NEW YORK (TheStreet) -- Small stocks were clobbered during the volatile markets of last year. In the third quarter, small blend funds lost 21%, according to Morningstar. For 2011, the funds lost 4.1%, trailing the S&P 500 by 6 percentage points.
Investors should not be surprised by the turbulent performance of small-cap funds. Many academic studies have shown that small-cap funds can be more volatile than large stocks. During rough times panicked investors can suddenly dump little-known small stocks and take refuge in giant blue chips, which seem like safer bets.
Although they come with risk, small stocks belong in nearly every portfolio because they can deliver strong long-term returns. Small-cap funds have ranked as one of the top-performing categories in recent years. During the past 10 years, small value funds returned 7.7% annually, outdoing the S&P 500 by four percentage points.
To find steady small-cap choices, I searched for funds that had outperformed their categories while taking only moderate risks. I started by screening for funds with strong five-year records. To avoid risky choices, I looked for funds with below-average volatility, as indicated by standard deviation, a measure of how much an investment bounces up and down. The winning funds include Hancock Horizon Burkenroad Small Cap, RS Select Growth and Tocqueville Opportunity TOPPX .
Among the strongest performers last year was RS Select, which returned 5.3%. During the past five years, the fund has returned 7.3% annually, outdoing 97% of funds in the small growth category. The RS managers prefer companies with track records for delivering consistent growth and rich profit margins. The managers aim to buy stocks that can continue growing for the next three years because of clear competitive advantages.
Portfolio manager Melissa Chadwick-Dunn says that many of the fund's stocks proved resilient during the rough markets of last year. "We have leading companies that people want to own during flights to quality," she says.
A holding is Align Technology ALGN , which makes clear dental braces. The company is gaining market share because teenagers and adults prefer Align's products instead of the unsightly wires and brackets of traditional braces. The company's sales increased 38% in the most recent quarter. "Align is an industry leader with strong intellectual property and a competitive advantage," says Chadwick-Dunn.
Another holding is Core Laboratories CLB , which provides software for oil and gas producers. Core's products help energy companies analyze the characteristics of reserves. The company serves 1,000 fields and is adding 50 new fields a year.
The Hancock Horizon fund has delivered steady results by following an unusual regional strategy. Based in New Orleans, the portfolio managers buy stocks that are headquartered in Alabama, Florida, Georgia, Louisiana, Mississippi, and Texas. Partly because the region is home to many companies in energy and basic materials, Hancock Horizon tends to be overweighted in those sectors. The portfolio is light on technology, an industry that is not concentrated in the South.
The home-grown strategy may limit selections, but the approach seems to work. During the past five years, the fund has returned 7.9% annually, outdoing 98% of competitors in the small blend category. The portfolio managers favor steadily growing companies that sell at reasonable prices. Many holdings are mundane businesses that attract little coverage from Wall Street analysts.
A holding is Sanderson Farms SAFM , a Mississippi poultry producer. "This is a simple business that has been a great performer over the last 10 years," says portfolio manager, David Lundgren.
Another holding is Tupperware Brands TUP , the longtime producer of storage containers and cookware. Based in Florida, the company has been expanding overseas.
The Tocqueville Opportunity fund looks for moderately priced companies that can grow at double-digit rates. During the past five years, the fund has returned 2.8% annually, outdoing 65% of small blend funds. The portfolio managers particularly like companies that can surprise Wall Street, growing faster than analysts expect. The managers favor companies with competitive advantages and distinctive products.
A holding is Dunkin' Brands DNKN , which operates Dunkin' Donuts and Baskin-Robbins outlets. Portfolio manager Thomas Vandeventer says that some investors view Dunkin' Donuts as a mature chain that can only grow slowly. But the company is expanding in states west of the Mississippi where the chain has a limited presence. "The company can grow its topline at a 6% to 8% rate, and the bottom line can grow 15%," Vandeventer says.
He also likes Herbalife HLF , which sells products that are used for weight management and nutritional supplements. Earnings have been growing at an annual rate of more than 20%.