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Macro Gains from Micro Stocks

Michael Corbett of the Perritt Micro Cap Opportunities Fund (PRCGX) likes trawling in largely uncharted microcap waters for stocks he thinks will deliver extraordinary long-term growth. However, his job has become a bit harder in the past few years as more and more Wall Street analysts have begun covering this long-ignored sector.

Despite that, the fund has been a strong performer of late. For the year ended June 30, the portfolio gained 10.1%, while the average small-cap growth fund gained 1.4%. For the five-year period ended in June, it rose at an average annualized rate of 8.9%, vs. a loss of 0.3% for its peers.

Based in Chicago, Corbett has been primarily responsible for the day-to-day management of the fund since November, 1999. In April, 2003, Perritt Micro Cap Opportunities was upgraded to the highest overall rank of 5 STARS by Standard & Poor's. Palash Ghosh of S&P's Fund Advisor recently spoke with Corbett about the fund's strategy. Edited excerpts from their conversation follow:

Q: How has the microcap sector changed in the past few years?

A: The big difference is that Wall Street appears to have taken a greater interest in the sector, which has led to some increase in liquidity. This is likely a result of the severe bear market in larger caps, which has forced some analysts to take a closer look at these long-ignored stocks. However, microcap stocks have remained as volatile as ever in terms of price and performance.

Q: Since we last spoke to you two years ago, has your stock-selection process changed at all?

A: No. We still look for companies with market caps below $400 million that we think can dominate a niche, deliver long-term growth and outperformance, and trade at modest valuations. They should also possess low debt and high insider ownership. We still like our portfolio to have a mix of both value and growth stocks.

Q: When Wall Street discovers and follows a microcap stock, is that necessarily a good thing?

A: When a big brokerage house on Wall Street becomes enamored with a microcap company, it's great for that company because it raises its profile and name recognition. But it could become a negative development for that company's stock.

What makes investing in microcaps so appealing is that the stocks are, by and large, ignored by Wall Street and priced inefficiently. Once brokers discover and follow a microcap company, its pricing patterns become more efficient. Moreover, when a company under analysis suffers some bad news, the stock's price gets hurt a lot worse than it would have if it were still ignored by the Street. I typically move out of a microcap stock if it has been embraced by the analysts.

Q: What are your top 10 holdings?

A: As of June 30: Matrix Services (MTRX), 2.1%; Nam Tai Electronics (NTE), 2.1%; Modtech (MODT), 2%; Healthcare Services Group (HCSG), 1.8%; Layne Christensen (LAYN), 1.7%; HPSC Inc. (HDR), 1.6%; Rimage (RIMG), 1.6%; Air Methods (AIRM), 1.5%; Flanders Corp. (FLDR); and Starcraft (STCR), 1.4%.

The fund has about $50 million in net assets and about 89 positions. We typically hold between 75 and 100 stocks in the portfolio.

Q: What are your top sectors now?

A: Our largest industry exposures currently are in medical and health-care services, which accounts for about 12% or 13% of fund assets. That is followed by consumer products and business services, each at 10%. Then comes energy and energy services at 8%, and retail, at 7%.

One of the big changes in the past two years is that we've significantly cut back our exposure to financial services, particularly regional banks. From a macroeconomic standpoint, this low interest-rate environment makes it increasingly difficult for these types of firms to generate higher profits and revenues. Valuations among regional banks have also become a bit too high.

Q: What sectors have been looking favorable?

A: We have been adding to our positions in energy, consumer products, retail, and cyclicals -- which positions the fund to benefit from an expected rebound in the U.S. economy later this year.

Q: What benchmark do you use?

A: Since no genuine microcap index yet exists, we still rely on the Russell 2000. However, given what has happened in the markets the past few years, that benchmark is getting a bit closer to us in terms of market cap. For example, the smallest companies in the index now have a market cap of only $100 million. Just a few years back, they had nothing lower than $160 million in cap size.

Q: How does your fund compare to the index and how have you performed against it?

A: The fund's average market cap is $115 million, compared to $550 million for the index. The fund has an average trailing 12-month p-e of 12.9, vs. 24.6 for the index. For the year ended June 30, the fund gained 10.1%, while the index dropped 1.6%. For the three-year period, the fund gained 11.8%, vs. a 3.3% drop for the benchmark.

Q: Can you discuss some of your top holdings?

A: Nam Tai Electronics is an electronic manufacturer based in Hong Kong. They make telecom and consumer-electronic products and currently have contracts with big corporations such as Texas Instruments (TXN) and Sony (SNE). When we first purchased this company, the stock was trading less than one times sales. Nam Tai has performed well, having doubled in price since last November. Based on what we expect the company to earn in 2004, the stock is still only trading at a p-e of about 8. Also, there's no debt on its balance sheet.

Q: What are your sell criteria?

A: We typically sell when a company's market cap becomes too large -- generally when it reaches around $1 billion -- but we might sell before that as well. We will also sell when fundamentals deteriorate, when valuation becomes inexplicably high, or when a company's financial condition slips.

Q: Can you cite some stocks you recently sold?

A: We sold Tractor Supply (TSCO), which is a farm and ranch retailer. Its valuation became too rich: Its market cap reached the $800-million level, and a number of Wall Street firms started covering the stock.

We also recently sold Blue Rhino (RINO), a supplier of propane grill products to retailers, which had been a longtime holding. We disposed of this stock once we learned that one of the company's insiders didn't disclose his personal ownership in a few distribution companies doing business with Blue Rhino. This represented a corporate-governance problem to us and we got rid of the company.

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