Small-company growth mutual funds are the most aggressive, broadly based domestic equity funds. Typically, they invest in rapidly growing companies in newer industries. They have a reputation for volatility. But, over the long-term, with the right stocks, their potential can be huge.
Some of these funds are highly concentrated, some widely diversified; some focus on the fastest-growing companies, others on those that are likely to grow more steadily; some buy and sell rapidly, others hold on for the long haul. From all this diversity, Morningstar Inc. recently selected Baron Asset Fund as its top pick among the 69 funds it tracked in this category.
The fund won its spot by being ranked in the top five funds of its type for the past five calendar years for both the highest returns and the lowest risk. In those five years, the fund had a total return of 149 percent, according to Lipper Analytical Services, compared with 104 percent for similar funds.
"We do our own research," portfolio manager Ron Baron explains. "We don't wait for others to tell us what is a great company." Baron sets out to buy what he calls unique, lesser- known or misperceived companies, though only if offered at good prices.
When the fund buys, it has high ambitions: Its goal is to buy stocks with the potential to provide a return of at least 50 percent within two years. It doesn't plan to sell at the end of that time, however; instead, its aim is to go on growing with successful companies. According to Morningstar, the portfolio's annual turnover in the past three years has averaged only 35 percent compared with 115 percent for its peers.
The fund finds that the long holding period provides residual benefits by enabling it to know company management well. And it pays a lot of attention to the quality of those managers. It looks for entrepreneurs who worry about all aspects of their companies' activities. One clue, Baron says, is how the owners relate to employees. "If an executive doesn't treat his employees well, it's not likely those employees will treat the firm's customers well," he says.
But even good managers can't do what Baron Asset wants if they're in a deteriorating environment. Therefore, the fund seeks to ally itself with investments in favorable climates, such as growing health-care, education and financial services markets.
Baron invests relatively little in technology, which is unusual for a small-company growth fund. Baron thinks change in technology is so rapid that investors holding for long periods may find themselves invested in a company and industry so altered, the original advantage has vanished.
The fund also avoids mature industries, many of which are cyclical or fiercely competitive, such as steel, tobacco and railroads. The fund looks for industries in which our children are likely to find jobs and shuns those that employed our parents or grandparents.
Having done its research, the fund is willing to make a large commitment to a smaller number of stocks. At a recent count, 40 percent of its assets were in 10 stocks and 20 percent in just three: Charles Schwab & Co. Inc.; Manor Care Inc., a health-care company; and Choice Hotels International Inc. A portfolio like this can obviously drop sharply, either in a general market decline or if specific companies fail to perform as expected. In 1990, the fund lost 18 percent, for instance. Remember, the low-risk scores noted by Morningstar are reassuring, but the past is not the future.
The best defense for the long term, says Baron, lies in its company selection method, which assesses value as much as growth. So far, the strategy has worked unusually well.