Out-of-Favor Small-Cap Growth Funds Worth a Look

In a year in which the S&P; 500-stock index gained 33.4%, the PBHG Emerging Growth fund fell 4% in 1997. The Oberweis Emerging Growth fund gave up 8.6%. And the Van Wagoner Emerging Growth fund sank a heart-rending 20%.

As an investor, should you sell these funds if you own them and steer clear of them if you don’t? On the contrary, now may be the time to buy aggressive small-cap growth funds like these.

That may seem like odd advice. After all, what sane person sticks money in a mutual fund that can’t turn a profit in a raging bull market?

But the idea isn’t as crazy as it sounds. All investors want to buy low and sell high, right? Here’s a chance to do it.

Small-cap growth funds were the darlings of the stock market three years ago. Harnessing the powerful gains made by technology stocks, aggressive fund managers such as Gary Pilgrim, Garrett Van Wagoner and Louis Navellier notched 1995 returns that neared or topped 50%, etching high profiles for themselves.

Van Wagoner, for example, enjoyed an average annual return from 1993 through 1995 of 52%--including an eye-popping 69% in 1995--when he ran the Govett Smaller Companies fund before branching out on his own.

But the small-cap growth sector has slumped badly since mid-’96, and even some of its top managers doubt it will soon return to favor.

For investors, though, the key is to realize that the group will at some point come back strongly--and that you want to be aboard when it does.

Small-cap growth funds load up on promising companies whose stocks always end up reflecting their great potential, experts say.

“Historically, you have these periods where they lag and you wonder if they’re going to go up again. And then, boom!”--they take off, said Michael Moe, growth stock strategist at Montgomery Securities in San Francisco.

With individual small-cap growth stocks, buying on severe weakness is a dangerous strategy. There’s nothing to stop a company from going out of business and investors from losing all their money.

But by their very nature, mutual funds are diversified and are unlikely to drop to zero. In fact, if a fund is run by a talented manager and has suffered largely because its investment style has gone out of favor--rather than because the companies it bought are duds--buying after a period of poor performance can be a good way to get in at a low price.

“My recommendation is to invest with these guys because they can find the highest-quality companies in the country, they’ve done it for a long time, and it’s not a skill a lot of people have,” said L. Keith Mullins, small-stock strategist at Salomon Smith Barney in New York. “I know for a fact that Pilgrim, Van Wagoner and Navellier are just as smart today as they were three years ago when everyone thought they could walk on water.”

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On average, small-cap growth funds returned 18% in 1996 and 14.6% in ‘97, according to fund tracker Morningstar. In absolute terms, those are respectable numbers.

But the group has lagged badly behind large-cap stock funds as well as small-cap value funds that target shares based in part on low valuations. What’s more, the most aggressive small-cap growth managers lost money last year.

The main problem, the managers say, has been the desire of so many investors to own large, supposedly safe stocks while shunning higher-risk, small-cap growth issues.

Why the widespread fear of smaller stocks? Beginning in mid-1996, many investors grew worried about the U.S. economy. A sharp pullback in the market that summer dashed many small-cap growth stocks as Wall Street suddenly decided against paying high valuations for smaller issues.

The sector had a nice run in mid-1997, but came undone again when the Asian economic crisis broke last summer.

As uncertainty over the broad market has risen, many investors have simply become reluctant to hold less-liquid small-cap issues for fear the stocks could be impossible to exit without drastic losses if the firms miss a quarterly earnings estimate by even a few cents.

“If Compaq was a small-cap stock, it would [have been] down 70%” on Monday, Van Wagoner said. Instead, shares of the big computer maker slipped only $2.19, or 8%, after it warned Friday of weak earnings.

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Yet small-cap growth managers also concede they could have done a better job with their funds.

Van Wagoner, who formed an eponymous fund group two years ago in San Francisco, says his funds were too concentrated in a relative few stocks. So a stock falling sharply had an outsize impact on his returns.

“We’ve certainly made some mistakes,” he said. “There’s no doubt about it.”

In response, Van Wagoner has added more stocks to his portfolios. He also has downplayed technology shares because of their volatility. Whereas techs once made up 50% to 60% of holdings, the Van Wagoner Emerging Growth fund now has a 45% tech weighting, the Micro-Cap fund has 35% and the Mid-Cap fund has 28%. He’s added retailer and consumer stocks that are more dependable.

Pilgrim, too, believes he’s had too many “torpedo” stocks. Normally, he said, about two-thirds of his stocks are outperforming and one-third are underperforming. Of that one-third, about 20% are torpedo stocks that suffer earnings disappointments and fall sharply.

Though Pilgrim disputes the notion, some critics believe he allowed his fund to get too large, thus saddling him with too many mediocre issues. Pilgrim closed the PBHG Growth fund to new investors in 1995 but reopened it in early ‘96, arguing he could still find good stocks.

While Van Wagoner and Pilgrim have clung to their basic investment approaches, Louis Navellier of the Navellier Funds in Incline Village, Nev., has massaged his style.

A few years ago, he sought out stocks whose earnings growth rates were increasing rapidly. But that style is out of favor, he said, so these days he’s looking more for consistent earners and growth stocks at “reasonable” prices.

“I shifted gears. That’s what saved my butt” last year, he said.

Still, analysts suggest that you make sure a small-cap manager still follows the basic strategy that made him successful in the past.

“You have to convince yourself your mutual fund manager hasn’t lost his mind,” said Pilgrim, who heads the PBHG funds and runs the mid-cap PBHG Growth fund in Wayne, Pa.

Can the small-cap growth sector become the market leader again soon? It’s up a bit more than 6% this year and has slightly outperformed small-cap value stocks. But it’s still trailing big stocks.

Enthusiasts say the earnings prospects of small stocks, and the relative valuation versus big stocks, are attractive. Analysts now expect earnings for the S&P; 500 to grow 10.5% this year, according to First Call Corp., but that number is likely to come down following last week’s spate of profit warnings from Compaq, Intel and Motorola.

Profits for the smaller companies in the Russell 2,000 index, by contrast, are projected to rise about 26% this year. And though that number is certain to come down as well during the year, it still should easily outpace the S&P;, many analysts say.

The 1998 price-to-earnings ratio of the S&P; is 21.3 versus the Russell’s 20.8. It’s rare for faster-growing small-cap stocks to be cheaper than big stocks.

Still, “even though the valuation discrepancy between large caps and small caps is historically as large as it’s ever been, I don’t think that alone is enough to change things,” Van Wagoner said. “We’re going to need some other catalysts, and I don’t think we’re going to get them” in the near-term.

“I hear a lot of managers of large and small growth funds say we’re going to have to go through a recession and come out the other side for small growth to really show a sustained rally and really outperform large growth stocks,” said Christine Benz at Morningstar.

Susan Belden, editor of the No-Load Fund Analyst newsletter, advises that “you have to know it’s a rough area of the market; you don’t want too much of your portfolio there, and you should know that when things go badly, they go very badly.”

But extreme performance also is true on the upside: When this sector takes off again--whenever that is--it will go like a rocket.

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Growth Funds: A Sampling

How some better-known small- and mid-cap growth stock funds have fared since 1996:

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Fund 800 phones 1996* 1997* Yr. to date* Franklin SmallCap. Gro. I 342-5236 +27% +16% +7% John Hancock Spec. Eq. A 225-5291 +4 +5 +5 Lord Abbett Dev. Growth 874-3333 +22 +31 +10 Navellier Agg. Growth 887-8671 +23 +10 +6 Nicholas Applegate Em. Gro. 551-8043 +18 +11 +7 Oberweis Emerg. Growth 323-6166 +23 --9 +7 PBHG Emerg. Growth 433-0051 +17 --4 +7 PBHG Growth 433-0051 +10 --3 +6 Van Wagoner Emerg. Growth 228-2121 +27 --20 +2 Avg. small-cap fund +20 +21 +5 S&P; 500 return +23 +33 +9

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*Total return

Source: Morningstar Inc.; Lipper Analytical Services