Posts Tagged ‘small cap’

The lagging small cap category this year has been the small cap growth category. At the Mutual Fund Site, we decided to take a quick peek at a fund that fell into this category and like the top performers we examined last month, the Marshall Small-Cap Growth Fund (MASCX) is an above-average fund. Rated at four stars by Morningstar, it is considered one of the better performers in this category.

Small Cap Growth funds have been lagging behind Small Cap Value and Small Cap Blend funds on a year-to-date basis

In looking at the risk adjusted rating, this fund hold the coveted 5-star rating for its 5 year performance record, which should not go unnoticed. Not surprisingly, the latest management addition happened in 2007, possibly a large contributor to the fund’s 5 year rating.

Another note about management is that the previously high turnover was noticed by Morningstar in 2009 and mention was made. Ironically, the same author noted caution about the fund in 2009 (due to turnover) but less than 1 year later made not of how the “fund is making a name for itself.” More on this later.

One of the things that we feel is most important to a fund’s long-term track record is its underlying portfolio. With the Marshall Small Cap Growth fund, 38% is in small cap securities, another 38% is in Micro Cap securities and the rest is in mid-cap securities. This spread of risk is important because it ensure the right balance, particularly in periods of heightened volatility. We like this kind risk mitigation for a small cap fund; the spread is nice, but there does seem to be enough money invested in mid cap securities that one might question whether the manager is comfortable with the small cap sector in the first place. Why so conservative?

Digging deeper, however, we see that nearly 19% of their assets is invested in Healthcare; followed by 13% in IT Hardware and lastly they have just a little less than 12% in Telecom. The risk in these sectors may be enough to point to that heavy mid-cap presence and get the justification one needs.

With just 82 stocks under management, roughly 28% of their holdings are in the top 10 holdings. Their biggest holding, Energy XXI (Bermuda) Ltd., is an energy play; Ebix Inc. is a software play (number 3 holding) and Heckmann Corp is a financial play (number 6). Let’s look closer at these holdings:

Energy XXI (Bermuda) Ltd (4.52%)
This is the fund’s largest holding. It is also one of the top contributors as far as the fund’s returns go. The interesting thing with Energy XXI is that it reported a loss for 2009 of over 1/2 Billion. Since then, their revenues have been a lot more promising, enough so that the analysts polled by Thompson/First Call have a hold rating on it (recently, analysts have been a little more bullish on the stock).

The biggest problem facing this company is its liquidity. Current assets are insufficient. However, their property holdings conrtibute considerably to their overall positive equity position and the stock price speaks for itself. We would not be surprised if Marshall (which also owns this company in its Mid Cap fund) starts to trim their position, especially after the run up it has experienced on a YTD basis.

Ebix, Inc (3.22%)
This number 3 top holding is a software play. This company focuses on helping insurance companies with their management of independent agencies, policies, administration and claims management processes as well as accounting, reporting and rating tasks.

This stock has skyrocketed in 2010. Currently trading in the $15 range, this stock has been as low as $1. (That is not a typo). Likewise, it has been as high as $51. A recent share buying announcement, increasing revenues on annual and quarterly basis as well as positive analyst opinion will certainly continue to drive this stock price upward.

Heckmann Corp (2.6%)
One of the worst performers in the portfolio with YTD returns of -19%, Heckman is the fund’s 6th largest holding. Although it is officially listed as a “financial” company, this company is actually a holdco for China Water and Drinks and Heckmann Water Resources. Both companies are involved in the delivery and transportation of water (like an oil pipeline, transport company, shipper, etc., except water).

Although this company has been losing a tremendous amount of money over the past 2 years, its concept remains sound and with greater demand for water, it may actually have a viable business model. Of course, the two analysts that cover this stock rate is as a buy and the firm not only has a ton of cash on hand, but virtually no debt whatsoever. In other words, it is a strong, viable company.

Our biggest beef with this holding is that the stock does not move all that much, thereby limiting potential gains. This could also be a selling point in that, as a top holding, its relative stagnant levels can provide stability to an otherwise fairly volatile portfolio (standard deviation is over 25%).

Overall, we like this fund. It’s low entry level, its low fees and decent Beta (at 1.1) suggest a medium risk investment (Morningstar rates it this way as well, giving it an “average” rating for risk and an above average rating for returns.

Provided that the fund remains closely managed, it could very well fit in a portfolio for someone with an apetite for volatility with the potential payoff of good returns.

The markets are down, making mutual funds all that much more important for risk averse investors. That is not to say stocks do not have their place, but the reason I love mutual funds so much is because they offer so much diversification (some would argue over-diversification) that risk becomes somewhat limited. So what does that mean for a mutual fund investor? It means greater participation in specialty funds like gold funds, small cap funds, BRIC funds, and so on. What this ultimately means for your every day investor is:

• yes, the markets will tank and bring down their investments. But when core investments drop, other investments hold down the fort. Which investments will it be? Bond funds? High Yield Investments? Small Cap funds? If I or anyone else could predict such things ahead of time, we would never both with those core holdings in the first place, would we? By being properly invested, the risk of being wrong is reduced or eliminated… something’s gotta win.
• opportunities to rebalance. Maintaining a proper asset mix is essential to long-term success (compared to chasing the winners every time a winner is identified). This means that as markets increase or decrease, the asset mix will shift. This calls for rebalancing, trimming those assets that have done well and dumping money into smart mutual funds that have not fared so well. This achieves two things: it reduces over-exposure and it allows to buy assets when they are considered “lower.”
• buy more when markets suck, buy less when they are heroic. This is the basis of dollar cost averaging, something we should probably stress more often at this site. Still, when markets tank, it reminds us of the importance of never throwing all of our money on the table at once. It reminds us to ease into a position(s) gradually.

Now what does this all mean to how I would invest 10,000? It means that if I was given $10,000 today and told that I had to invest it (instead of spending it on a bunch of toys for the summer), I would:

1. Determine my asset allocation model. You can do that right on this site if you want, or you can ask your advisor to help you figure it out for you. Mine will show: 60% Equities and 40% Income (this is after I decided to ignore the cash recommendation and invest instead in fixed income). Seems conservative unless I am a balanced investor, yes. But let’s take a closer look…
2. Research the following mutual funds; a good Balanced Fund like the PIMCO All Asset fund, which is a medium risk, high return 4-star rated fund. I would throw $7,500 at this fund because it is not only well managed, but the underlying assets are those that I actually believe in. And then I would invest in the Ivy Small Cap fund (a fund I have been laughed at for picking and sticking to, but one that maintains all of the fundamentals that I personally believe in and trust). This fund will allow me to invest $1,500 of the remaining $2,500, leaving me with $1,000 which I would throw at the Franklin MicroCap Value fund, another 4-star fund but one that has virtually no risk associated with it and a track record that would make old pros blush.
3. Review, review, review. Yes, three times.  Per month, that is. Because I think these assets are placed so well, the portfolio would fall out of balance fairly quickly.

If permitted, I would add a 4th point: split the $10,000 into ten $1,000 contributions. This would not be possible in the case of the funds I chose here, but if I had, say, $40,000 to invest, I would invest 10K now, the remaining $30K over the next 2 years. And all of it would be in mutual funds; small cap funds and a balanced fund, maintaining as close to a 60/40 split as I possible can given that balanced funds will not report in real-time what their holdings are.

Nearly a decade ago, David B. Leoper of Wealthcare Capital Management published a well-read paper on asset allocation. In his paper, he argued that diversification alone, which we underline here at the Mutual Fund Site, is not enough to water down the risk attributes of a portfolio. It seemed to me when I first came across his piece that he was either nuts or the concept of asset allocation, which is one of the fundamentals driving all mutual funds, might be widely misunderstood.

Diversification alone is not enough

One of the most striking arguments that Mr. Leoper makes in his paper is that diversification should not be used as a carte blanche excuse to explore higher risk investments within one’s portfolio. And while we have examined some very worthy small cap funds at length recently, Leoper’s point is extremely valid.

Just because you might have the risk tolerance to jump in bed with the RBC Micro Cap fund, it does not necessarily mean you should. Even if you were to limit that exposure to just 5% or even 2%, making an investment like that needs to be done for the right reasons.

And that, the idea of making investment decisions for the right reasons, is really the message we and every other financial planner, consultant, advisor should aim for. And while it sounds hokey, superficial and possibly even contrived, the reason for really getting to know an investment, whether mutual fund, ETF, or individual security makes perfect sense.

Make investment decisions for the right reasons

Ultimately, each investment within your portfolio will relate differently with other securities. It is like having a classroom full of male computer geeks (yep, I would be there!) and then adding an aggressive female athlete into the mix. All of a sudden, the dynamic changes. Some students might compete for the female’s attention, others might take a more aggressive position when it comes to their projects, etc.. Either way, the classroom would change, maybe dramatically or maybe subtly, but definitely it will change. And with time, that change may have a positive or negative impact; either way, there will also be an impact.

To invest for the right reasons, investors will want to understand how the new, added investment will change the portfolio’s dynamics. This might involve simply aligning the investment with other asset classes and sub-classes or it can involve something as complicated as R-Squared.

More importantly (and a lot simpler), the new investment should make sense with the portfolio’s overall objective. For example, if one wants long term growth, choosing an investment that focuses on speculative technologies might not make much sense. As well, this sub category may not correlate well with other asset classes within the portfolio.

By taking a closer look at one’s portfolio, it can be fairly easily ascertained whether a new investment will make much sense at all. Of course, for investors who are die hard mutual fund investors, the concept of diversification is an easy one to understand and appreciate. But that alone does not give free reign to buy assets that add no value, either tangibly in terms of risk-adjusted returns or intangibly in terms of how well such an investment compliments the balance of the portfolio.

The idea that one mutual fund company can be better than another is not a new one. Because so many investors remain on edge after the market “correction” that took place in the last few years, deciding to jump in bed with a small cap fund is even more difficult than normal. And small cap funds, as we have discussed elsewhere on this site, are really not all that risky in terms of their long-term performance track records. So just imagine how people with the right risk tolerance might feel about investing in other types of mutual funds; likewise, how low risk investors will feel about Balanced Funds or Income funds.

Can Big Fund Companies Eliminate Risk?

While large mutual fund companies will have more assets under management than smaller companies, it does not necessarily mean they will eliminate risk better than small fund companies. This statement is supported by the following:

• it can be argued that smaller fund companies (based on assets under management) have “more” to lose than larger companies and will therefore take a more conservative approach to security selection.
• large mutual fund companies might have better access to top talent, but like all big companies they will be more heavily focused on their own bottom line profitability. This can translate in underpaying their talent or working with less progressive and astute analysts and managers.
• large mutual fund companies are often able to offer better incentives to the sales force; smaller companies will be restricted by their budgets.
• at the end of the day, both large and small companies worry about beating the index and their peers. Failure to do so will often result in cash outflows. Therefore, smaller mutual fund companies will be more sensitive and therefore more intent on making the right investment decisions.

So does it make sense to choose a Fidelity mutual fund over, say, an Adirondack fund?

Tough to say. The best performing Fidelity small cap value fund (which is unrated by Morningstar.com) actually under-performs against the top performing Adirondack small cap fund. Both funds have the same risk profile.

However, many people will find things with each fund that either works or does not work for them. Which makes the argument that choosing the best fund for your portfolio should really boil down to how well the fund, its management and performance compliment your own asset management strategy. Taken one step farther, the best mutual companies will be two different companies for two different investors. And, of course, this is why it is impossible to say, one way or another, whether bigger mutual fund companies are better or worse than smaller mutual fund companies.

The small cap growth category is an interesting one. Since small cap mutual funds are an interesting breed to begin with, investing in small cap growth funds implies less risk in a category that is abundant with risk anyway. The Wells Fargo Advantage Small Cap Growth fund illustrates just how it can be that a small cap fund can be less risky than others in its category.

The Wells Fargo Advantage Small Cap Growth fund illustrates how you can have less risk in a category that has an abundance of risk.

Starting with rates of return, the Wells Fargo Advantage Small Cap Growth fund has outperformed the Index every year since 2003 except in 2008. It has outperformed its category every year since 2003 except in 2008. And up to April 30, 2010, it has also outperformed. Each year’s performance has deviated wildly from the Index, meaning that in all but one year, it provided exceptionally greater returns than the Index and Category.

The reverse is true for that one year, in 2008, when it underperformed.

Yet on a 10-year basis, Morningstar considers the fund’s returns as just “average.” (Overall, and its 3 and 5 year returns are considered Above Average, High, and High, respectively).

Wells Fargo Advantage Small Cap Growth has taken a clear position with its portfolio make up.

When it comes to this small cap fund’s portfolio, it is evident that this Wells Fargo fund has taken a clear position in certain securities. With just 104 stock holdings, the fund can be considered average in its size. With 69% of its total $ under management invested in Small Cap, this fund has remained true to the Small Cap Growth sectory. The fund also invests 21% in Micro Cap and another 10% in Medium cap securities to round out the portfolio.

Most small cap funds that we have seen this month have spread the risk equally among different sectors. Wells, on the other hand, is pretty deep into Business Services with 23.6% of holdings. The second largest sector is Healthcare at 16.8%, and the third largest is Software at 11.3%.

In terms of individual holdings, the Fund’s Top 10 (22.4% of total holdings) consists of just one Business Services firm, one Healthcare firm, two software firms, and three Consumer Services firms. Interesting approach, one that has worked well for the fund.

The three top picks we will examine are GSI Commerce, Gartner Inc., and Live Nation.

GSI Commerce (2.97%).
At nearly 3% of total holdings, GSI represents a fairly significant holding. So what does GSI do, exactly? Well, it creates and operates over 100 e-commerce websites for retailers, manufacturers, entertainment companies, etc. It earns revenues from sales made through these sites, earning a commission for each transaction. This business model has proven profitable. This company has earned 3 years of consecutive year-over-year growth. This company also generates good cash flow that is nearly 3 times greater than it was previously. As a “Software” company, there is little reason to question why GSI makes up such a large percentage of the fund’s total holdings.

Gartner, Inc. (2.62%)
Gartner provides analysis and forecasts for IT planning for companies that would prefer to outsource this task. Overall, they provide a valuable service, mostly to chief technology officers and chief financial officers to help budget for IT programs. However, with the economic slowdown, such services have not been in high demand. With that said, Gartner has been able to maintain a relatively stable revenue level as well as maintain their equity level. For firms in this space, Gartner is definitely the one to own.

Live Nation (2.08%)
Live Nation is the sixth largest security holding in the Wells portfolio. Considered Medium Cap, Live Nation is the world’s largest event host, owning booking rights to over 155 venues. The company generates revenues in excess of $4 Billion. However, the past few years have seen net losses to the tune of $350 million in 2008 and $7 million in 2009. With such a strong equity position, the company is likely to recover nicely once the economy gets back on track.

The top holdings outlined above are pretty strong, although some uncertainty is worth noting on the Live Nation holding. Overall, the Wells Fargo Advantage Small Cap Growth fund has certainly invested a lot of attention in picking its top holdings. This small cap mutual fund, while lower in risk overall than many others surveyed here at the Mutual Fund Site, would be best suited to a growth oriented investor who refused to hold value equities and who needs to fill a somewhat larger gap (say 10% to 15%) in their equity space and needs a small cap fund to achieve that.

With the Small Cap Value fund category holding a good second spot in terms of Year to Date mutual fund returns, it would make great sense for people to be taking a keen interest in this category. The top-rated funds are found easily enough, but what about those small cap mutual funds that are not top-ranked but show some decent, tangible promise? Well, we found one such fund – the RBC Microcap Value Fund (TMVAX).

The RBC Microcap Value Fund Shows Great Future Promise

One of the ways that mutual funds are measured is on their risk-adjusted rates of return. This fund, with an astounding 395 securities in its portfolio, has had many years where it buried its competition based on performance and rates of return. But since 2003, there were two years where it underperformed and one of those years has left the 3-year compounded rate of return seriously negative.

In speaking about rates of return, the RBC Microcap Value fund has returned more than 13.2% (as at May 19, 2010), more than 3.5% better than the category. This says a lot; but its negative 39.5% return in 2008 has been hurting its long-term performance, which is likely the big reason behind Morningstar attributing a 2-star (low) rating to this fund.

As far as asset management and asset mix, the fund currently has a relatively low turnover rate at 17%, meaning it holds its positions for the long-term. This could be one reason why losses were so substantial in 2008 and why returns are finally starting to turn around and pick up in 2010. And since 84.3% of total assets are microcap, it makes sense — these were among the hardest hit assets when the markets corrected. Let’s take a closer look at those top asset classes:

At 19.3% of total assets, the Financial Services sector represents the fund’s biggest holding; Consumer Services at 15.1% and Consumer Goods at 13.8% represent the second and third top sectors, respectively.

With no single security representing more than 0.75% of the total portfolio, it appears that the RBC Microcap Value fund has adequate spread its risk. It further demonstrates that no single asset or asset class can by itself cripple the fund and destroy investor returns.

In reviewing those assets:

1. Consolidated Graphics (0.75%) represents the fund’s top holding. Having contributed 29.61% to the fund’s total return so far, this company’s security has been an aggressive asset for the fund to hold. As a Business Services firm, this company provides high quality printing services to corporations (annual reports, multi color brochures, etc.). Although demands for this type of service and product is highly volatile and seasonal, Consolidated has a solid customer base and has proven its ability to survive cutbacks in business spending. Compared to other business services firms, Consolidated has enjoyed three years of positive revenue growth, but its equity position has suffered on account of higher costs (in 2009). This becomes a speculative play.

2. Willis Lease Finance Corp (0.59%) holds the number 3 spot among the top holdings. As a business services firm, this company has yet to provide investors with positive returns. Year to Date, it has returned a negative 18.13%. In terms of revenues, Willis has remained relatively flat over the past couple of years, but it continues to report fairly stable net income and its equity position has grown thanks to smart asset choices. Although Willis remains in a negative cash flow position, its position as a provider of operating leases on spare commercial aircraft engines (aftermarket) will help it enjoy greater returns as cost-conscious airlines start spending more money on aircraft engines, airframe and engine components.

3. National Western Life Insurance (0.56%) is the first financial services firm in the portfolio. Although its Price to Earnings ratio is attractive, it has not performed at all year to date (to be precise, it returned -0.33%). In terms of its financial strength, National remains well positioned to take advantage of a recovery in the US market. With an equity position in the billions, the company has started to generate positive cash flow in 2009 and it is expected to continue into 2011. A growing asset base combined with well managed liabilities has helped keep total equity fairly high, even though 2008 saw revenues drop by over 13%. Although speculative in nature as a microcap financial services firm, National stands to benefit from the economic recovery currently underway and with its P/E ratio as low as it is, the security provides decent value within the RBC Microcap fund.

Without question, the RBC Microcap fund is the most aggressive and risky small cap mutual fund we have reviewed this month. However, its total asset allocation suggests that if the underlying assets have been properly researched and analyzed, the fund can stand to see continued, above-category level gains, particularly as more recovery from an economic standpoint happens. With this in mind, this mutual fund should be purchased only by investors with a higher risk tolerance who fully understand the risks.

It is not easy to find mutual funds that have earned double-digit returns on a year-to-date basis. But it seems that this small cap fund has done just that, earning 12.5% since January 2, 2010 even though its investment strategy might seems a little, well, unique compared to others in its category. But before we dig into three of its top 10 holdings, here is a small review of the ING Small Cap Opportunities Fund (NSPAX).

The ING Small Cap Opportunities A fund is a Small Cap Growth Fund with a great track record.

With just $109,500,000 under management, the ING Small Cap Opportunities fund has outperformed its category in 4 of the past 5 years, including its YTD returns. This coincides with Steve Salonek’s arrival on the fund in 2005, suggesting that the change in management at that time was a profitable change for ING.

In addition, this fund ranks in the Top Quartile for its YTD, 1, 3, and 5 year performance track record, another great achievement given how broad a category this is. Currently, Morningstar ranks this fund as having AVERAGE risk, and it has held this rating since Morningstar has started rating this fund. Currently, it has a risk-adjusted rating on this fund of just 3-stars, even though the fund has consistently held 4-star ratings in all periods except for its 10-year period where it held a 2-star rating, and its overall rating is, again, 3-stars.

On paper, this small cap mutual fund does not look all that inviting. But let’s take a closer look at its holdings. At the Mutual Fund Site we believe that the underlying portfolio of any mutual fund should motivate an investor into taking a long-term investment position, a short-term position, or no position at all. This highlights, therefore, the importance of portfolio, and in the case of the ING Small Cap Opportunities fund, the portfolio has a fairly aggressive (+18%) position in the Healthcare sector. Its next closest sector is the Software sector at 11.56% and third up is the Consumer Services Sector at 11.35%.

While Healthcare will certainly see its day, we believe it could be a little premature at this point to be so heavily invested in that sector when there are others that stand to see a quick, solid rebound with favorable economic news.

As a fund of just 145 underlying securities, this small cap mutual fund places relatively low importance on its top 10 holdings — which make up just a little more than 12% of the total holdings. In fact, its largest overall holding is a money market fund, and aside from that its first Healthcare security (at 1.28% of assets) is number 5 on the Top 10 list. At any rate, let’s take a look at 3 of its top 10…

1. Solera Holdings (1.47%). This company provides software and services to the insurance industry, assisting with the claims process. Overall, this industry is a growth industry given the increasing number of claims that insurers face on an annual basis — not including recent increases in fraudulent claims on account of the recession. With strong, consistent earnings growth over the past 3 years, it comes as little surprise that analysts polled by Thompson/First Call rate this stock as a strong buy.

2. Bally Technology (1.44%). Bally provides gaming machines and solutions for casinos. Although the company has seen a slight bounce in revenues since its 2007/8 levels, its Q1 levels are below 2009 Q1. We have commented elsewhere on whether gaming stocks are a good idea in our review of the Buffalo Micro Cap fund and the bottom line is that they should probably be avoided until economic data supports people spending and wasting money on this type of entertainment. We will elaborate here and warn investors that Bally Technology could be a long-term investment for this fund, a view that seems supported by the analysts at Yahoo!, this “HOLD” stock.

3. Gymboree Corporation (1.14%). As a children’s retailer, Gymboree operates over 620 retail stores in North America, competing with companies like GAP, Carters and the Children’s Store. This is some pretty stiff competition, yet Gymboree has weathered the economic storm extremely well. The company is very well managed, having achieved revenue growth over the past three years when so many others have suffered in this segment. Ultimately, we like Gymboree for its innovative branding and revenue growth in such tough periods. The biggest threats, which have been well documented, is the ease of entry into this segment from newcomers that may be able to offer similar product at a fraction of the price, not to mention alternate retailers who offer similar product — such as Wal-Mart.

Overall, the ING Small Cap Opportunities fund may be a small cap mutual fund that many people would be nervous about owning. However, with its AVERAGE risk rating and ABOVE AVERAGE returns, the fund has a well balanced portfolio in terms of risk diversification, as evidenced by its low concentration in its Top 10 holdings, the small/low percentage of total assets of its top 10, as well as its strong diversification (despite healthcare, as a whole representing nearly 1/5 of total holdings).

At the Mutual Fund Site, we like this small cap mutual fund and believe it would recommend it for investors who need a relatively neutral holding with smart investment management and good diversification.

The Fidelity Small Cap Discovery Fund (FSCRX) is an aggressive small cap mutual fund made up of mostly small cap securities (70.81%) with some assets invested in micro cap (15.75%) and even less in medium cap. As far as mutual funds go, Fidelity has been a steady performer even though their risk is marginally above average compared to other mutual funds in its category.

The security composition is mostly value but since 2009, they have shifted to more of a blended approach. As a result, this small cap mutual fund has been able to outperform the index in 4 of the past 5 years (failing in 2008 miserably), as well as the category (also failing in 2008).

Given its strong and steady performance, the Fidelity Small Cap Discovery fund has been a favorite over at Morningstar, achieving a 5-star rating in all categories except ten years since it has not been around quite that long.

In terms of the fund’s composition, there are just 52 holdings in total. This is where investors will either take comfort or become unsettled, the fund’s top listed sector is the Financial Services Sector, with 21.9% of its holdings in this group. This group has clearly been instrumental in providing great returns recently, with a YTD return (as at May 12, 2010) of 18.98% versus just 5.44% for the category and 13.17% for the Index.

Strong returns — YTD of 18.98% beat the Index by more than 40% and kill the Category by nearly 250%

The Mutual Fund Site likes its top holdings — it became something of a challenge when it came time to deciding which top holdings to look at most closely. This is partially the result of the fund not taking an obvious bias toward any given top holding; the risk is spread expertly among its top 10 holdings. This, of course, makes for a good thing in terms of asset allocation.

Since we are mostly bullish on the Financial Services sector, we chose the top, 3rd and 5th largest holdings.

1. Meritage Homes Corporation (MTH) at 2.86%
As a homebuilder, Meritage had its shares of problems, adjusting poorly to the changes in homebuilding that began in 2007 and up until 2010 was extremely challenging. However, with the real estate markets starting to show signs of bottoming out, Meritage seems poised to make great strides. Thus far, it has contributed impressive returns of 24.42% YTD to the portfolio.

Meritage operates in those higher risk areas of California, Arizona, Texas, Nevada, Colorado and Florida. Although they have reduced their home prices over the past few years, the company is still facing an uphill battle (in our opinion) with shrinking revenues, systemic problems in some of its largest markets as well as its overall size.

However, the company remains solvent with a decent equity position, and the financials have been very well managed over the years with expense management allowing for a considerable improvement to net income in 2009 over 2008 despite gross revenues shrinking by nearly 40%.

Fidelity likes this company, holding nearly 4.8% of it in another fund. T. Rowe Price, owns a over 6% between two o its funds.

And of course, the Mutual Fund Site believes that this homebuilder will indeed profit well once the housing market turns around. With its good equity base, ability to generate cash flow, this is clearly a smart homebuilder to own, despite the current-day risks.

2. RTI International Metals (RTI) at 2.83%
As a Titanium-mill and other specialty metals producer, RTI is an interest small cap play. With $410 million in sales, it does not compare equally to larger players like, say, Rio Tinto, but the company is fairly well managed and should perform well in the medium term.

In terms of revenue diversification, RTI is heavily involved in aerospace, defense and energy. Each of these sectors is heavily dependent on private and government funding, which may account for some of its poor revenue showings in the past 3 years.

Problems facing RTI include negative growth over the past 3 years. With such a higher concentration on sectors that depend on government funding, RTI could be one of the larger risks in the portfolio, yet to date it has already returned 3.62%. As well, in 2008 it was voted as one of the 100 fastest companies in the US.

Analysts are also bullish on this stock, declaring it a buy.

3. Wesco International Inc. (WCC) at 2.79%
A distributor of electrical supplies, Wesco is his heavily involved in construction (36%) and industrial (40%) sectors. Unlike many of its competitors, its reliance on utility sales (17%) is muted compared to the private sector, positioning Wesco to gain from a construction and manufacturing turn around, a true value play.

In addition to its strong positioning in the market, Wesco has contributed 46.7% on a YTD basis to the funds overall returns. This has not gone without notice; 16 analysts covering this stock have progressively ranked it as more of a buy over the past year.

Financially, Wesco remains in a strong equity position despite falling sales and a tighter market, yet it continues to generate cash on a year-over-year and quarter-over-quarter basis. Clearly, this is a sign of strict and disciplined management.

Risks facing the security include negative sales growth over the past 3 years. Of course, this is not uncommon given its concentration on the construction and industrial sectors, which have also been hammered but which, on the whole, are showing positive signs of recovery.

For investors with the Risk Tolerance, Fidelity Small Cap Discovery makes good sense.

Overall, we like this small cap mutual fund. It performs well and, despite the higher risk rating, its holdings position the fund to enjoy fairly substantial gains during the upcoming years of economic recovery and expansion. While flaws can be found in virtually all of its top 25 holdings, those threats or weaknesses also present the most compelling opportunities.

The Franklin MicroCap Value Fund (FRMCX) is one of those top performing funds that has stuck to its strategy over the past ten-plus years and, as a result, has been able to provide investors with great returns. As a Small Cap Fund, this Franklin fund is a steady performer, something that not all mutual funds are able to achieve by remaining so focused and dedicated to their asset mix.

What strikes the Mutual Fund Site as particularly interesting about this fund is exactly that: it’s dedication to the micro cap asset class. With roughly 84.3% invested in such assets, it would seem difficult to achieve consistent year over year returns, yet in the last ten years (the period between 2000 and 2010) it has only underperformed the S&P 500 two times, once in 2007 and again last year, in 2009.

The reason for 2009 under-performance will have a lot to do with the type of stocks that saw gains — lower quality small caps, for example. But Franklin might just be on to something here with their MicroCap fund.

Perhaps the one area that might concern some people is the actual asset mix, with 26.7% invested in Consumer Goods, 22.1% in Industrial Materials and 21.9% in Business Services. The good news is that the fund has properly diversified its holdings so that the risk has been adequately spread across these three key areas that are obviously a focal point for the fund.

The Top 3 holdings of the funds are equally interesting. Since the fund owns just 77 securities and the portfolio turnover is quite low at just 11% according to Morningstar, choosing the “right” companies becomes a tremendously important, and difficult, task for the fund.

Seneca Foods 4.3%
Seneca Foods supplies processed fruits and vegetables to a domestic (US) market. They remained profitable over the past three years, a difficult feat considering how badly the economy was beaten down in 2008 when consumers might have otherwise opted for often-cheaper fresh foods.

Sales for 2010 are expected to be released some time in May 2010.

As a financial entity, Seneca has only increased and improved its equity position through retained earnings and keeping tight control over expenses.

Healthcare Services Group 3.46%
Healthcare Services provides housekeeping and food services to nursing homes, rehabilitation facility and hospitals through the United States. With their services in growing demand, Healthcare Services Group continued to remain profitable over the past couple of challenging years, each year enjoying higher sales numbers and achieving a record year in 2009.

Their balance sheet remains strong, however a spike in short-term liabilities (accounts payable) is worth keeping an eye on for the year to come. It is unlikely that this is not something that Franklin has looked at in greater depth.

SFN Group Inc 3.4%
SFN Group is a staffing company that provides professional and regular staffing solutions for companies in Canada and the US. As can be expected, the company was impacted by the economic slowdown over the past couple of years. This has resulted in weaker financial position, but the company has managed their balance sheet well, reducing liability by nearly 50% from 2007 levels.

Income has also taken a hit with a 2009 loss of over $6 million (compared to a loss of $118 million in 2008). Much will hinge on its First Quarter of 2010 results which are expected any day now.

Of the three top holdings, SFN is quite likely the most uncertain. However, with the economy turning around and demand for skilled and professional workers climbing, revenues are expected to recover as well. And given the company’s smart financial management, as demonstrated over the past few years, this could bode well for the Franklin fund.

Overall, the Franklin fund has a lot to celebrate. An excellent track record while staying true to its identity as a true microcap fund speaks well for the fund manager who has been heading up this fund since 1995.

As well, Morningstar rates this fund as low risk, the lowest risk profile among its peers. Returns have been good with YTD returns over 18%.

On the negative side, those hefty returns are considered just average. Also, heavy investments in business services could backfire on the fund if the economy does not continue to grow or improve.

This fund is best suited for someone with a low to medium risk tolerance who needs additional asset class diversification and is willing or eager to get into a small cap fund to fill such a need. Given the lower risk profile and the strong historical performance, the Mutual Fund Site rates this as a smart investment for that specific type of investor.

For investors with greater risk tolerance and who want something more aggressive, there are other Small Cap funds that may be more appealing.

Buffalo Small Cap Growth (BUFSX)

Overall, this fund has been a top performer in its category for many years. since 2000, it has been in the Top 5 for 4 years. Its worst year was in 2007 where it was ranked 84th; to date, it ranks 4th in the category.

In terms of returns, it has only underperformed the category in 3 of the past 10 years (since 2000). This kind of consistent makes for an appealing fund.

Morningstar also seems to like the fund, having it ranked currently as a 5 star fund overall. This says a lot about its risk-adjusted returns; in fact, the fund has a beta of just 1.05 when measured against the S&P 500. This means that for every point the S&P 500 moves, this funds should move 1.05 points. Ultimately, the closer to 1, the less risk. But the closer to 1, the less likely the fund is to outperform that index… in theory. Clearly, Buffalo Small Cap has no trouble outperforming by a large margin without having to take crazy risks.

Currently rated 5-stars, this small cap fund can brag about a YTD return of 17.88% vs. 13.2% for category. This is quite promising since the risk rating of the fund is considered below average.

As for the investments, this fund has a small cap, growth-oriented portfolio, which has remained consistent over the past 3 years, if not longer. This provides the investor with a fair degree of comfort, knowing that the manager is not simply chasing the popular money for the sake of short-term returns at a cost of long-term returns.

Speaking about the make up of the fund, 31.93% is invested in Medium cap stocks while 56.67% is in small cap and 11.41% is in micro cap stocks. With such a heavy weighting in medium cap stocks, investors will need to make sure this fund does not deviate too much from its mandate as a small cap fund. However, with so much in small and micro cap, this does not seem to be a substantial area for concern.

With just 56 stocks in the portfolio, the manager has taken some fairly considerable positions with the fund’s assets. But with turnover at 15%, it is evident that the manager is committed to seeing those picks return appropriate gains.

The three largest sectors held within the fund are: Business Services at 21.22%; Consumer Services at 18.79% and; Health Care at 17.17%. The three largest holdings are:

1) WMS Industries
-is the largest individual holding; they are a leading slot machine supplier to the larger casinos.
-while some see risks in holding this type of security, others see an inevitable demand for slot machine replacements, an expense that many casinos have been putting on hold for several years. WMS, which aims to be the largest supplier, can benefit.
-even during “tough” past years, WMS has managed to increase sales on an annual basis and continue reinvesting into the company. Its equity position remains strong and has been getting strong with every year.
-According to Thompson/First Call, the 13 brokers that cover this stock rate it as a strong buy and the current price remains below the lowest 1-year price target.
-However, given the conflicting belief and information about the growth rate of this industry, including machine demand, it becomes a speculative investment based on one’s personal views about machine demand.

2) Life Time Fitness
One of top 5 largest holdings, Life Time Fitness targets a higher end fitness group. Its clubs are considered spa like and aim to provide an escape for its members.
-Financially, this company is well managed. As at the end of 2009, sales continued to increase and the equity position continued to grow through good capital management. The company has done well by paying down short-term and long-term debt.
-Overall, the 12 brokers who cover this stock according to Thompson/First Call rate this stock a hold.
-Some concerns facing this company is competition and potentially waning demand for this kind of niche (expensive) fitness club.

3) Waddell & Reed Financial
-An asset management and advisory firm, Waddell and Reed has fared quite well given the market turbulence. While they have seen lower revenues, the firm has been able to maintain a healthy equity position. They currently provide investment management services for Ivy (one of their largest clients).
-Overall, there are 10 brokers who cover this stock and the average rating is HOLD.
-Fears about a high concentration of revenue coming from a small percentage of clients has some investors/analysts more neutral on this stock.
-However, as the economic situation improves and the market cycle starts to improve, Waddell and Reed should see a growing demand for their services.

Evidently, Buffalo has taken a bold position in these firms, trusting that their belief (remember that for every position they take there is another position that feels otherwise) will yield positive results for the investors.

At the Mutual Fund Site, we feel there is simply too much emphasis placed on assets that have an uncertain future for 2010. If slot machine demand remains stable or drops, if high-end fitness club membership sales ease and if demand for investment management and advice services drop, the firms above could be easily and negatively impacted. There simply seems to be too much emphasis on service-based assets here.

However, there is no disputing the performance of the Buffalo Small Cap Growth fund. This fund has an extensive history for shooting past its competitors in terms of returns and safe performance.

Depending on an investor’s Asset Allocation Model, we would limit exposure to this fund to 1/3 or less of the specialty equity class.

A little more than 3 months ago, the Mutual Fund Site provided a couple of firm recommendations on where mutual funds investors should invest their money. As far as we were concerned, these were exactly where to invest, even though our gut told us at the time that then-current market conditions made such a task rather difficult.

Those two funds were the Janus High Yield Fund as part of our Income Class recommendation and the Ivy Small Cap Value Fund as part of our Growth Asset Class.

To date, the Janus High Yield Fund has returned 4.37% YTD, a reasonably good return given all of the speculation and doubt surrounding the Income asset class these days. Are we satisfied with this return? With the performance?

Yes, indeed we are. The fund remains under the management of Gibson Smith and has stuck to its mandate. It remains invested primarily in mid-term, below investment-grade bonds (the average yield is a touch over 10%) and, well, provides investors with a positive rate of return. This is no easy task since, as we all expected, interest rates are on the move.

Our other fund, the Ivy Small Cap Value Fund, has returned 13.39% YTD. Some of the reasons this fund has performed so well could have something to do with Ivy’s overweightedness in financial services. However, we are not overly concerned that this fund is at risk the way most individual investors and some other funds are. The reason is simple: Ivy has invested in medium and small cap financial services firms. Dividend yield are strong (they would make GE and other financial firms look cheaper and greedier than they are) and many of the underlying assets have yet to enjoy the gains that the rest of the sector has thoroughly enjoyed recently.

Would we change anything?

No, not at this point. Both funds remain healthily below average in terms of the risk profiles versus their peers. And both have returned more to investor than anyone else would have expected at the start of the year (we even found some interesting trash talk on another, nameless website). Which bring us to the rest of the year…

We expect the Janus fund to handle the obstacles ahead with relative ease. They have performed well to date, but the challenges will keep Gibson busy.

We also believe that the Ivy Small Cap Value fund will face challenges, particularly when so many individual investors who have poured their money into these big bank stocks realize that the fundamentals are not there to support those price run-ups. However, the fact remains that the companies in which the Ivy fund has invested remain profitable and well capitalized with continued improvements to their equity positions through retained earnings. Overall, both funds are not only where to invest your money, but will continue to see some strong returns throughout the year.

When we look at the recent popularity of bank stocks, it is evident that a lot of people will get burned. The recent run up has resulted in higher volatility, which means that just as quickly as things have risen, they will drop. And up until the point that the prices really start to head south, someone will keep buying up these “popular” bank stocks. Everyone except the mutual funds who, for the most part, know better that to get sucked into the popular investment strategy when things rise, they will only keep rising.

Taking a contrarian investment approach like those we discussed elsewhere on this site might help.

Or it might not. After all, financial services firms remain relatively unpopular unless we are talking specifically about the “big banks,” the same stocks and companies that burned people in the past. But not all financial services firms are created equally. People who want to know where to invest their money might do well to examine the smaller firms, like those where Ivy Small Cap Value fund invests.

After all, our recommended Ivy Small Cap Value Fund has rewarded investors with a 13.39% return YTD.

Evidently, the folks at Ivy are doing something right, yet in their top 25 holdings you will not find any Citigroup, AIG, Fannie/Freddie, et al. holdings. Not a single one of them. In fact, they invest a large chunk of their assets in Small-cap stocks… not large, not Giant. (To a lesser extent, they invest in Medium cap securities, but as a small cap focused fund, they are pretty keen on sticking to their small-cap guns.

Given that less than 4 months of the year have passed, a 13.39% return (as at April 9, 2010) is pretty respectable. They know where to invest, no doubt about that, especially when it comes to investing in financial services firms. So, for those investors who have enjoyed the volatility rise and continue to pour money into some of these unsupported (fundamentally anyway) financial services firms, don’t let yourself get burned. Invest in a mutual fund that pays the pros to put your money where it belongs — in the right firms.

An interesting philosophy exists, whether you invest in mutual funds or straight equities, that suggests we can all know where to invest if we go against the current rather than with it. In other words, if we adopt a contrarian mentality, we stand see some sold long-term gains in our portfolios. As an investment strategy, this is not always an easy thing to do. When you get into picking the best mutual funds, it becomes even tougher. (And of course if we are short-term traders, then it becomes virtually impossible).

So, where to invest…

Common sense and history tell us that if we all invest in a single asset, we drive the price of that asset up. Look at Oil in 2007. Look at Gold today. Look Apple shares. But the risk you run when you follow the herd is that you end up buying that asset somewhere near the peak of its price range, exposing your portfolio and investment to some serious and very real risks. For these reasons, we often try to find that diamond in the rough, that undiscovered security that is trading at a terribly low valuation — look at RIMM seven years ago, for instance, Teck Resources (TCK) even 1 year ago. Again, with the power of hindsight, we would all be retired by now, and we would all be millionaires.

With this “find the diamond in the rough” mentality, a couple of things can happen. One, we take on exaggerated risks because the assets we buy are simply cheap; they lack the fundamentals to support investing in them at all. The second thing that happens is that we hit a grand slam, we pick the right security at the right time when everyone else threw money at the latest and greatest Wall Street gem. The latter, of course, is an example of Contrarianism and this is exactly how we should invest, according to some.

What is Contrarianism?

This type of investment practice can mean a different things for different investors. The obvious interpretation is to sell when and what others are buying, and vice versa. It speaks to Warren Buffett’s famous quote: “Sell when others are greedy and buy when others are fearful” (not an exact quote, but the message is bang-on).

On a deeper level, it involves going in areas that others are ignoring. It means buying Citigroup (C) when it was trading at $1.02 and everyone else was not only ignoring it, but buying bonds at ridiculously low rates. It also means believing in the company’s fundamentals, trusting that the Board is doing the right thing by appointing Vikram Pandit after Charles Prince resigned (of course, each company will be different, the names will change but, in Bon Jovi’s words, the streets are the same).

It is in my opinion that this second type of Contrarian investment practice is the one we want to adopt as amateur, novice and even intermediate investors. Not only is it less risky (e.g. ignoring a strong asset class altogether and dumping money into unfavored classes even when fundamentals do not support it), but we can actually apply this practice to mutual funds purchases.

Now, understand that great websites like Morningstar have built tremendous intellectual capital, websites, and businesses doing exactly the opposite. That is to say that their models often favor top-performing funds where regular investors are flocking (this website’s Top Picks are great funds that Morningstar has ranked well, also). And other sites like FundAlarm also takes this view, ranking funds as “dangerous” if they fail to meet or exceed their group or category for three measurement periods.

But Contrarianism takes a different view. Often, the mutual funds you should invest in under this theory are those with net redemption figures, which are often triggered by poor performance track records that gets noticed by those two websites mentioned in the previous paragraph. Some Small Cap Funds like the Ivy fund (YTD return of 9.74%) we like, for example, invest heavily in small to medium cap financial services firms. Investing in this Ivy fund could certainly be considered a contrarian move; investing, on the other hand in the High Yield Investment fund that we recommend (YTD return of 3.80%), would not have been.

While both funds above are in completely different asset classes, they have both outperformed their peers, which leads to a natural question: do Contrarian Investment Practices really work?

The simple answer is: yes they do, especially with mutual funds.

(More to follow… check back soon as we take a deeper look into this interesting investment strategy and provide a tangible foundation to our argument).

It may seems obvious to some and it is definitely obvious once it is pointed out to investors, but where to invest in periods of economic expansion is definitely not in typical bond portfolios. Instead, value funds or mutual funds with a good blend of value and growth securities would be the most logical place to start. As an investment strategy, this is not an art or a learned skill; it simply makes sense once the description of an economic expansion is properly understood.

So what is an economic expansion?

According to Smart Money, which published a great article about the Yield Curve, and economic expansion typically occurs immediately after a recession. Now, we have to be careful about how we define a recession. Yes, it means for tough economic times and periods of cutting back and sacrifices. But economically, a recession is different than what people like you and I experience. Instead, a recession is categories by certain economic statistics, including among other things, several periods of consecutive negative growth. Once that trend is broken and other economic statistics line up, that recession is over. And strange things start to happen.

Like what?

For starters, yields on treasuries and bonds steepen. This means that the rate on a 3 month treasury bill more than 3% lower than the rate charged on a 30-year treasury bond. As of today (March 15, 2010, that spread is more like 4.47%), this certainly holds true according to data on bloomberg.com. And if the Yield Curve is at all accurate in everything it has suggested since the late 1970’s, then we are in a period where the economy is expected to start growing quickly in the near future.

What does that tell us about where to invest!

Before we get to that, consider what it tells us about where not to invest. Obviously, when rates are expected to increase (everything we hear today combined with the yield curve tell us as much), bonds are out of the question. This means lightening up on income-class securities and moving money into equity based securities.

But does that mean growth funds or value funds (or a blend of both).

At the Mutual Fund Site, we have suggested that some small cap funds are actually no brainers. We outline the reasons why in some detail, but let’s look at the most fundamental reasons why some small caps are a good starting point:

• Value. Yes, we said it. Small caps offer tremendous value right now. Why? Because they were beaten down the credit crisis of 2007 dragged through 2008 and into 2009. The fear was that small cap stocks would disappear off the face of the earth once they could not fund their operations through credit or they went broke trying to make payments on higher-rate capital. In many cases, this did not happen and the survivors stand to benefit. In our case, we like regional financial institutions because they have government stimulus and people’s returning to work (okay, in some cases where employment is over 20% like in some areas of California, this seems like a stretch, but things will improve even in these highly unemployed areas) on their side. Plus, many of these companies have been very profitable during the last few years… even with the world crumbling around them!
• Small caps are one of the first segments to record steeper profit growth. This could be a numbers game in some cases, but it could also be the result of smaller companies willing to take the risks that larger corporations are unable to take. Blame it on smaller boards, less restrictive financial covenants, etc., but smaller cap companies take risks where larger companies simply will not… and this often bodes well for them.
• Lastly, small cap securities are one of the first to experience a “pop” in security price when recessions are over. Look at Citigroup as an obvious example (although you cannot say they are small cap, their story is quite well known). When it became clear that they would survive after all, its share price popped on the news alone. All they had to say was they were going to survive! Imagine a company that had numbers to back this up! Small caps have those numbers.

Does that mean we recommend small cap stocks? If small cap stocks are where to invest, what does that say about less risky alternatives?

Well, we believe that value funds are where to invest. Because even larger cap securities (and many mutual funds hold them) offer tremendous value, even in today’s market. And this is where investors should be — in value funds or funds that invest in such securities. Is it too late? No, not if we believe what the yield curve is telling us. I mean, look at GE, one of the world’s largest and most-diversified conglomerates. In 2008, its stock price touched below $6.00. Talk about extreme value… now it trade at nearly $16 and it still has inherent value.

Of course, we advise clients to be careful when they look at value funds and make sure they are investing in something that meets their investment needs and risk tolerance.

One of the reasons we like the Ivy Small Cap Value fund so much that we named it as one of our top mutual fund picks for 2010 is that it invests heavily in the right kind of financial services firms. The kind that have great value, even if they are consider small cap stocks or mid-cap stocks. We feel that as an investment strategy, these types of securities will allow the Ivy fund to not only outperform in pure growth areas but with its generous dividend it will also generate some decent income.

One of our reasons for liking the Ivy fund is that its underlying securities stand to benefit handsomely from a housing recovery, something we have already started to see according to a recent post over at Reuters about Homebuilder Confidence.

So why Ivy Small Cap Value and not something like the Fidelity Real Estate Income fund? After all, some of these real estate funds produce fairly substantial gains and income — Fidelity’s sure is one of them with a nice 4.8% yield and high returns compared to its peers, along with its “low” risk rating. But comparing Fidelity’s fund to Ivy’s is not a proper comparison. You cannot compare the two.

You cannot compare a real estate income fund to a small cap value fund.

For starters, funds like Fidelity’s are part of the income class. They invest in income-producing securities with roughly 50% of their total holdings in bonds. Of the 20% they hold in  stock, guess what 91% consists of? (Hint, we talk about about them a lot and suggest the difference between “good” and “bad” financial services firms to hold. Somewhat surprisingly, they seem to be holding the “bad” ones).

In comparison, the Ivy fund is equity driven. They have a purpose, with roughly 40% of their portfolio invested in the type of securities that will benefit from the same recovery from which a pure real estate fund (equity based) should.

So while the Fidelity Real Estate Income fund exists to produce income, Ivy Small Cap Value exists to generate long-term gains with income being a nice bonus. For people who are bullish on real estate, Ivy still makes better sense as an equity play because it stands to profit from the recovery. For the Fidelity fund to remain attractive, rates would have to continue dropping, which is still possible given how fixed mortgage rates continue to drop).

Ivy, however, does not need a housing recovery to remain a top-performing small cap stock fund. Why? Because the majority of its securities are already profitable. Remember, there is a difference between good and bad financial stocks; Ivy knows the difference because they hold the good ones. And those firms will only see their revenues increase when housing makes its come-back.This of course is one of the benefits to holding small cap stocks in a portfolio in the first place.

Would we recommend the Fidelity fund as an income play? Not now (besides, we prefer the Janus High Yield Fund as our preferred income fund for the year. Does that mean the Fidelity Real Estate Income fund is a bad one? Definitely not; it just does not make much sense as an investment strategy right now. And we feel our statement is fully backed up by the yield curve.