High-Flying Fund More Than Doubles in 'Lost Decade' for Stocks

BOSTON ( TheStreet) -- Patrick Gundlach's Marshall Small-Cap Growth Fund ( MRSCX) has more than doubled investors' money in the so-called lost decade of the past 10 years.

And now the mutual fund manager is seeing a divergence in share prices from companies' prospects, leading him to conclude that investors are overreacting in driving stocks into a bear market. By following the fundamentals -- corporate profits have come in above research analysts' projections -- Gundlach says some stocks are getting more attractive the more they decline.

"We haven't made substantial changes to the fund recently because, like a year ago, we aren't seeing evidence of fundamental deterioration of our companies," he says. "We'll stick to our guns and believe we'll be rewarded for that, as we were a year ago, when we were much more likely to be adding to existing positions. While the stocks were acting negatively, we weren't seeing big fundamental changes. There was no evidence of anything substantially negative."

Small-cap stocks, as measured by the Russell 2000 index, have plunged 22% in the past two months. Larger companies, which are perceived to be safer, have fallen a lot less -- the benchmark S&P 500 is down 15%.

During this downturn, the steepest in three years, fund managers have been highlighting the defensive nature of large-cap stocks, with the most notable feature being the outsized, dependable dividends. Gundlach understands why investors would shy away from small-cap stocks these days, though that could become a costly mistake.

"You need a strong stomach for the moves that individual stocks have. The moves many of these stocks have can be pretty substantial," Gundlach says. "That can be nerve-racking for investors of any type to handle. But when you diversify, you can smooth out the volatility and company-specific risk. We'd say the current environment is providing a lot more attractive opportunities as opposed to reasons to be fearful."

For his part, Gundlach looks past headlines moving the market, from the constant barrage of uncertainty and negativity from the Eurozone to slowing economies across the world to ineptitude from the U.S. Congress. Gundlach employs a so-called bottom-up analysis of companies -- focusing on the basics such as orders and sales -- allowing him to take advantage of opportunities as they that present themselves.

Gundlach, who's managed the Marshall fund since mid-2007, looks for companies whose growth is explainable and sustainable. Based on calendar-year returns, the $617 million fund has outperformed the benchmark Russell 2000 Growth index in nine of the previous 10 years, with the only exception coming during the market meltdown in 2008. The Marshall Small Cap Growth Fund has a 10-year average annualized return of 7.8% as of June 30, compared to 4.6% for the benchmark index. An investor who put $10,000 into the fund a decade ago now has more than $23,000.

That outperformance and the discipline of avoiding speculation has helped Gundlach and his team navigate through wild swings in the market and decipher whether there are head fakes or sustained changes in the market cycle. That has been key for Gundlach as a small-cap growth fund manager, as that asset class typically outperforms coming out of a recession and usually gets crushed first going into a recession.

Gundlach isn't whistling through the graveyard, though. He's diligent about monitoring his holdings and potential investments for signs of weakness in fundamentals. Although he says it's too early to tell if this market decline is another head fake or economic cycle shift, he says he has seen a divergence lately that makes him positive on equities.

"Stocks are acting poorly even as companies put out fairly strong outlooks," Gundlach says. "In mid-August, we were going through earnings reports and more were beating than missing. That flies in the face of what you're seeing in stock action. And yet, small-cap stocks have been underperforming most of the other categories in this recent downturn."

Looking back over the period from March 2009 to now, Gundlach says the market and economy have been in recovery mode and that he's seen a few periods of uncertainty similar to the one investors are currently faced with. With the success he has had over that time, Gundlach offers three small-cap growth stocks that he sees opportunity in now that have been beaten down during the selloff.

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