In a tough year for mid-cap stock funds, the average fund in the category lost better than 45 percent of its value; American Century Veedot (AMVIX) managed to beat out almost two-thirds of its peers.

Part of that outperformance is attributable to the fact that, although the fund is classified as a mid-cap growth offering, it’s extremely heavy on small- and even micro-cap stocks. Those two groups account for almost 60 percent of the fund’s portfolio. And last year smaller-cap stocks actually outperformed the mid-cap category.

The fund’s success is also partly rooted management’s unique approach to the investment process. Rather than putting a team of analysts to work crunching numbers on hundreds of companies, the fund relies on a two-step computerized screening process that manager John Small helped develop.

The system first screens a defined stock universe from a fundamental perspective, looking for growth factors that trigger a potential buy. That first layer of screening is designed to leave the portfolio with lower price-to-earnings, price-to-book and price-to-sales ratios than its peers. That helps reign in the growth-at-any-price mania that so often takes over at small- and mid-cap funds. The approach has left American Century Veedot with companies that sport close to 20 percent long-term earnings growth.

Once the companies with the best growth potential have been identified from a fundamental perspective, the second step of the process is a technical screen to identify entry points. Here the process gets a bit murkier, simply because management doesn’t actually disclose the technical indicators it uses. However, it doesn’t appear that the fund relies on momentum alone, and judging by the fund’s performance the system works.

The system applies the same basic methodology to determine sell points, looking for deteriorating fundamental characteristics or bearish technical indicators, and doesn’t hesitate to sell if gets negative signals. The fund is burdened with a gut-wrenching annual turnover of 257 percent, meaning it’s not tax-efficient by any stretch of the imagination. But after the losses the fund has taken in this sustained bear market, it can more than shelter any potential capital gains over at least the next two years.

Small’s meticulous nature and strict buy/sell discipline is largely due to the fact that he came into fund management later in life, joining American Century in 1991 and taking over the Veedot fund in 1999. Prior to that, he was a US Navy test pilot and earned advanced degrees in laser optics and business administration. Interestingly enough, he also served as the chief pilot of American Century’s flight department before moving out of the hanger and into the office building. Although that may seem like an odd career path, each experience fosters strong attention to detail and commitment to risk management.

Those traits allowed the fund to generate five-year annualized total returns of more than 6percent prior to the current bear market, handily beating the S&P 500 and ranking it in the top quarter of its Morningstar category.

Since the downturn has taken hold, the five-year annualized return has reversed to a bit more than a 5 percent loss. But it’s still outperforming the S&P 500 as well as the small-cap category (in which it would probably be a better fit) by a slim margin.

Small-caps will likely face continued weakness over the coming months. It will take time for the ship to right itself as the massive amounts of stimulus spending trickles through the economy. But when the markets turn, as they inevitably do, small-caps will likely outperform as the bulls get their legs and recover their risk appetite. And small-cap stocks have been so beaten down over the past year it won’t take much to make them move.

And given the tight credit conditions with which these companies have had to contend, many will emerge as leaner, meaner, much more competitive enterprises. In the meantime, though, American Century Veedot fund is well-positioned to weather the storm.

The fund is heavy on health care names, both large and small; the sector accounts for more than 30 percent of portfolio assets. Veedot’s holdings in the space include pharmaceutical giants Bristol-Myers Squibb (NYSE: BMY) and Novartis (NYSE: NVS) as well as less recognizable names such as Almost Family (NSDQ: AFAM), a provider of home health care, and Cantel Medical (NYSE: CMN), which focuses on infection prevention and control.

The fund also holds healthy stakes in recession-resistant companies such as Dollar Tree (NSDQ: DLTR), Family Dollar Stores (NYSE: FDO) and Aaron Rents (NYSE: RNT).

As do most small-cap funds, Veedot has more than 20 percent of its assets in financials, primarily smaller regional banks and insurance companies. The fund hasn’t been exposed to any major blowups in this sector, however; the insurance companies it holds stayed away from the derivative products that almost destroyed the major players. And the small banks it holds didn’t have the asset base to fully take advantage of the real estate boom–or suffer its bust.

But such holdings do add some level of risk. If you don’t plan on holding the fund for the long-term and can’t handle high volatility, this fund probably isn’t for you. But if you’re in for the long haul, American Century Veedot has proven its ability to survive bear markets and thrive in bulls.

American Century Veedot
Kansas City, MO 800-345-8765
www.americancentury.com AMVIX
Sales fee: none
Assets: $83 million
Early withdraw: 2% (if less than 180 days)
No. of holdings: 76
Turnover rate: 257%
Expense ratio: 1.25%
Assets in top 10 holdings: 18.6%
Min. initial investment:  $2,500
Largest quarterly loss*: -25.3%; 3^rd Qtr 2008
Largest quarterly gain*:  16.8%; 2^nd Qtr 2007
Top five positions (symbol): Dollar Tree Stores (DLTR), LHC Group (LHCG), AeroVironment (AVAV), Cantel Medical Corp (CMN)

*Past three years

Source: Morningstar