Best And Worst Funds: Small-Cap Growth Style

by: David Trainer

The small-cap growth style ranks ninth out of the twelve fund styles as detailed in my style roadmap. It gets my Dan­ger­ous rat­ing, which is based on aggre­gation of fund rat­ings of 486 small-cap growth funds as of Feb 13th 2012. Arti­cles on all style and sec­tor funds are here.

Fig­ure 1 high­lights the alarm­ing truth that none of the 486 small-cap growth funds are worth buy­ing. They all get a Neutral-or-worse rat­ing. Dig­ging into the qual­ity of the funds' hold­ings shows that 1645 of the 1960 stocks (over 85% of the mar­ket cap) held by small-cap growth funds earn a Neutral-or-worse rat­ing. The take­away is: fund man­agers allo­cate too much cap­i­tal to low-quality stocks.

Investors seek­ing expo­sure to small-cap growth stocks should buy a bas­ket of Attractive-or-better rated stocks and avoid pay­ing unde­served fund fees. Active man­age­ment has a long his­tory of not pay­ing off.

As detailed in "Cheap Funds Dupe Investors", the fund indus­try offers many cheap funds but very few funds with high-quality stocks, or with what I call good port­fo­lio man­age­ment.

Fig­ure 1: Small-cap Growth Style Land­scape For Funds & Stocks

Sources: New Con­structs, LLC and com­pany filings

The 486 small-cap growth funds are very dif­fer­ent. Per Fig­ure 2, the num­ber of hold­ing varies widely (from 26 to 1163), which cre­ates dras­ti­cally dif­fer­ent invest­ment impli­ca­tions and rat­ings. Review my full list of rat­ings along with free reports on all 486 small-cap growth funds.

How do investors pick the fund that will most likely deliver the best future returns?

Fig­ure 2: Funds with Most & Least Hold­ings - Top 5

Sources: New Con­structs, LLC and com­pany filings

To iden­tify the best funds within a given cat­e­gory, investors need a pre­dic­tive rat­ing based on analy­sis of the under­ly­ing qual­ity of stocks in each fund. See Figure 3.

My pre­dic­tive fund rat­ings are based on aggre­gat­ing (1) my stock rat­ings on each of the fund's hold­ings and (2) all of the fund's expenses. Investors should not rely on backward-looking research of past performance.

Fig­ure 3 shows the five best and worst-rated funds for the style. The best funds allo­cate more value to Attractive-or-better-rated stocks than the worst funds and vice versa. The worst stocks offer poor fund man­age­ment and charge high total annual costs. For exam­ple, Bhirud Funds, Inc: Apex Mid Cap Growth Fund's (BMCGX) charges 10.25%, after account­ing for all costs. That is the high­est of all 7400+ funds we cover. For per­spec­tive, BMCGX must out­per­form its ETF bench­mark by 10.3% annu­ally over any hold­ing period to jus­tify its higher costs.

Fig­ure 3: Funds with the Best & Worst Rat­ings - Top 5

* MF des­ig­nates Mutual Funds and ETF des­ig­nates Exchange-Traded Funds

Sources: New Con­structs, LLC and com­pany filings

My top-rated small-cap growth fund is Vir­tus Equity Trust: Vir­tus Small-Cap Core Fund (MUTF:PKSFX), which gets my Neu­tral rat­ing. One of its largest hold­ings and part of the 36% allo­cated to Attractive-or-better stocks is Copart Inc. (NASDAQ:CPRT). This small-cap stock might not be small much longer. With an ROIC of 17% and eco­nomic earn­ings grow­ing faster than account­ing earn­ings (24% vs 10%) in 2011, this busi­ness is gen­er­at­ing big-time cash for share­hold­ers. Car auc­tions are mean­ing­fully more prof­itable and scal­able oper­a­tions with recent tech­no­log­i­cal advances, and Copart is build­ing a very strong foot­print that could enable it to grow faster and for longer than its competitors.

The val­u­a­tion of the stock assumes the company's growth will hit a brick wall in two years. At ~$46.47/share, the cur­rent val­u­a­tion implies just two years of after-tax cash flow (NOPAT) growth at 7.5%.

My worst-rated small-cap growth fund is Bhirud Funds, Inc: Apex Mid Cap Growth Fund (BMCGX), which gets my Very Dan­ger­ous rat­ing. This fund is a dou­ble loser. Its hold­ings get a Dan­ger­ous rat­ing and its costs get a Very Dan­ger­ous rat­ing. As noted above, BMCGX has the high­est all-in costs of any of the 7400+ funds we cover (10.3%). Ouch.

One of its largest hold­ings and part of the 54% allo­cated to Dangerous-or-worse stocks is TiVo Inc. (NASDAQ:TIVO), which gets my Dan­ger­ous rat­ing. I have used a Tivo DVR for over a decade, and I love it. How­ever, their busi­ness model is in real trou­ble. Legal expenses incurred to pro­tect their patents are killing the busi­ness. I do not think they will be able to pre­vent other firms from sell­ing per­fectly func­tional DVRs with­out pay­ing them roy­al­ties. The company's 2011 ROIC is -117%. It is far from turn­ing a profit.

Yet, the val­u­a­tion of the stock seems obliv­i­ous to its unprof­itable ways. At ~$12/share, the cur­rent val­u­a­tion implies the com­pany will grow its rev­enues at 50% com­pounded annu­ally for 12 years while also increas­ing its ROIC from -117% to 20%. There are too many other stocks in the mar­ket with lower expec­ta­tions and bet­ter busi­nesses to take the risk in own­ing this stock.

Investors should avoid all small-cap growth funds since all 486 earn a Neutral-or-worse rat­ing and are not worth buy­ing. Fig­ure 4 shows the rat­ing land­scape of all small-cap growth ETFs and mutual funds. Our style roadmap report ranks all styles and high­lights those that offer the best investments.

Fig­ure 4: Sep­a­rat­ing the Best Funds From the Worst Funds

Sources: New Con­structs, LLC and com­pany filings

Fig­ure 5 lists our Pre­dic­tive Fund Rat­ing for the 5 largest and most pop­u­lar small-cap growth funds.

Fig­ure 5: Five Largest Small-cap Growth Funds

* MF des­ig­nates Mutual Funds and ETF des­ig­nates Exchange-Traded Funds

* Analy­sis uses the top-ranked class for each fund

Sources: New Con­structs, LLC and com­pany filings

Review my full list of rat­ings and rank­ings along with free reports on all 486 small-cap growth funds at

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.