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The small-cap value style ranks last 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 327 small-cap value funds as of Feb 15th, 2012. My 25 arti­cles on the Best & Worst Funds in each sec­tor and style are here.

Fig­ure 1 high­lights that 91% of small-cap value funds earn a Dangerous-or-worse rat­ing and should be sold. These poor rat­ings are dri­ven by poor qual­ity hold­ings. 1899 of the 2258 stocks (over 79% of the mar­ket cap) held by small-cap value 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 value 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 Value Style Land­scape For Funds & Stocks


Sources: New Con­structs, LLC and com­pany filings

The 327 small-cap value funds are very dif­fer­ent. Per Fig­ure 2, the num­ber of hold­ing varies widely (from 23 to 1660), which cre­ates dras­ti­cally dif­fer­ent invest­ment impli­ca­tions and rat­ings. Review my full list of rat­ings along with free reports on all 327 small-cap value 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 funds offer poor port­fo­lio man­age­ment and charge high total annual 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 value fund is Royce Fund: Royce Spe­cial Equity Fund (RSEIX), which gets my Neu­tral rat­ing. One of its largest hold­ings and part of the 45% allo­cated to Attractive-or-better stocks is AVX Cor­po­ra­tion (NYSE:AVX), which gets my Very Attrac­tive rating.

I'm bull­ish on the Tech sec­tor and AVX is one of the best stocks in the sec­tor. As a man­u­fac­turer of prod­ucts that store and reg­u­late energy for elec­tronic devices, there will con­tinue to be plenty of demand for AVX prod­ucts. The com­pany has a pos­i­tive and ris­ing ROIC over the past 3 years with a 2010 ROIC of 21%, which earns a top-quintile rank. With a strong busi­ness model and strong demand, the com­pany is well posi­tioned to con­tinue to grow eco­nomic earn­ings.

But the stock's val­u­a­tion sug­gests the oppo­site. At ~$13.46/share, the cur­rent val­u­a­tion implies its after-tax cash flows (NOPAT) will per­ma­nently decrease by 50%. The no-growth value of the stock is over $28/share. Nice com­bi­na­tion of low risk and high poten­tial reward.

My worst-rated small-cap value fund is Ivy Funds: Ivy Small Cap Value Fund (IYSBX), which gets my Very Dan­ger­ous rat­ing. One of its largest hold­ings and part of the 32% allo­cated to Dangerous-or-worse stocks is Tri­umph Group Inc. (NYSE:TGI), which gets my Very Dan­ger­ous rat­ing. Aero­space is not exactly a high-growth indus­try. Its is dom­i­nated by a few large com­peti­tors who must con­stantly wran­gle with heavy reg­u­la­tion. I don't see this chang­ing any time soon unless a moon base becomes reality.

Triumph's prof­itabil­ity, when you dig beneath the reported account­ing results, reflects the chal­leng­ing nature of the indus­try. First, my model shows TGI's account­ing earn­ings are mis­lead­ing, which means the com­pany reports pos­i­tive and increas­ing EPS while its eco­nom­ics earn­ings are actu­ally neg­a­tive and decreas­ing. Investors reliant on the P/E and EPS val­u­a­tion mind­set may view TGI as an attrac­tive com­pany, but I can assure you, they are wrong. The com­pany earns a mea­ger 7% ROIC on its 3.2 bil­lion of invested cap­i­tal.

To jus­tify its val­u­a­tion, the stock at $63 implies the com­pany will grow its prof­its at 10% com­pounded annu­ally for 15 years. Good luck. The com­bi­na­tion of mis­lead­ing earn­ings and expen­sive val­u­a­tion make this stock very dangerous.

Investors need to avoid all small-cap value funds, as none are not worth buy­ing. In fact, over 91% of the small-cap funds earn a Dangerous-or-worse rat­ing and should be sold. Fig­ure 4 shows the rat­ing land­scape of all small-cap value 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 value funds.

Fig­ure 5: Five Largest Small-cap Value 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 327 small-cap value funds.

Source: Best And Worst Funds: Small-Cap Value Style