red Flags
|
Laura Lallos
What is Red Flags?
Red Flags is designed to alert
you to funds’ hidden risks. Such
risks can take many forms,
including asset bloat, the depar-
ture of a solid manager, or a
focus on an overhyped asset
class. Not every fund featured in
Red Flags is a sell, and in fact,
some are good long-term hold-
ings. But investors should be
prepared for a potentially bum-
pier ride in the near future.
