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Microcaps Are Looking Mighty

Dismal as the stock market may seem, one bright spot of late has been microcap stocks. They're a favorite of Gerald W. Perritt, president of Perritt Capital Management and co-manager of Perritt MicroCap Opportunities Fund (PRCGX). He believes the market may be near a bottom, based on the length of the current bear run -- 27.5 months now -- compared with 34 months for the bear market that accompanied the Great Depression.

Perritt says his microcap fund is up 5% so far this year, compared to a loss of 19.5% for the S&P 500-stock index. Last year it was up 35%, and it also scored a positive return in 2000. His criteria for picking companies include significant management ownership of stock and good growth.

These were among the comments Perritt made in a chat presented July 11 by BusinessWeek Online on America Online, in response to questions from the audience and from Jack Dierdorff and Karyn McCormack of BW Online. Edited excerpts from this chat follow. A complete transcript of this chat is available from BusinessWeek Online on AOL, keyword: BW Talk.

Q: Jerry, can you give us any encouragement at all about the market?

A: Probably a lot of encouragement, actually. We've got to be closer to the bottom than the top. The economy is getting better, the consumer is still spending, interest rates are low, inflation is nonexistent, and values on Wall Street are about half of what they were a year ago.

To put it in perspective, the bear market that accompanied the Great Depression lasted 34 months, and this bear market is 6.5 months longer than the great bear market of 1973-74.... Once the Great Depression bear market ran its course, large-cap stocks returned [an average of] 11.6% a year for a decade and small-caps returned 15% a year for a decade. After the 1973-74 bear market ran its course, large-caps returned 15% a year for a decade, and small-caps 25% a year. So the silver lining here is that above-average returns are on their way.

Q: Do you have both microcap value and growth in your fund?

A: Our's is a so-called blend fund, which blends value microcaps with growth microcaps. However, during the last 2? years, the fund has been heavily tilted toward value. The better-performing microcap stocks and better-performing microcap funds have all stressed value during this period. We have a large number of stocks in our portfolio growing at better than 15% annually -- selling for 10 to 13 times our estimates of 2002 earnings per share. We think that's real value.

Q: How do you find your portfolio holdings?

A: Here are the criteria that we like to see in a potential microcap investment: Market cap below $400 million, above $300 million. Demonstrated top- and bottom-line growth. Significant management ownership. Companies ignored by other institutional investors and mutual funds. Companies with minimal amounts of long-term debt. And these form the basic screens. We then subject candidates to rigorous, old-fashioned securities analysis -- balance-sheet and income-statement analysis.

We have nine financial criteria that we apply to each potential investment. If a company passes a criterion, it receives one point. So a perfect score would be nine points. We only retain companies for further analysis if they score a seven or better. At that point, we usually contact management.

Q: Jerry, can you tell us about some of your favorite holdings?

A: Sure. Let's start with Helen of Troy (HELE). They're a manufacturer and marketer of brand-name personal-care products, like hair dryers, combs, women's shavers, mirrors, etc. Here's a company selling at about $13.75.... This is a $380 million market-cap company that has recorded earnings gains during 30 of the last 32 quarters, currently priced at less than 12 times annual earnings. We think this company is still a bargain.

Another one: Modtech Holdings (MODT). This is a builder of modular structures for the commercial office and education markets, located primarily in California and the Southwest. It's a $150 million market-cap company that should earn $1 [per share] this year, has historically been a 15% annual grower, currently selling for $12, or 12 times earnings.

These are [two] examples from a portfolio of 85 stocks. They're companies that are easily understood, provide highly recognizable products, have a long history of double-digit annual growth, and are very, very reasonably priced. For the most part, you probably would categorize these companies and their products as ultra-low-tech.

Q: How much harder is it to manage money with stocks that have such a small float?

A: It's a portfolio manager's worst nightmare. First, you have to own a lot of these companies. Our fund generally holds somewhere between 80 and 100 [companies]. Second, even if you love a company, you can't make it a significant portion of your portfolio. Generally, our largest holding represents less than 3% of portfolio assets. When we find a company we really like, it takes us one to two months to build a position.

Q: The bubble bursting -- has it not hurt microcaps big time? Was your fund burned at all?

A: We're up a total of about 50% since the tech [dot-com] bubble burst in March, 2000. Prior to that, we did own a number of tech-related stocks, mostly in the semiconductor equipment sector. Soon after the bubble burst, we purged our portfolio of those holdings and thus sidestepped a lot of the carnage felt by steadfast believers. You have to have patience to be a microcap-portfolio manager -- but that doesn't mean that you also have to be pigheaded. When your expectations go unfulfilled, you must sell immediately. And we do that.

Q: How do you avoid accounting problems? Is there anything in particular on the balance sheet you look for?

A: We rely heavily on published financial statements, thus we must trust that they are reasonably accurate. Interestingly, companies in the microcap sector have, on average, 30% of their outstanding shares owned by management. We think that this gives us reason to believe that the financial statements fairly reflect a company's activities, because if managers were willfully committing frauds, they would be defrauding themselves -- the company's largest shareholders.

Q: Any rules of thumb for diversifying your fund?

A: We like to hold from 80 to 100 different stocks in the portfolio, with no single industry or sector accounting for more than 15% of portfolio assets and no single stock accounting for more than 3% of portfolio assets.

Q: What drew you to microcaps in the first place?

A: I'm an academic, and I found an obscure PhD dissertation that indicated that microcap stocks deliver more returns than can be accounted for by their underlying risk. It was the only free lunch I've ever seen offered on Wall Street. So I've been advising and managing microcap portfolios since then -- and that was in 1981.

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