Quick Take: Investing in small-cap growth companies can be challenging because few analysts follow them, and share prices tend to be volatile. Paul Graham and David Wabnik, managers of UBS US Small Cap Growth Fund (BNSCX), believe they can dampen these risks by keeping track of the setbacks that change small-cap growth stocks from doves into turkeys.

Performance data suggest that Graham and Wabnik have not only done well, but have held down volatility. For the three-year period through March, the fund surged an annualized 19.3%, while its peer group gained 6.1%. For the one-year period through March, the fund rose 12.6%, while its peers were up a modest 3.2%. The fund’s beta is 1.28, while the average for small-cap growth funds is 1.33.

Graham and Wabnik expect the economic recovery to favor small-cap growth stocks this year, although gains may be limited if the upturn proves to be mild.

The Full Interview

S&P: Small-cap stocks have done better than large-cap stocks in recent years. Do you think that will continue?

GRAHAM: Historically, small-caps have outperformed large-caps because the small-cap market is more inefficient. That hasn’t changed. Information about small-cap stocks isn’t as good as information about large-cap stocks, so investors demand higher returns for small-cap stocks because of the added risk and uncertainty. The average large-cap stock is covered by 20 to 25 analysts; the average small-cap stock has four to six analysts.

S&P: What’s your outlook for small-cap stocks overall and small-cap growth stocks in particular?

GRAHAM: Small-cap’s gains tend to run for five- to seven-year cycles, because it takes a while for institutional and retail money to shift from large-caps to small-caps. Since recoveries tend to favor small-caps and their valuations are still below historic averages, we think there is plenty of room for small-caps to grow.

Small-cap growth tends to outperform small-cap value in a recovery, according to most independent research that I’ve seen. Small-cap value has outperformed small-cap growth in the past two years, but that’s unprecedented and unreflective of the fundamentals of the two categories. Investors typically overreact in both directions, so I think we’ll see a reversion to the mean.

S&P: Do you think this recovery will affect small-cap growth stocks differently than previous recoveries?

GRAHAM: The only difference I see is this has been a very moderate recession. It could be that since we had a mild economic downturn, you won’t get as much strength coming out helping small-cap growth names.

S&P: What’s unique about UBS’s approach to small-cap growth investing?

WABNIK: We use a very disciplined investment process based on proprietary quantitative screens and in-depth fundamental research. Our process is about 50% quantitative and 50% fundamental research. We initially consider about 6,000 companies with market caps greater than $100 million and less than $1.5 billion. We screen for companies with earnings growth in the top 40% of the small-cap universe and trading volume of at least $15 million per month.

S&P: How does individual judgement figure in your process?

GRAHAM: A small-cap growth stock is a lot like a dove: It’s beautiful and soars to the sky, but then something clips its wings and it falls like a turkey. We try to understand what’s likely to clip the wings of a small-cap growth stock.

We look to see if a company’s numbers are real. A lot of times, there’s Wall Street hype behind a stock, so we ask if a company’s earnings growth is sustainable. Where is a company in its product cycle? What’s its competitive position?

S&P: The fund’s literature says you look for companies with strong business franchises and attractive competitive positions. How do you find these companies?

WABNIK: Strong small-cap companies tend to have niche positions. Often, a company will come up with a novel idea that changes the dynamics of an industry or sector. For example, Cytyc Corp. (CYTC) developed a replacement for the traditional pap smear a few years ago and has since gained significant market share from traditional pap smears.

S&P: The fund is less volatile than most of its peers. How do you reduce risk?

GRAHAM: It’s very easy to get stuck in illiquid positions during difficult conditions and watch your holding vaporize. We tend to be more diversified than the average small-cap growth fund over a market cycle. No one position makes or breaks us. We never buy a position that would be more than 1.5% of the portfolio, and we automatically trim it when it reaches 4% of the fund. We hold between 50 and 100 names, averaging about 80.

We’re also fairly well diversified at a sector level. We won’t hold more than a 15% overweight in technology, health care, or consumer goods, which are the major small-cap growth sectors. In the smaller sectors, we won’t go more than a triple overweight. As of March 31, our largest underweight was technology at 24.7% versus 29.1% for the Russell 2000 Growth Index, our benchmark.

S&P: Do you sell a holding when it reaches a maximum market cap?

GRAHAM: We’ll purchase a stock with market caps of up to $1.5 billion and typically sell out when its market cap reaches about $5 billion. We try to keep our average market cap well within the small-cap growth universe. Our average market cap was $1.375 billion, as of March 31, and the average for the Russell 2000 Growth Index was $888 million. We don’t own the smallest market-cap stocks in the Russell index, and we let our winners run.