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.

He also likes Deckers Outdoor ( DECK), maker of UGG boots. Barringer says the company showed healthy growth in the last quarter and raised its guidance. The company should continue growing as it expands into international markets.

Another steady fund is Janus Triton ( JGMAX), which has returned 9.2% annually during the past five years, outdoing 99% of its small growth competitors. The Janus portfolio managers look for companies that can consistently grow at double-digit rates. The aim is to buy strong growers and hold them for three to five years. "We want to find small companies with 5% market shares that can grow to be mid-caps with 20% shares," says portfolio manager Chad Meade.

Meade looks for companies with advantages that will enable the businesses to grow even during times when most competitors stagnate. A favorite holding is CoStar Group ( CSGP), which provides data on commercial real estate to brokers and property owners. While its customers are still struggling, CoStar is taking market share by supplying information on sales prices that is not available elsewhere. "They have just begun to penetrate their markets," says Meade. "CoStar will show exciting growth as commercial real estate recovers."

Another holding is SBA Communications ( SBAC), which provides the towers that are used by wireless phone companies. Companies, such as AT&T ( T) and Verizon ( VZ), pay rent to SBA for use of the towers. Demand is growing as data traffic increases rapidly. Meade says that revenues are very predictable because companies must sign long-term contracts, and prices increase every year.

Meade also likes Transdigm Group ( TDG), which makes parts for aircraft. Since airplanes must constantly replace parts, Transdigm can increase sales even during periods when airlines are struggling. Because it dominates a niche, the company can push through price increases. "During the recession, Boeing's ( BA) profits were down, but Transdigm sailed through," says Meade.


Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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