Ready to bet on small-company growth stocks?

13-Feb-2012

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Commentary: Economic improvement could boost small caps

By Robert Powell, MarketWatch

BOSTON (MarketWatch) — It’s beginning to look as if it might be time to make a big bet on small-company growth stocks.

Yes, the economy is starting to show signs of improvement and, as most investors know, that’s usually a good time to consider overweighting one’s portfolio with stocks likely to benefit the most from an expansion.

To be sure, small-company growth stocks are already on the rise. In fact, small company growth stocks are already fifth-best performing fund category among domestic stocks funds this year, rising nearly 12% through Feb. 3, according to Morningstar.

But analysts say it’s not too late to take advantage of what could be a long-term investment trend. “The macroeconomic trends are going the right way, and generally higher beta stocks, small-company growth stocks, do well when macro-economic conditions improve,” said Janet Yang, a CFA charterholder and analyst with Morningstar.

Plus, if you are a reversion-to-the mean investor, this could be a good time to be in small company growth stocks whether or not the economy is expanding.

But which growth stocks or funds?

According to Yang, there are at least two that carry Morningstar’s gold rating worth considering: The Morgan Stanley Focus Growth fund AMOAX +0.40% , which is a “high-conviction” version of its large-cap sibling, the Morgan Stanley Institutional Growth fund MSEQX +0.46%  , and the Brown Capital Management Small Company Institutional fund BCSSX -0.23%  .

The Morgan Stanley Focus Growth fund, which is managed by a team led by Dennis Lynch, tends to invest in established brand-name companies with a competitive advantage as well as firms that offer hard-to-replicate products and services, Yang said.

For example, many of the top 10 holdings in the $1 billion in assets fund were household names such as Amazon.com AMZN -0.02% , Apple AAPL +0.01% , Google GOOG -0.07% , Mead Johnson Nutrition Co. MJN -0.07% , and Monsanto Co. MON -0.83% . But the fund also holds some non-household names as well, including Baidu Inc. BIDU -0.26% , Motorola Solutions Inc. MSI -0.18% , Brookfield Asset Management Inc. BAM -0.72%  , Intuitive Surgical Inc. ISRG +0.07%   and Edenred EDNMF +1.03% . And last but not least, the fund was holding some non-publicly traded securities, including Facebook, Inc. Class B.

So far this year, the fund is up more than 11% — about four percentage points better than Russell 1000 Growth index, which tracks large-cap growth stocks, and on par with the Russell 2000 Growth index, the small-cap growth index. A word of caution: Investing in this fund isn’t for everyone. Investing in this fund could be a bit like riding a roller coaster: In 2008, the fund fell 53% and then rose 73% in 2009.

Meanwhile, managers of the Brown Capital Management Small Company Growth fund BCSIX -0.25% , which is up more than 12% year-to-date, tend to invest in high quality vs. high-flyer stocks. Plus, the fund’s management team, which is led by Keith Lee, tends to take a long-term view of the stocks they hold, as evidenced by the fund’s low turnover ratio. The category’s average is about 85% while this fund’s turnover ratio is just 7%.

According to Yang, the portfolio management team looks for firms with annual revenues of $250 million or less. And that mandate largely points the managers toward micro-cap stocks, according to her report on the fund.

To wit: CARBO Ceramics Inc. CRR -0.54% , Abaxis Inc. ABAX -1.21% , Diodes Inc. DIOD -0.61% , Balchem Corp. BCPC -1.14% , Gen-Probe Inc. GPRO -0.37% , Blackbaud Inc. BLKB +0.49% , Tyler Technologies Inc. TYL +2.36% , FEI Co. FEIC +0.02% , and Cognex Corp. CGNX -0.18% , were among the fund’s top 10 holdings as of Dec. 31, 2011.

Meanwhile, Kevin W. Gamble, a CFA charterholder who manages a small-cap equity portfolio for the Retirement Systems of Alabama, says it would be wise to exercise “some caution” toward the small-cap growth group, especially after a four-month rally in the equity market.

“That being said, the mergers and acquisitions backdrop has never been better for selected small-cap growth stocks in the technology space in particular, as many large-cap technology companies continue to struggle with a lack of organic growth, can borrow easily at historically low levels of interest, have excess cash on their balance sheets and are currently building upon this excess cash every quarter,” said Gamble, who is also immediate past president of the CFA Society of Alabama. “Many are hesitant to admit they are mature companies and thus don’t want to pay out a higher level of dividend yield, so the logical conclusion is that mergers and acquisitions will pick up in a big way as we move through 2012.”

According to Gamble many potential targets include Taleo Corp. TLEO +0.08%  , Sourcefire Inc. FIRE -1.23% , Fortinet Inc. FTNT +1.69% , SolarWinds Inc. SWI +0.63% , Quest Software Inc. QSFT +0.89% , TIBCO Software Inc. TIBX +1.99% , MicroStrategy Inc. MSTR -0.21% , Qlik Technologies Inc. QLIK -0.15%  , Constant Contact Inc. CTCT +0.47% , and Informatica Corp. INFA -0.18%  .

“We see a basket of these small-cap technology acquisition targets as having a positive risk/reward from current levels given the potential reward to shareholders from a pickup in acquisition activity,” Gamble said.

Others agree that it’s too soon to bet big on small caps, but they do note that there are pockets of opportunity. For the American auto industry, we are seeing increased unit volumes which would benefit the OEMs, but on the small-cap side should also help the suppliers,” said Jeff Tryka, a CFA charterholder and director of financial communications with Lambert, Edwards & Associates. One company being American Axle AXL -1.20% .

“Similarly, with increased new model introductions and renewed focus on quality, small companies such as Perceptron Inc. PRCP -3.73% stand to benefit from line changes and new production technology,” he said.

In banking, Tryka said there are many small cap community banks, such as Mercantile Bank Corp. MBWM +0.96%  that have spent several years working to remake their businesses with renewed focus on community lending that would stand to benefit from a revitalization of consumers in a growing recovery.

Tryka also said retail apparel and footwear companies such as Wolverine Worldwide Inc. WWW +1.17%  may benefit from improving demand as consumers turn more bullish and begin to open their wallets.

Of course, there are those who have an entirely different view of whether to invest in small-cap growth stocks now. “We are encouraged by clear improvement in the U.S. economy and by small business lending growth, which we believe will benefit small cap growth stocks,” said Matthew Harrison, a CFA charterholder, certified investment management analyst, and chief investment officer of RMH Investment Management in Tucson. “However, we believe structural headwinds to economic growth remain, including no longer declining interest rates, higher tax rates and demographic headwinds — or, in other words, deleveraging and addressing the U.S. budget.”

In addition, Harrison expressed concern about possible exogenous event risk, specifically, in Israel and Iran. “Weighing these factors, we are not adding to small-cap growth stocks at this stage and find more comfort in blue chip U.S., large-cap developed international and emerging market equities — all of which, we see as relatively attractive today.”

That may be true. But it still might be worth going from underweight to overweight on small cap stocks — if the economy is truly expanding and if as Gamble said, M&As are on the horizon.

http://www.marketwatch.com/story/ready-to-bet-on-small-company-growth-stocks-2012-02-08?pagenumber=2


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