SAN FRANCISCO (Dow Jones) -- Quality can make a big difference with smaller- company stocks, especially in volatile periods such as investors have seen over the past several weeks.
That's one reason why Matthew Ziehl searches for solid small-cap companies that can deliver earnings growth, regardless of market conditions, for the RS Small Cap Core Equity Fund (GPSCX) he manages.
"In this market environment, companies with better balance sheets and better market share are definitely in a better position to weather increased market volatility," Ziehl said.
Small-cap stock funds have been drummed recently, Ziehl points out, with the Russell 2000 Index (RUT) taking a back seat to the large-cap S&P 500 Index (SPX) benchmark.
Meanwhile, firms with cash and little debt are faring best. "Companies that aren't highly leveraged and don't need to go to the capital markets for financing are the most attractive to us," Ziehl said. "Businesses that can grow organically and are leaders in their industries can make their own weather, so to speak."
The fund's benchmark is the Russell 2000. Ziehl keeps a diversified portfolio of 75-100 names. He estimates that the fund is about 50% invested in growth stocks, 25% in value and 25% in a blend of the two.
In general, growth stocks now look relatively cheap, he says. "Small-cap growth stocks are trading at 15%-25% lower valuations than small-cap value stocks," Ziehl said.
The blended strategy has worked well for this small-cap core fund over the past 12 months, with the portfolio gaining 17.6% versus its peers' 13.6% average return, according to fund tracker Lipper Inc. The fund's three-year annualized 13.7% return is on par with its category's 13.5% gain.
Ziehl says he considers himself a growth-at-a-reasonable-price investor. " We're looking for companies where the fundamental prospects haven't been fully priced in by the market," he noted. "We're interested in things like the quality of management, market positioning of the company and profit margins relative to their peers."
A new portfolio holding is Sonic Corp. (NASDAQ-NMS:SONC) (SONC) , which was added to the fund in July. The fast-food restaurant chain has produced negative returns this year. " We bought it after they guided down expectations for the current quarter, which ends at the end of August," Ziehl said.
He says most of the bad news has largely been priced into the stock. " Restaurants in general have had a very tough year with rising food and labor costs," Ziehl said. "Sonic isn't immune to those issues."
The chain is about 80% franchised. "So that insulates the company somewhat from the cost pressures," Ziehl said. "They earn a percentage of sales from their franchisees.
