NEW YORK With little attention from Wall Street analysts and more than 2,000 companies to choose from, the vast universe of small caps can overwhelm investors looking for the next big thing.
The surging stock market offers little help. In a year when the Russell 2000 index of small-cap stocks is already up nearly 10 percent, portfolio managers are facing one of the few downsides of a stock market rally: how to find stocks that will still look good two or three years from now, no matter market conditions.
Portfolio managers with a small-cap focus who are winners of 2013 U.S. Lipper Fund Awards stick to a clear investment philosophy. The strategies of this year's award winners range from a focus on niche companies to one emphasizing executive turnovers or other major changes.
The funds have been recognized for delivering consistent performance during the three-year period ending November 2012.
Here is how three Lipper award winning funds are playing the small-cap world in 2013.
In a conference room in Memphis, Tennessee, the five members of the investment team behind the Southern Sun Small-Cap Fund spend most of their time finding reasons not to buy stocks.
Any small-cap company added to their concentrated portfolio must first meet basic requirements like having a dominant position in a specialty industry, a strong free cash flow and the potential to double its share price over the next three to five years. Even then, the team member who pitches the idea must defend it as if it were a dissertation.
"You end up having to find the answers to questions you never even thought of," said Phillip Cook, who works on the fund alongside his father and company founder, Michael Cook.
As a result, the fund typically adds only a handful of new positions a year, and its managers emphasize meeting with a company's executives to learn more about the business.
Phillip Cook convinced the team to buy Iconix Brand Group, a $1.6 billion market-cap company, to the portfolio in March of last year. The company owns dozens of brands, including Candie's, Mossimo, Rocawear, and Starter, that are sold by retailers such as Wal-Mart Stores and Sears Holding Corp. Iconix ranks behind Walt Disney as the second-largest licensing company in the world.
Cook was attracted to the company's licensing model, which limits its costs, and says the company was undervalued. Since the end of March 2012, its shares are up approximately 33 percent, and Cook says the company has more room to run.
Another niche company, Hill-Rom Holdings, joined Southern Sun's portfolio at the end of July. The $2 billion company manufactures medical equipment like stretchers, hospital beds and slings. The company's shares are up 37 percent since dropping to a low of $25.30 on August 2, and have risen 21 percent in 2013 alone.
The Southern Sun Small Cap fund gained an annualized 25.3 percent over the three years ended November 30, 2012, compared with an average gain of 13 percent for small-cap core funds.
Mark Foster, a portfolio manager of the $58 million Kirr Marbach Partners Value Fund, which won a Lipper Award for multi-cap core funds, keeps about 30 percent of his portfolio in small-cap stocks. Foster each week screens for companies announcing management changes, reorganizations or spin-offs. He then evaluates each company using traditional valuation measures like price to earnings.
Foster recently began buying shares of Arris Group, a $1.9 billion company that makes specialty equipment that allows cable operators to carry more data and have faster speeds on their broadband networks. On December 19, the company announced a $2.3 billion deal to purchase Google's Motorola Home business.
"We think that this is a misunderstood business," Foster said, noting that a new generation of cable boxes will lead companies and consumers to update their devices.
Foster has a price target of $26 per share, nearly a 50 percent premium to its current price of $17.81, based on his expectation that the company will earn $2.15 per share this year and trade at a multiple of 12.
The Kirr Marbach fund returned an annualized 19.7 percent over the three years ended November 30, 2012, compared with an average gain of 9.89 percent among multi-cap core funds.
Bruce Aranow, a portfolio manager of the $1.1 billion AllianceBernstein Small-Cap Growth fund, focuses on companies that are growing faster than Wall Street expects.
"We can identify really well-run small companies that are on their way to becoming mid and large companies. The ones that get there faster than people expect are the ones that we make the most money on," Aranow said.
As a result, Aranow often sells companies that report flat or negative quarters, leading to an average turnover of 88 percent in his portfolio of about 100 companies.
But averages can be deceiving, Aranow said, citing a position in Kirby Corp, a $4.3 billion inland barge company that the fund has held for more than a decade. Aranow recently added to his position in CoStar Group Inc, a $2.7 billion market-cap company that provides data to the commercial real estate industry. "This is an incredibly defensible business," Aranow said, noting that it will continue to improve as the real estate market rebounds.
He's also added to his stake in Lumber Liquidators Holdings, a $1.7 billion market-cap company whose 43 percent earnings per share growth are roughly double that of competitor Lowe's.
But his team is ready to sell should the rate of earnings growth slow, he said. ""There's rarely a one-quarter problem in the small-cap growth world, and mean reversion can be very powerful," he said.
Aranow's fund returned an annualized 21.5 percent over the three years through November 30, compared with an average of 14.2 percent among small-cap growth funds over the same time.
(Reporting By David Randall. Editing by Lauren Young and Steve Orlofsky)