Manager David Nicholas thinks smaller growth stocks have an edge.

    For most of the last five years, small-company value funds have trounced small-company growth funds. But David Nicholas, manager of the Nicholas Limited Edition Fund, contends that as the economic recovery matures investors will once again give the nod to small growth companies with steady earnings. 
    "It isn't unusual for cyclical value stocks to perform better than growth stocks as the economy is coming out of a recession," he says. "In 2002, value stocks were coming off severely depressed levels and year-to-year growth comparisons looked great. But as the hefty growth rate of cyclical stocks trails off, I believe we'll see the market begin to favor growth companies with consistent earnings."
    He says transition has already begun to occur. "Commodity price inflation has slowed down, and that's hit some cyclical companies hard. Since the beginning of the year there's been kind of a dance going on between value stocks and steady, consistent growers that tend to do better in the mid to late cycle of an economic recovery."
    That dance has brought some welcome relief to small-company growth funds like Nicholas Limited Edition, which have had to cede dominance to their value counterparts for some time. The average small-company value fund has had annualized returns of 16.9%, 14.5% and 14.7% over the last one, three and five years, according to Morningstar. Small-company growth funds have averaged returns of 9%, 9.8%, and -1.93% over the same periods.
    While others have predicted a revival for growth stocks recently, most of the attention has been focused on larger companies whose foreign operations get a boost from a weaker U.S. dollar. By contrast, smaller companies without an overseas presence have no such tailwind. And because small-cap stocks have outperformed large-cap stocks for so long, some contend that the latter are screaming bargains poised to return to market leadership.
    Nicholas, the son of Nicholas Company founder Albert "Ab" Nicholas, and manager of the fund since 1993, argues that smaller growth companies still hold an edge. He finds large-company growth stock valuations "not all that attractive" at this point, and believes small and mid-sized companies have the potential to grow earnings at a better clip. Still, he concedes that even small-company growth stocks aren't the bargain they once were. "The pickings are certainly slimmer than they were in 2001 and 2002," he says. "But the last two years have been fairly good ones, so valuations are only average at this point."
    As in the past, Nicholas remains watchful for temporary pullbacks on stocks he likes for buying opportunities. Once he buys a stock, Nicholas aims to hold on to it for at least a few years, if not longer. "One of my favorite holding periods is forever," he quips.
    International Speedway, which the fund has owned for more than a decade and is one of its largest holdings, exemplifies that loyalty. Though not a racing enthusiast himself, Nicholas notes that NASCAR racing is one of the fastest-growing sports in the world. Its fan base has spread from the South to a broad geographic and upscale demographic base that draws an increasingly large pool of advertising dollars.
While focusing on valuations and long holding periods may seem out of character for a small-company growth fund manager, it is consistent with Nicholas's preference for undiscovered or out-of-favor small and mid-sized companies with good operating margins, free cash flow, low levels of debt and reputable management teams with meaningful stock ownership. He also likes to see sustainable earnings growth of at least 10% to 15%. Companies in the portfolio have averaged earnings per share growth of 16.5% over the last three years. The presence of 101 stocks in the portfolio, each accounting for less than 2% of assets, shows that Nicholas likes to spread his bets. 
    The fund's conservative approach has helped it hold up better in bear markets than many of its peers. But it didn't work as well in bull market years like 1999, when small-company growth funds that invested heavily in technology stocks with no earnings surged ahead. With no presence in such stocks, Nicholas Limited Edition performed worse than 98% of its peers that year.
"    We were never opposed to technology stocks, but the valuations were so out there that we couldn't justify those kinds of investments," says Nicholas. "We're just weren't able to do well in such a crazy, speculative environment." 
    Morningstar analyst Andrew Gogerty mirrors that observation, noting, "The fact that the fund stays out of the market's more speculative stocks will likely turn more aggressive investors to other offerings." But, he adds, the tactic "was a boon during the recent bear market and helped investors avoid gut-wrenching losses."
    Despite the fund's conservative profile, Nicholas won't back away from technology stocks if they have the characteristics he likes and their price is right. In 2000, he hired a technology analyst who pointed him toward some battered bargains in the technology sector that he picked up in 2001 and 2002. Today, he sees potential for consolidation among software companies, which have a lot of cash to spend on acquisitions. Two portfolio holdings, Business Objects and Hyperion Solutions, could benefit from such a trend. The latter company makes accounting software that has been in high demand as companies seek to comply with Sarbanes-Oxley reporting requirements, and it significantly broadened its product portfolio with the acquisition of Brio Software in October of 2003. Business Objects, a somewhat larger competitor, produces planning and reporting software that helps companies organize data into a more accessible format.
    Even though information technology accounts now for 18% of fund assets, making it the second-largest sector weighting in the fund, Nicholas says he hasn't edged into more speculative territory. "These are solid companies with predictable earnings and well-established brands, rather than companies whose fortunes rest on the next greatest product," he says.
    They are also companies that, like the rest of the portfolio, he expects will hold up relatively well even if economic growth slows down. "The challenge for growth stocks is to have sustained earnings growth in a slowing economy. We're looking for more defensive companies in health care, technology and consumer sectors that have the ability to do that."
    Holdings in the health care sector, which account for about one-quarter of fund assets, diverge from the usual hospital and pharmaceutical company fare. Nicholas cites veterinary facilities, such as fund holding VCA Antech, as one of the most resilient, recession-proof niches in the group. "These are cash businesses that don't depend heavily on insurance reimbursements," he says. "More people own pets, and many of them have multiple pets that they're willing to spend money on."
    For pet owners and other bipeds, health care facilities that provide dialysis services, such as holdings Renal Care Group and DaVita, cater to the growing number of individuals who require such treatment. Although these companies depend heavily on reimbursements from Medicare and insurance companies, Nicholas believes that critical dialysis services are unlikely to be affected by any cutbacks.
    In the financials sector, where the fund invests some 16% of its assets, Nicholas prefers firms that generate fees over banks, which could be hurt by a flattening yield curve that threatens to make lending less profitable. Holdings include National Financial Partners, which owns and operates financial consulting and advisory services, and insurer Brown & Brown.
    He also has about 15% of the fund in the consumer discretionary sector, with holdings in high-growth restaurant chains such as Applebee's International and P.F. Chang's China Bistro. He's fairly confident that middle-class Americans will continue to spend money on leisure pursuits even if the economy slows down, although lower-end fast food chains and dollar stores could be more vulnerable.
    Recently, Nicholas has been trimming some of the fund's energy holdings. With more supply coming into the market he feels there is a good chance that oil prices will continue to drop, making prospects for the stocks less enticing. He's also sold off some stocks he considers too richly valued, including restaurant chain Panera Bread. He initiated the position last year when a string of mediocre sales brought the stock down into the thirties, a pricing level he considered attractive. But improving sales have pushed the stock to over $60 a share. "This stock is fairly valued in the $40 to $45 range," he says. "And if it gets back down to those levels, we'll be looking to buy it again."