Awash in Cash, with No Place to Go

Small-cap value funds have hit the wall

Three years ago, portfolio manager Scott Barbee of the small-cap Aegis Value Fund was practically begging shareholders to stay in his fund. But few had any interest in the cheap Old Economy stocks that he was buying. While Barbee was acquiring shares of auto-parts makers, real estate operators, and defense contractors with market caps of less than $1 billion, investors were flocking to Cisco Systems (CSCO ) and Yahoo! (YHOO ) "We spent a lot of time then trying to convince clients of the folly of investing in these giant tech stocks," he says.

After a two-year rally in small-cap value shares (chart), investors have gotten his message. Since the start of 2002, his fund has more than doubled in size, to $175 million, thanks mainly to new investors. Now, the problem for Barbee and others is that small-cap value stocks are no longer cheap. "Historically, these value stocks trade at a 40% discount to the valuation of growth stocks during the worst of times and at parity during the best of times," says Satya Pradhuman, a Merrill Lynch small-cap strategist. Today, he adds, the discount is 10%, which means there isn't much upside at all.

Indeed, there is no longer all that much difference in valuations between the rallying small-cap value funds and other U.S. equity funds. The trailing one-year price-to-earnings ratio for small-cap value funds is up from 18 in June, 2000, to 25.7 in April, 2002. That's not much cheaper than the 31.2 average p-e for all other domestic equity funds and the 33.5 average p-e for small-cap growth funds.

If you're an investor in a small-cap value fund, now is the time to reassess your holdings. The more bloated your fund, the greater the chance it will underperform its peers. The biggest risks: Either the fund is sitting on too much low-yielding cash or it is acquiring stocks that aren't good values, because they're too expensive or they are cheap for a good reason. In the latter category would be telecom companies with hefty debt loads or companies with severe asbestos litigation liability.

Because of the dearth of bargains, Barbee is having a hard time investing the new money. More than half the fund's assets are in cash. His quandary is not unique. According to fund tracker Lipper, assets in small-cap value funds have more than doubled, from $31.5 billion to $82.2 billion since the stock market peaked in 2000. Much of that growth has come from investors fleeing cratering growth stocks.

Not every fund handles the inflows in the same way. The managers generally have five methods for dealing with an excess of new money: shutting the fund to new investors; holding cash; buying more stocks; buying larger-cap stocks; or buying more expensive stocks. According to Morningstar, all five methods are currently in use. Each approach has different consequences for shareholders (table).

Closing the fund to new investors is ideal for current holders. They can still add to their holdings, but with new money shut out, the manager isn't forced to search for new stocks or bid up prices on existing ones. Eleven top small-cap value funds have closed in the past year, including Wasatch Small Cap Value and Numeric Investors Small Cap Value, which have both performed well.

The size at which a fund closes is important. One study conducted by fund manager Turner Investment Partners estimated that $3 billion is the maximum level of assets a small-cap value fund can manage and still trade in and out of illiquid small stocks easily. But effective trading and effective investing are two different things. Many value managers think the asset size should depend on the amount of bargains available in the market. "Given the current valuations, we'd probably shut down at $400 million," says Barbee. "But if stock prices fell significantly, our capacity would grow." Numeric Investors' fund, which closed with $250 million, is the top performing small-cap value fund this year.

It's also important to consider how much of the firm's total assets are invested in the sector. William Blair Value Discovery Fund recently closed with just $150 million in assets, but the firm had an additional $850 million invested in the same style in private accounts. "We trade our private accounts and the mutual fund together," says the fund's manager, Glen Kleczka. So any purchase or sale of a stock has a $1 billion entity behind it, not a $150 million one.

Holding cash is less desirable than closing the fund because it will act as a drag on performance when small-cap value stocks rally. It also means you're paying the higher fees of a stock fund to get the low returns of a money-market portfolio. Barbee defends this strategy, on the grounds that it keeps him from straying from his investment style. "We want to have the right valuations before we put the cash to work," he says. Indeed, it's getting harder to find small-cap stocks selling below book value. Barbee now has 22% fewer stocks to choose from than he had two years ago. Moreover, the cash will act as a cushion if small-cap value stocks fall.

Some managers would rather buy more richly valued stocks than sit with cash. They argue the move is justified as the most beaten-up sectors--technology and telecom--offer some good value. And sure, the p-e ratios are unusually high, but that's because of the companies' depressed earnings. "Our definition of value is not the traditional one," says portfolio manager Warren Isabelle, whose $150 million ICM/Isabelle Small Cap Value Fund has 25% of holdings in tech stocks. "We'll go wherever we can find bargains."

Many other value managers are dipping into the tech sector. But that begs the question: Why buy a small-cap value fund in the first place if it owns the same stocks as a small-cap growth fund, which may have more experience with those types of companies? "The growth stock side of the small-cap equation looks fairly attractive right now," says Preston Athey, portfolio manager of the T. Rowe Price Small-Cap Value Fund. "If I were free to invest in any area, I would find a lot of happy hunting on the growth side."

Athey isn't chasing tech, but he has been buying a lot more stocks. His $3 billion fund has 250 positions, up from 200 at the end of 1999, suggesting that he may be resorting to marginal picks. "When you increase the number of stocks in your portfolio, you're really putting in your B-rated ideas," says Aegis' Barbee. Athey says he has 30 T. Rowe analysts helping him pick stocks, much more than smaller funds such as Aegis and ICM/Isabelle, which only have one or two analysts. So he may be able to find more good stocks. But his staff has reached its limit, and on May 24, he is closing the fund. "I'm not willing to buy every stock I own at a higher and higher price to get rid of new cash," he says.

Still, given his fund's size, he may have waited too long to close. Smart investors should buy a small-cap value fund that agrees beforehand to close at a specific size--the smaller the better. Some fund companies, such as Undiscovered Managers, disclose their size limits on their Web sites; others will give you a closing range if you call. But with all of the hot money in this sector, it may be wise to avoid it right now and look for opportunities elsewhere.

By Lewis Braham

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