Small-Caps That Still Want You

Many hot small-company stock funds are closed to newcomers -- but not these

Tried to invest in a good small-company stock fund lately? One by one, funds that specialize in small- and micro-cap stocks have been slamming the door on new investors. In the past year, more than 27 have closed, including leading performers such as the Fidelity Low-Priced Stock (FLPSX ) and Royce Opportunity (RYPNX ) funds.

You can hardly fault the managers. Last year was super for small-company stocks, with the Russell 2000 small-cap index gaining 47% and the Wilshire Micro-Cap Index rising 92%. (Small-cap companies have assets below $2 billion; micro caps often go no higher than $400 million.) The gains, coupled with massive inflows from investors, make it harder to find enough stocks at attractive prices to fill their bulging portfolios. Rather than lowering standards or reaching up to the mid-cap universe -- either of which can hurt returns for current shareholders -- many managers slow the flow by turning away new investors.

Closing doors are frustrating for investors who think there's still money to be made. Analysts say a pickup in merger activity, plus forecasts for strong earnings, should bolster these stocks in the near term. And small caps deliver over time: They outperformed large caps in 48 out of 59 20-year periods since 1926, according to Prudential Equity Group (PRU ). Small caps play a key role in a diversified portfolio.

With that in mind, BusinessWeek set out to find worthy small-cap funds that still welcome new investors. We screened the Morningstar database of 414 funds, focusing on portfolios of less than $100 million, which should leave ample room for expansion. We asked each firm about plans to cap fund size. Finally, we checked performance. Most funds on our list are fairly new, but the managers have earned their stripes on similar portfolios. Here's what we came up with:


Bridgeway's John Montgomery is a whiz at selecting small-cap stocks. He already manages three successful small-company funds that are closed to new investors, including Bridgeway Ultra-Small Company (BRUSX ), which is up an annualized 37.09% over the past five years (through Apr. 16) and ranks at the top of its peer group. Montgomery is a by-the-numbers investor who says he can find better buys by crunching corporate data than by chatting up CEOs. "We are not visiting companies or thinking about demographics or future trends or competitive analysis," he says.

The stocks that make it into his two new growth and value portfolios introduced last October are culled from 3,000 that his firm considers the most liquid. That helps cut transaction costs. And both new funds have an expense ratio below 1%, compared with the typical 1.68%.


You can get in on the ground floor of this fund, which is expected to launch in late April or early May. It will be run by the same four-member team that oversees the $1.4 billion Buffalo Small Cap Fund (BUFSX ), which has delivered an average annualized return of 24.75% over the past five years.

Because this micro-cap fund is still awaiting final approval by the Securities & Exchange Commission, Buffalo officials can't talk about it. According to the prospectus, the fund will focus on companies with market caps below $600 million. It is expected to close after it reaches $250 million in assets.


Manager Carl Wilk is another small-cap ace. He formerly ran the chart-topping Munder Micro-Cap Equity (MMEAX ), which gained an annualized return of 23.05% from 1997 through 2001. Nearly two years ago, he launched Gartmore Micro Cap, which is available through financial advisers. Wilk expects to close the portfolio when assets hit the $200 million to $250 million range.

Wilk generally sticks to market caps of $300 million or less that are expected to increase annual earnings by 20%. He is a fan of companies with rapidly expanding earnings. One of his favorites is Celadon Group (CLDN ), a North American trucking service with a fairly new management team, which is selling at a deep discount to its long-term growth rate. Earnings are expected to jump 42% in 2004, and the stock is trading at a price-earnings ratio of 17 for the fiscal year ending June 30. That's not the only attraction. Wilk says Celadon's "wild card" is its truck-parts supply business. "Nobody knows about it or pays attention to it," Wilk says.


The fund is up some 77% since it launched in May, 2002. But what really distinguishes this portfolio from its peers is that its manager can sell stocks short and hedge up to 25% of the fund. With those tools, Vincent Gallagher helped the fund stay buoyant as small caps dipped earlier this year. He has since cut short positions in half, to 3%.

Gallagher is also co-manager of Needham Growth (NEEGX ), a mid-cap growth fund that is up an annualized 6% in the past three years. Both portfolios specialize in growth stocks, but Gallagher tries to buy them on dips. In fact, he recently purchased defibrillator-maker Zoll Medical (ZOLL ) after it missed its first-quarter earnings estimates and fell from $43 to $31. Gallagher isn't concerned about the shortfall. Zoll has no debt, and aging baby boomers are driving demand for its devices, he says.

Another reason to like Needham Small Cap Growth: Gallagher is one of the most accessible fund managers around. His direct phone number and e-mail address appear on the fund's Web site. At a time when most fund companies restrict manager comments to official reports, it's refreshing to find one who actually talks to shareholders.

By Lauren Young

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