(PUB) Morningstar FundInvestor

October 2013

Morningstar FundInvestor

11

Small Growth Packs Risk After Rally Red Flags | Laura Lallos

Rank the small-cap growth category in the Morning- star 500 by P/E, and it’s the same story: The next four on the list— Artisan Small Cap Investor ARTSX , Buffalo Small Cap BUFSX , Loomis Sayles Small Cap Growth LCGRX , and Conestoga Small Cap CCASX —have P/Es of 29 or higher. They also have tech stakes greater than a fourth of assets and are up more than 30% for the year. While this rally is a broad one and each portfolio is distinctive, Medi- data Solutions pops up in several of these funds, as does Angie’s List. High P/Es aren’t necessarily a sell signal. Four of the five are Morningstar Medalists, which means Morn- ingstar analysts believe they are likely to outperform over the long run. (Loomis Sayles Small Cap Growth has not been rated.) What’s more, none of them has been riskier than the average small-growth fund, and Conestoga Small Cap has low risk ratings. That fund’s managers and the Brown Capital Management team follow deliberate, low-turnover strategies. (Turnover for both was around 15% at last count, compared with more than 40% for the category.) It’s also worth noting that the top-performing Morn- ingstar 500 small-growth fund, William Blair Small Cap Growth WBSNX (up 42 . 1% ), has a relatively small tech stake and a P/E of 24 . That fund, however, also has above-average risk ratings and suffered steeper losses than the others in 2008 . That said, lofty P/Es are a reminder that for most investors, small-growth funds fit into a relatively small “aggressive” slot in a diversified portfolio. If you have a fund that’s been riding the small-cap Internet rally this year, it’s time to revisit your risk tolerance and perhaps rebalance your portfolio. œ Contact Laura Lallos at laura.lallos@morningstar.com

The small-cap growth category has had a fantastic run so far in 2013 . Averaging a 30 . 4% return through Sept. 30 , it is the top-performing diversified-domestic category by a mile. In second place, the small-blend category is trailing well behind with a 23 . 8% return. (Meanwhile, large-cap funds are averaging around 20 . 0% .) Fueling these returns are high-flying small- cap technology names such as Angie’s List ANGI (up 87 . 6 % ) and Zillow Z (up 203 . 8 % ). Jeff Cardon, manager of the Gold-rated Wasatch Small Cap Growth WAAEX , told us in late August: “Such companies are valuation-stretched. It’s not an Internet bubble, but it is pretty close.” While Cardon is a low-turnover manager who buys stocks and hopes to hold them for five years, he has been trim- ming picks added earlier this year. His fund is also trailing most of the rest for the year to date, with an 24 . 3% return. (That’s not cause for concern: The fund sometimes lags in rallies, but Cardon has pro- duced one of the best records in the category during his tenure of more than 25 years, and the fund is notable for its low Morningstar Risk ratings.) Not surprisingly, the top-performing funds in the cate- gory this year tend to have healthy slugs of tech- nology and correspondingly high price/earnings ratios. (The P/E ratios mentioned here are based on trailing 12 -month earnings.) In August’s cover story on various risk exposures in the Morningstar 500 , we mentioned Brown Capital Management Small Company BCSIX as an example of price risk. Indeed, that fund’s P/E of 33 is the highest in the small-growth category, which averages a P/E of 22 . At the end of August, the fund had more than 60% of assets in tech stocks; its top position was cloud service provider Medi- data Solutions MDSO , up 152 . 5% through Sept. 30 . It was also one of the top-performing small-growth funds, with a 38 . 1% return.

What is Red Flags? Red Flags is designed to alert you to funds’ hidden risks. Such risks can take many forms, including asset bloat, the depar- ture of a solid manager, or a focus on an overhyped asset class. Not every fund featured in Red Flags is a sell, and in fact, some are good long-term hold- ings. But investors should be prepared for a potentially bum- pier ride in the near future.