Small-cap growth stocks are notoriously volatile, and many investors shy away from this arena. But Conestoga Small Cap (CCASX) pursues a risk-averse approach to stock selection that reduces volatility considerably. Indeed, the fund performs best relative to its peers during bear markets. In 2008, for example, the fund ranked in the top 2 percent of Morningstar’s Small-Cap Growth category, while the fund currently ranks in the top 4 percent of its category year to date.

The fund’s seasoned management employs a fundamental, bottom-up approach to stock selection with what it describes as a “growth at a reasonable price” valuation methodology. They’re not content to merely analyze a firm’s financial statements and interview its executive team, they also interview a firm’s competitors, suppliers and customers.

With this intensive research process, the fund managers hope to indentify companies with the ability to generate annual earnings growth of at least 15 percent over the ensuing three-year period. They seek firms that have strong balance sheets, low debt burdens and high levels of inside ownership, so that management’s interest is firmly aligned with shareholders. The fund managers invest with conviction, as evidence by a low 9.9 percent portfolio turnover ratio.

The fund’s largest holding, Sun Hydraulics Corp (NSDQ: SNHY), manufactures hydraulic fluid valves that control fluids used in industrial and agricultural machinery. Management notes that the firm opportunistically reinvested in its business during the economic downturn, successfully positioning itself for growth once the economy emerged from recession.

The fund recently initiated a position in Pros Holding (NYSE: PRO), a company that develops software that helps businesses find optimal pricing for products and services. The fund’s management says the company has firmly established itself with the hotel, airline and cruise industries and is poised to expand its sales to other industries. They believe the company should be able to deliver earnings and revenue growth exceeding 15 percent annually.

Given the fund’s growth orientation, the technology sector comprised its largest allocation at over 38 percent of its portfolio at the end of the second quarter. It also had a similarly substantial allocation toward industrials, which accounted for almost 29 percent of its portfolio.

Despite this relative concentration, the fund’s higher-quality names incur only moderately greater volatility than the broad market. This has enabled the fund to do an impressive job of preserving capital during downturns. During the 2008-09 bear market, for example, the fund’s largest rolling 12-month loss was 32.9 percent, as compared to a 43.3 percent loss for the S&P 500.

This risk-averse approach causes the fund to lag the market during bull runs, though it should outperform over the long term. The fund ranks in the top decile in its category over the trailing five years, returning 3.6 percent annually, in contrast to the market’s annualized loss of 1.2 percent.