NEW YORK ( TheStreet) -- Small growth stocks have been leading the markets lately. During the past year, small growth funds returned 31.2%, outpacing the S&P 500 by 10 percentage points. At a time when the economy is sluggish, many investors may continue favoring the limited number of companies that can show rapid earnings increases.
But before you write a check to a hot fund, keep in mind that small stocks are no longer cheap. The average small growth fund has a price-to-earnings ratio of 23.8, according to Morningstar. That is a big premium compared to the S&P 500, which has a multiple of 16. In addition, small growth funds can be volatile. If the market drops, small stocks could fall a long way.
To limit risk, consider some top small growth funds that deliver relatively steady results. By holding cash or focusing on quality companies, these funds outperformed their peers when markets collapsed in 2008. Top choices include Kalmar Growth-With-Value Small Cap (KGSCX), Needham Small Cap Growth (NESGX) and Oppenheimer Discovery (OPOCX).
Needham has been especially steady. While the average small growth fund dropped 41.6% in 2008, Needham lost 23.4% and outdid 99% of its peers. During the past five years, the fund returned 9.1% annually, surpassing 92% of peers. To limit losses, Needham portfolio manager Chris Retzler sometimes holds cash or sells short. During 2008, the fund had as much as 45% of assets in cash.Retzler likes solid companies that seem likely to grow faster than Wall Street expects. He favors companies with little debt and the ability to survive hard times. The fund rarely holds financial companies because they tend to have big debt burdens. The portfolio includes many technology companies that have big cash holdings on their balance sheets. Retzler favors stocks that are unloved by the market. He often takes turnaround candidates, companies that have struggled but now seem ready to report stronger results. A holding is FormFactor (FORM - Get Report), a troubled maker of equipment that is used to test semiconductors. After dissatisfied customers cut orders, the company began reporting losses. But new management has taken over and introduced new products. "They are regaining customers," says Retzler. "It will take 12 months before the story looks positive, but we are long-term investors."