Small-Cap Funds for the Recovery

NEW YORK (TheStreet) -- Small-cap growth funds have been on a tear this year, returning 16.0% and outpacing the S&P 500 by 7 percentage points, according to Morningstar. More good news could be on the way. Small stocks typically outdo large ones during the three years following a recession. That happened in recoveries that began in 1982, 1991 and 2001.

Small-cap stocks excel in rebounds because as the economy recovers, investors often gain confidence and place bets on second-tier businesses, which are considered relatively risky. But make no mistake, small stocks can be volatile. During the downturn of 2008, the average small-cap growth fund lost 41.6%, trailing the S&P 500 by 4 percentage points.

These days there is a special need to proceed with caution because small-cap stocks no longer look cheap. Small-cap growth funds have an average price-to-earnings ratio of 20, a full valuation at a time when large-cap growth funds have a P/E of 17.5.

To bet on a continuing recovery, consider some of the steadiest small-cap growth funds. These top funds excelled during the downturn, and they offer a cautious way to participate in a sector that can take investors on rough rides. A low-risk choice is FBR Small Cap(FBRYX). During 2008, the fund proved relatively resilient, outdoing 99% of competitors and topping the category average by 14 percentage points.

Portfolio manager Robert Barringer controls risk by emphasizing companies with little or no debt and fat profit margins. He prefers companies that can grow steadily year after year. As a result, the portfolio tends to be overweight cash-rich technology and service businesses and light on cyclical energy and industrial companies. "We avoid cyclical companies with heavy debt," says Barringer. "That has helped us in downturns."

Barringer steers away from highfliers. Instead, he prefers solid companies that have fallen out of favor. Top holdings include teen fashion retailers American Eagle Outfitters(AEO) and Aeropostale(ARO). Both companies have sizable cash stakes and no debt, but the stocks have been under a cloud since the recession began. "Everyone is afraid that the slow economy will hurt consumer sales, but these companies will keep growing," says Barringer.