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Small-Cap Value Funds Thrive with Low Rates, Weak Economy: Mutual Fund Focus, September 2010

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Now that low interest rates and a sluggish economy seem to have insinuated themselves into a state of apparent semi-permanence, investors and their advisors may as well figure out how to take advantage of them rather than biding time until they magically disappear. Of course, that’s a trick not easily done, but there are several reasons to think that at least one asset class can pull it off: small-cap value stocks.

Low interest rates benefit small caps in several ways: besides reducing their borrowing costs and making stocks in general more attractive, low interest rates also make it more enticing for larger companies to make acquisitions, and those larger companies often target smaller companies that fill market niches or offer promising technologies. Acquisitions are even more attractive during times of sluggish growth, since they offer one of the few ways to boost revenues. The value side of the small- cap market is particularly attractive, because those companies are cheaper relative to their earnings, making them more attractive acquisition targets.

Merger and acquisition activity slumped during the recession that began in 2008, but appears to be reviving now. Standard & Poor’s 500 companies are sitting on “an unprecedented level” of spendable cash “permitting them for the first time in memory to undertake multi-actions simultaneously,” says Howard Silverblatt, senior index analyst for S&P Indices. (S&P Indices operates independently from S&P Equity Research.) Deal activity has been heating up lately, including the first hostile offers in recent memory, and more deals are on the way: a survey released in September 2010 by Merrill Datasite of 119 large-cap companies found that 51% expect to make an acquisition in the second half of 2010. A strong majority, 71%, of those expect to buy smaller companies costing less than $500 million, because they will drive revenue growth without much increase in risk. Activity will pick up further in 2011, 72% of respondents said.

There are well over 100 mutual funds that invest in U.S. small-cap value stocks. To identify the most attractive, we screened for funds that are open to new shareholders, have assets of $20 million or more, no sales load, and a five-star ranking from S&P. Just seven funds passed that screen, and of those, we chose three that offered a combination of strong historical performance over three- and five-year periods as well as below-average cost.

The Big Performers Among the Small Caps

No. 1: Heartland Value Plus. Of the three small-cap value funds meeting those criteria, the largest and best performing fund is the $1 billion Heartland Value Plus Fund (HRVIX), which boasts the second-best five-year performance–5.63% annually–among all small-cap value funds as of Sept. 16, 2010, and the third-best three-year performance of 1.51%. Since it opened in October 1993, it returned an average 10.21% annually, according to Lipper data.

Also, HRVIX’s expense ratio is among the lowest of its peers. At the end of June 2010, the fund had 72% of its assets in companies valued at $300 million to $2 billion, and another 11% in micro-cap companies worth less than $300 million, for a weighted average of about $1.2 billion. It is managed with a strong focus on dividend paying stocks–88% of its assets were held in dividend-paying stocks at midyear, though its dividend yield of 2.14% is lower than its peer average of 2.7%. Almost half its assets are in the financial or health care sectors; its top three holdings at midyear were Unit Corp. (UNT), an Oklahoma natural gas company; Chemed (CHE), a Miami provider of hospice care; and Omnicare (OCH), a Kentucky-based provider of drug therapy at nursing homes.

No. 2: Homestead Small-Company Stock. The Homestead Small-Company Stock (HSCSX) fund has delivered similar performance to HIVIX at about the same cost in recent years, returning an annual average of 4.95% over the past five years (sixth best among small-cap value funds) and 1.48% over the three-year period (fourth best), though it is much smaller, with about $72 million in assets. Since it opened in March 1998, it has returned about 6.2% annually. Its portfolio is vastly different, however, with industrial and consumer discretionary stocks making up slightly less than half the total while financial and health care stocks account for about 13% of the fund. The average market capitalization for its holdings was $2.8 billion, according to Lipper data, and its dividend yield was lower than the Heartland fund at 1.47%. The top three holdings for the Homestead fund as of mid-year were Denver-based oil and gas producer Cinmarex Energy (XEC), Cooper Tire (CTB), and Nordstrom (JWN).

No. 3: Adirondack Small Cap Fund. Another fund worth looking into is the Adirondack Small Cap Fund (ADKSX), which has the eighth-best five-year total return among small-cap value funds at 4.92%, and the second-best three-year return at 2.72%. Started in April 2005, the fund had $22 million in assets at mid-year 2010, double what it had a year earlier. This fund’s portfolio is heavily weighted toward information technology companies, which accounted for 32% of assets as of March 31, 2010, the most recent data available. The average market cap for its holdings is just $1.7 billion, smaller than the other two, and its dividend yield of 2.47% is the largest of the three. At mid-year, its top three holdings were DDI Corp. (DDIC), a California-based maker of printed circuit boards; Minneapolis-based medical device maker Vascular Solutions (VASC); and Trinity Biotech (TRIB), an Ireland-based maker of medical diagnostic products.

S&P Senior Financial Writer Vaughan Scully can be reached at [email protected]. Send him your ideas for mutual fund story topics.