From the March 2007 issue of Wealth Manager Web • Subscribe!

March 1, 2007

Pick and Choose

Many growth investors began 2006 full of optimism. After trailing value stocks since 2000, growth shares seemed due for a revival. But growth stocks continued to lag. Small value funds led small growth specialists by 5 percentage points during 2006, according to Morningstar.

Will growth finally take the lead this year? Perhaps. In recent years, value managers have gotten a giant boost from one of their long-time staples, energy stocks. Meanwhile, growth managers have been dragged down by their traditional specialties, including technology. But now with oil prices sagging, Wall Street analysts expect energy companies to report scant earnings growth. On the other hand, technology could present a healthier picture as consumers race to grab the latest mobile phones and flat screen TVs.

Whether or not small growth funds spring to life soon, they can still provide important diversification. Of the nine major styles tracked by Morningstar, small growth has the lowest correlation with the S&P 500 as measured by R-Squared scores. This extra diversification can provide important cushioning in erratic markets.

To find the best choice in the small growth category, Wealth Manager again turned to the eight-part screens developed by Donald Trone, chief executive officer of FI360, a consulting firm in Sewickley, Pa. Trone's due-diligence process seeks funds that have more than $75 million in assets and are at least three years old. One- and three-year total returns must exceed the category medians as must five-year results if the fund is that old. The expense ratio must fall below the top quartile, and at least 80 percent of the fund's holdings must be consistent with the category.

The screens reduced the field of 551 funds to 124 contenders. Top performers included Columbia Acorn USA, Excelsior Small Cap, and First American Small Cap. But we awarded the title to Royce Value Plus Service, which had the top five-year returns of the finalists and among the highest alphas.

True to its name, Royce Value avoids the priciest stocks. But the fund stays squarely in the growth box by seeking companies with the potential to deliver strong earnings gains. Many holdings have below average price-earnings ratios and above average earnings growth. The formula has enabled the fund to return 21.6 percent annually for the past five years, outdoing 99 percent of its peers.

Portfolio managers Whitney George and James Skinner avoid trouble by sticking with companies that have strong balance sheets and high returns on invested capital. The managers like to buy after a stock has plummeted. In many cases, the target is a longtime growth stock that has delivered an earnings disappointment. Sometimes the managers take turnaround situations where a troubled company seems headed in a new direction. "We want to buy things that other people are ignoring," says Skinner. "But we want to take contrary positions in a way that limits risk."

A favorite holding is Knight Capital Group, which has a price-earnings ratio of 14, and an annual earnings growth rate of 29 percent. The company executes trades for brokers and manages hedge funds. At a time when the cost of trading has been declining, investors feared that Knight's margins would drop. But the company is prospering by moving into more specialized electronic trading, making big transactions for mutual funds. "They have been getting out of commodity businesses and shifting to the higher-margin fields," says Skinner.

The company holds $4 per share in cash. That provides an important cushion for a stock that only trades around $21.

Lately, steel stocks have been softening as investors worry that the U.S. economy will slow, and demand for manufactured goods will decline. But Skinner figures that any downturn will be minor. With countries around the globe racing to build their infrastructure, prices of specialized steel will remain firm. He recently bought IPSCO, a producer of tubes used for oil production and steel plate designed for builders of ships and rail cars. The company only commands a price-earnings ratio of 6, even though earnings are growing at a 47 percent annual rate. "Because this company has a strong balance sheet, it has done a great job of surviving industry downturns in the past," Skinner says. "Even if we have another downturn, IPSCO should do well because a lot of its competitors have gone out of business or mothballed factories."

In the last several years, Skinner has been buying small gold mining companies. He figured that worldwide reserves were not adequate to satisfy growing demand from emerging markets. The bet proved worthwhile as mining stocks skyrocketed along with prices of precious metals. Now gold shares are no longer such bargains, but Skinner believes that some of the stocks still hold potential. "In emerging markets, investors are becoming wealthier, and they are buying gold and silver to protect their assets," he says.

Skinner recently bought Ivanhoe Mines, a small company that is developing what could be a huge gold mine in Mongolia. While the project is moving slowly, Skinner became interested after the company sold 10 percent of its stock to Rio Tinto, a big British miner. "The Rio Tinto executives should provide important assistance because they are very experienced at working in developing countries," Skinner says.

Such little-known mining stocks could flop. But Skinner limits risk by staying diversified, holding about 90 stocks and keeping less than 2 percent of assets in each name. The precautions should help avoid big losses and enable the fund to continue delivering steady results.

Stan Luxenberg (sluxenberg1@nyc.rr.com) is a business writer and has long been a regular contributor to Wealth Manager.

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