Time to Bet on Small-Company Growth Stocks?

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Feb. 8, 2012, 12:01 a.m. EST

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By Robert Powell, MarketWatch

BOSTON (MarketWatch) "� It's beginning to look as if it might be time to make a big bet on small-company growth stocks.

Yes, the economy is starting to show signs of improvement and, as most investors know, that's usually a good time to consider overweighting one's portfolio with stocks likely to benefit the most from an expansion.

To be sure, small-company growth stocks are already on the rise. In fact, small company growth stocks are already fifth-best performing fund category among domestic stocks funds this year, rising nearly 12% through Feb. 3, according to Morningstar.

But analysts say it's not too late to take advantage of what could be a long-term investment trend. "The macroeconomic trends are going the right way, and generally higher beta stocks, small-company growth stocks, do well when macro-economic conditions improve,"? said Janet Yang, a CFA charterholder and analyst with Morningstar.

Plus, if you are a reversion-to-the mean investor, this could be a good time to be in small company growth stocks whether or not the economy is expanding.

According to Yang, there are at least two that carry Morningstar's gold rating worth considering: The Morgan Stanley Focus Growth fund /quotes/zigman/224947 AMOAX +0.16% , which is a "high-conviction"? version of its large-cap sibling, the Morgan Stanley Institutional Growth fund /quotes/zigman/200449 MSEQX +0.19%  , and the Brown Capital Management Small Company Institutional fund /quotes/zigman/7732398 BCSSX -0.23%  .

The Morgan Stanley Focus Growth fund, which is managed by a team led by Dennis Lynch, tends to invest in established brand-name companies with a competitive advantage as well as firms that offer hard-to-replicate products and services, Yang said.

For example, many of the top 10 holdings in the $1 billion in assets fund were household names such as Amazon.com /quotes/zigman/63011/quotes/nls/amzn AMZN +0.86% , Apple /quotes/zigman/68270/quotes/nls/aapl AAPL +1.18% , Google /quotes/zigman/93888/quotes/nls/goog GOOG +0.44% , Mead Johnson Nutrition Co. /quotes/zigman/526383/quotes/nls/mjn MJN -0.59% , and Monsanto Co. /quotes/zigman/267799/quotes/nls/mon MON -0.95% . But the fund also holds some non-household names as well, including Baidu Inc. /quotes/zigman/97715/quotes/nls/bidu BIDU +0.92% , Motorola Solutions Inc. /quotes/zigman/3019739/quotes/nls/msi MSI -0.43% , Brookfield Asset Management Inc. /quotes/zigman/35346/quotes/nls/bam BAM -1.12%  , and Edenred /quotes/zigman/2807899 EDNMF +1.03% . And last but not least, the fund was holding some non-publicly traded securities, including Facebook, Inc. Class B, and Intuitive Surgical.

So far this year, the fund is up more than 11% "� about four percentage points better than Russell 1000 Growth index, which tracks large-cap growth stocks, and on par with the Russell 2000 Growth index, the small-cap growth index. A word of caution: Investing in this fund isn't for everyone. Investing in this fund could be a bit like riding a roller coaster: In 2008, the fund fell 53% and then rose 73% in 2009.

Meanwhile, managers of the Brown Capital Management Small Company Growth fund /quotes/zigman/8001202 BCSIX -0.25% , which is up more than 12% year-to-date, tend to invest in high quality vs. high-flyer stocks. Plus, the fund's management team, which is led by Keith Lee, tends to take a long-term view of the stocks they hold, as evidenced by the fund's low turnover ratio. The category's average is about 85% while this fund's turnover ratio is just 7%.

According to Yang, the portfolio management team looks for firms with annual revenues of $250 million or less. And that mandate largely points the managers toward micro-cap stocks, according to her report on the fund.

To wit: CARBO Ceramics Inc. /quotes/zigman/160292/quotes/nls/crr CRR -5.92% , Abaxis Inc. /quotes/zigman/68511/quotes/nls/abax ABAX -1.80% , Diodes Inc. /quotes/zigman/71078/quotes/nls/diod DIOD +0.53% , Balchem Corp. /quotes/zigman/68855/quotes/nls/bcpc BCPC -1.55% , Gen-Probe Inc. /quotes/zigman/88003/quotes/nls/gpro GPRO +0.16% , Blackbaud Inc. /quotes/zigman/92153/quotes/nls/blkb BLKB -0.65% , Tyler Technologies Inc. /quotes/zigman/203663/quotes/nls/tyl TYL +1.18% , FEI Co. /quotes/zigman/58676/quotes/nls/feic FEIC -0.81% , and Cognex Corp. /quotes/zigman/70115/quotes/nls/cgnx CGNX -1.06% , were among the fund's top 10 holdings as of Dec. 31, 2011.

Meanwhile, Kevin W. Gamble, a CFA charterholder who manages a small-cap equity portfolio for the Retirement Systems of Alabama, says it would be wise to exercise "some caution"? toward the small-cap growth group, especially after a four-month rally in the equity market.

"That being said, the mergers and acquisitions backdrop has never been better for selected small-cap growth stocks in the technology space in particular, as many large-cap technology companies continue to struggle with a lack of organic growth, can borrow easily at historically low levels of interest, have excess cash on their balance sheets and are currently building upon this excess cash every quarter,"? said Gamble, who is also immediate past president of the CFA Society of Alabama. "Many are hesitant to admit they are mature companies and thus don't want to pay out a higher level of dividend yield, so the logical conclusion is that mergers and acquisitions will pick up in a big way as we move through 2012."?

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