Scoping Out Stocks `Below The Radar Screen'

Less is definitely more, according to mutual funds that are concentrating in microcap shares. While only a handful of funds can actually be called microcap, the ranks of those that invest predominantly in companies with a median market capitalization of $200 million or less have doubled, to 40, in the past three years. That's still a drop in the bucket of more than 3,000 stock funds. But in time, you're likely to see more of these wee funds, which are exploiting the uncharted territory at the bottom of the equity bin.

Microcap stocks add diversity and higher returns to a portfolio. Under-researched, they represent a less efficient and potentially more profitable market than even the traditional small-cap class, which falls in the $200 to $700 million range. Of course, with greater reward comes greater risk and higher trading costs. That's why mutual funds may be the best way to ride little stocks to bigger gains.

BIG BANG. Most microcap companies escape the scrutiny of Wall Street analysts because it's not economical to follow them. That leaves plenty of finds for diligent stock-pickers. "The world has adopted small-cap as a real genre," says Charles Royce, manager of Royce Micro-Cap. "What's remaining is below the radar screen, and it's a large area for opportunity." About 3,000 tiny companies fit the definition of microcap, compared with 420 large-cap stocks--those with a minimum market cap of $2.4 billion.

Another draw of micros is that the smaller you go, the heftier your return over time. "Historically, this is the group that has given you the biggest bang for the buck," says Claudia Mott, quantitative analyst at Prudential Securities Inc. Over the past 20 years, the smallest companies have produced average annual returns of 21% for those with a market cap of $60 million or less, vs. 17% for small-cap stocks and 13% for large-cap, according to Merrill Lynch senior quantitative analyst Satya Pradhuman.

Most microcap funds take a value approach, buying on dips in a company's stock price, because "when you get this small, it's a dig-them-up, buy-and-hold style," says Morningstar analyst Laura Lallos. One reason Montgomery Asset Management Limited Partnership opened a microcap fund is that when Montgomery Growth manager Roger Honour screened companies to buy, he found himself tossing out some impressive stocklets because they were too small for his fund. When he launched Montgomery Micro Cap Fund in January, $100 million poured in during the first 20 days, forcing him to close the fund just to get the money invested. It reopened in June, but may soon close again.

It's hard to know how the new funds will fare, but a look at their older compatriots judged best by Morningstar gives you a glimpse of the micro scope. Warren Isabelle, who scored an average annual return of 19% in the last three years for Pioneer Capital Growth, sees four ways to make money in this market. One is turnarounds: buying micros that are so undervalued, it looks like curtains when their stocks fall. The perception is often much worse than the reality. "People are looking for these companies to go bankrupt," says Isabelle, "so even if they return to average, you can make money."

A second strategy is riding cyclical stocks out of their troughs. For example, Isabelle picked up NL Industries, a maker of titanium dioxide with a market cap at the time of $200 million, as low as $4 a share in late 1992, down from its peak of $50. Now the stock sells for $16. "If you know an industry and what it can do at its peak and trough," he says, "you have history on your side to determine the value as you approach the peak of the cycle." The other strategies are buying companies that are creating new businesses or have potential breakthrough products. For example, Isabelle owns $39 million Alkermes, a Cambridge (Mass.) biotech company that is developing products to penetrate the blood-brain barrier, which screens out molecules that could treat illnesses arising in the brain.

DFA U.S. 9-10 Small Company takes a different approach from Pioneer. Essentially a passive index fund, DFA generated an average annual yield of 11% over the past 10 years. The fund buys companies that fall into the smallest one-tenth of stocks listed on the New York Stock Exchange--figuring in over-the-counter and American Stock Echange issues. DFA holds 2,000 stocks at a time and updates its list each quarter. It requires a minimum investment of $100,000. Like most index funds, DFA usually fares well when small companies in general do well, but other funds will "beat us when small companies do poorly," says manager Rex Sinquefield.

An emphasis not on size but bargain-hunting puts Franklin Balance Sheet Investment in the micro category. "We buy below book value, and frequently that leads us to small companies," says co-manager Bill Lippman. Like other microcap managers, his five-year annualized 16% return is partly due to the fact that micros are often bought out. He paid $21 a share--$16 below book value--for Trico Products, a $119 million maker of windshield wipers. A year later, the stock was inching up when the company was sold for $85 a share. A $250 million cigarmaker, Colbro, was another success. Spain's state-run tobacco company bought a 49% stake a month ago, causing the stock to jump 50%.

Still, there are plenty of losers at the bottom of the heap. "The biggest problem is that most companies which are very small deserve to be," says Montgomery's Honour. "They're often family-run and have only one good product." He searches for companies that are willing and able to grow.

UPWARD DRIFT. Another problem is that because the stocks are illiquid, trading costs can run as high as 3% to 5%. That's because smaller companies have wider bid-ask spreads, says Prudential's Mott. Most fund managers deal with illiquidity by buying very small stakes in many companies. But you'll want to know how a fund handles trading expenses to avoid wiping out the microcap premium on returns.

DFA keeps costs down by using a basic buy-and-hold strategy. Royce Micro-Cap relies on an elaborate infrastructure of electronic markets to deal "between the spreads," which "would be impossible for the individual investor to do," says Royce. Preston Athey, who manages the T. Rowe Price Small Cap Value Investment fund, controls costs with a low annual turnover of about 20%.

If you're interested in buying a microcap fund for diversification, you'll also want to know how strictly the fund adheres to size limitations. DFA, T. Rowe Price, Royce, and Heartland insist on selling companies that have grown beyond the funds' size parameters. But you may want to monitor funds such as Franklin and Pioneer, which hold some larger-cap companies, because small-cap funds tend to drift up in size as their successful picks grow. "You have to actively manage to make sure the small stock fund stays small," says Minneapolis financial planner Ross Levin.

The stabilizing effect of diversifying into many asset classes means you can put 5% to 10% of your assets into micros without increasing your risk over strictly large-cap holdings, says Merrill's Pradhuman. Although it may not sound like much, he says, "from a long-term investment perspective, that's powerful."

You may have to act fast to get into a microcap fund. Such funds can't accommodate vast amounts of assets and still invest in lilliputian companies. A top performer, Heartland Value, which has boasted returns of 16% over 10 years, is closing its doors on July 1, after growing to $800 million in assets. And Montgomery Micro Cap, which reopened on June 1, plans to close when assets hit $200 million. Still, as money continues returning to U.S. stocks from overseas and as fund companies try to generate more business, microcaps may continue to proliferate. Hopefully, there won't be so many that managers can't still pluck up plenty of bargains with tweezers.

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