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The Market's Sparrows Are Flying High

BusinessWeek Investor: Investing

The Market's Sparrows Are Flying High

Microcap funds are hot--but be prepared for high risk

After a long period of lagging behind the market, small-company stocks roared to life this spring. But unbeknownst to many investors, shares issued by the tiniest companies rallied even more explosively. As a result, microcap funds--which specialize in companies valued at $300 million or less--rose 22% from April through June, leaving every other category of domestic equity fund in the dust, according to mutual-fund tracker Lipper. The microcaps even trounced the small-cap funds, which were up 15.6%. "Whenever we find ourselves in a small-cap market, the fantastic returns tend to be amplified as you move down in size," says Satya Pradhuman, director of small-stock research at Merrill Lynch.

But can the good times continue to roll for small and tiny stocks? In the past month, the market has shifted back to large caps. But small stocks--or the shares of companies in the $300 million to $1.5 billion range--have continued to fare well. And now that investors are shrugging off the risk aversion that prompted their flight to blue chips during the Asian financial crisis of 1997 and 1998, small-stock gurus are betting the smart money will continue to take a chance on the market's minnows. One big attraction is that small-cap shares are cheaper relative to blue chips than they have been in years.

Microcaps are even better deals. Based on the ratios of stock prices to sales, Pradhuman says microcaps are trading at 0.30 times the average for large caps. That is 14% cheaper than the 0.35 they hit in 1996, the decade's previous low.

Microcap funds are also relative bargains. Investors must spend an average of $30.34 to receive $1 in earnings from funds that invest in the largest stocks, vs. $26.27 for small stocks and $21.67 for those specializing in microcaps, fund tracker Morningstar says. "The small caps are playing catch-up, and there's a lot of room left to go before they get back to normal," says Frank Sustersic, portfolio manager at Turner Micro Cap Growth Fund, up 60% on an annualized basis since its inception in March, 1998. Among the stocks Sustersic has snapped up are athletic shoe and apparel maker Saucony, which trades for 18.2 times estimated 1999 earnings, well below its three-year 30% annual growth rate. Because investors often chase hot performance, microcap funds might soon find themselves awash in new cash. Any investor interest would propel the thinly traded stocks sharply higher.HIGH COST. Of course, for this scenario to come about, small-cap earnings must not disappoint. After trailing in the second quarter, small-company earnings are expected to outstrip those of the blue chips by 9.5 percentage points in the third quarter and 31 points in the fourth quarter, analysts polled by First Call predict. Although a relatively high cost of capital might restrain small-company profits, Pradhuman expects the sector's earnings to be more predictable this year than last, helping the stocks do well.

But there are no sure bets--especially in microcaps. "People holding microcaps should be willing to go through dramatic volatility," says Dan Coker, author of Mastering Microcaps: Strategies, Trends, and Stock Selection (Bloomberg Press, $55). In a given year, microcaps post ups and downs that are 86% more extreme than those of large stocks and 25% greater than those of small caps, says Prudential Securities.

Tiny stocks pose other outsized dangers too. Because microcaps are thinly traded, even a small sell-off can cause a stock's price to slide precipitously. And even if you find a great prospect, others may not notice. So the stock price may languish.

Microcap investors generally experience the worst whiplash during dry spells for small-company stocks. Interestingly, that was not the case from 1996 to 1998, when small-company stocks endured their worst three-year performance relative to large stocks in more than a generation. Over the past three years, microcap managers have posted an average annual return of 12.8%, vs. 10.5% for small-cap funds, Lipper says. But it's a big leap to conclude that microcap funds are better all-weather bets than their slightly larger rivals. Indeed, several one-time factors likely explain why they have gained an edge recently.

For one thing, fund companies are just starting to mine the asset class. Five years ago, only four funds used the word "micro" in their names. Today, driven by pension fund interest, 46 funds use the micro label, according to Morningstar. With money flowing into this largely overlooked backwater, the stocks have enjoyed support even amid a small-stock dry spell, Pradhuman argues.

A second explanation of the microcap phenomenon has to do with the huge runups in Internet and technology stocks. Although most Net stocks immediately skyrocket past microcap status these days, that was not the case as recently as two years ago, when fledgling Net companies helped bolster microcap fund returns, Pradhuman argues. This year, technology stocks have fueled the sector's hot performance. One favorite of the high-ranked Wasatch Micro-Cap fund is SDL, which makes semiconductor lasers that help computer networks handle high traffic volumes, says senior analyst Jim Larkins.

Another theory has to do with the unusual nature of the recent small-cap downturn. Most times, when small stocks are punished, it's because earnings or other fundamentals slump. But during much of their recent underperformance, small stocks' earnings were superior to those of the blue chips. During the Asian financial crisis that started in 1997, institutional investors flocked to the perceived safety of blue chips simply because of their greater liquidity. They indiscriminately dumped less-liquid small-cap holdings.

But microcap shareholders held on. Why? Because most are employees and other small-time investors intimately familiar with the companies and content to remain loyal as long as the fundamentals hold up, says Richard Hefter, editorial director of microcap Web site, If earnings had turned south, the stocks surely would have too.

Despite the microcaps' outsized volatility, history suggests that patient investors will be rewarded. Since 1926, Prudential says, microcaps have outperformed the rest of the market on an absolute basis. Their compounded annual return of 12.4% was higher than the 11.8% for small caps and the 10.7% for blue chips. But because shorter time horizons are associated with greater volatility, microcaps fall short on a risk-adjusted basis unless held for more than seven years, according to Coker's calculations. Whether you take the plunge now or later, examine your risk tolerance. After all, there's nothing tiny about the short-term risk inherent in microcaps.By Anne TergesenReturn to top

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