Try These SmallCaps On For Size

Funds little enough for veteran managers to run nimbly come out as winners

For those who feel they missed the bull market in small-capitalization stocks, now may be an opportunity to get in. The Russell 2000 Index, a small-caps benchmark, has pulled back 7% in three weeks.

But good luck trying to find a worthwhile mutual fund that invests in these companies. Of the 50 funds with the best five-year records, 30 are closed to new investors, while most of the others have grown too big to continue investing their assets as effectively as they have in the past. Funds small in size are desirable, but they're often run by less experienced portfolio managers, who are not.

BusinessWeek searched the world of small-cap funds, examined track records, and interviewed managers to identify some funds with those rare attributes: a veteran manager with a small-to-modest-sized asset base. An extra bonus: They're no-load, too.

PRESIDIO FUND One way to find a veteran manager with a new fund is to follow those who leave larger shops to open their own. That's the case of Kevin O'Boyle. He ran the successful Meridian Value Fund (MVALX ) from 1995 to 2004. Then he left to launch KCO Investments and the Presidio Fund one year ago. Right now his entire firm manages only $34.5 million, compared with the $1.9 billion Meridian Value had before his departure. "When Meridian Value got to be large, it would take us days if not weeks to build a position in a small company," O'Boyle says. "Now I can usually get in or out in a day."

O'Boyle favors busted growth stocks -- small or midsize companies in rapidly growing industries that have suffered a few quarters of poor earnings. One recent buy, Cardiac Science (CSCX ), a defibrillator maker with a tiny $200 million market capitalization, has a trading volume of about 70,000 shares a day. "When a stock has a volume that low, you can only acquire about 10,000 shares a day without pushing up its price," O'Boyle says. "In a big fund, I probably wouldn't even own it." During O'Boyle's lengthy tenure at Meridian Value, the fund boasted a 21.3% annualized return, vs. just 11.1% for the Russell 2000. That performance bodes well for his new fund.

NEW RIVER SMALL CAP Co-managers Andrew Taylor and Michael Cook are newbies to mutual funds, but not to small-cap investing. Prior to the Memphis- based fund's October, 2003, launch, they managed private accounts for their firm, Cook Mayer Taylor, with the same strategy that they use in the fund. Those accounts have had only one down year, a 5% loss in 1990, since the firm's founding in 1989. In the 10 years prior to the fund's launch, the accounts earned a 14.2% annualized return after fees, compared with 11.3% for its benchmark, the Russell 2000 Value Index.

Taylor says he follows the strategy first articulated by famed value investors Benjamin Graham and David Dodd in their 1934 book Security Analysis. He tries to buy companies at a 50% discount to their private market value, or the value a knowledgeable investor would pay to acquire the company. Yet while he spends a lot of time crunching numbers, he thinks evaluating corporate management is equally important. Among the larger holdings are Trinity Industries (TRN ), a builder of barges and railcars, and Agco, which makes agricultural equipment.

Knowing management and each company as well as possible is especially important because New River typically holds only 25 stocks, so a few stock picks can hit the fund hard. Although the firm manages $800 million in its private accounts, the mutual fund has only $40 million, plenty of room to grow.

PERRITT EMERGING OPPORTUNITIES FUND (PREOX ) If trading small-cap stocks is difficult, trading in microcaps can be grueling. Typically a small stock has a market value of less than $1 billion, but the average in newbie Perritt Emerging Opportunities Fund is less than $100 million. "Experience trading these tiny companies is critical," says manager Michael Corbett. "You have to figure out how to get shares without affecting the market or tipping your hand to other investors who may try to end-run your trades."

Corbett has more than 10 years of experience running the Perritt Micro Cap Opportunities Fund (PRCGX ), which has a $242 million median market cap and a lofty 15.1% 10-year annualized return. During his tenure, he has developed relationships with smaller brokerage firms that help him to place discreet trades in stocks with daily volume as low as 10,000 shares. Corbett plans to close Emerging Opportunities when its assets reach $110 million, a low enough level to remain nimble.

ADAMS HARKNESS SMALL CAP GROWTH If fund managers gain their best experience during bear markets, then small-cap growth managers are more fortified than most. They took the worst beating during the 2000-02 bear market. Indeed, Mary Lisanti of the Adams Harkness Small Cap Growth Fund is not afraid to show her battle scars. With 28 years' experience in the small-stock arena, she says she has "seen every kind of market." During the '90s she became a celebrity manager posting boffo returns at Pilgrim Small Cap Opportunities, which morphed into ING Small Cap Opportunities in 2000 after a merger. In 1999 the fund gained 146.9%, then lost 33% in 2001 and an additional 45% in 2002.

Lisanti says she learned from the experience. For one thing, she's more conservative in making earnings estimates for the fast-growing companies she invests in, and she pays more attention to macroeconomic factors such as inflation. "The biggest change is that all I do now is manage the fund," Lisanti says. "At other firms I spent a lot of time on administrative duties."

Lisanti runs only $100 million, about $20 million of it in the small-cap growth fund. And since she is an aggressive trader, managing a small asset base really helps. The fund's turnover ratio is nearly 300%, meaning she holds stocks for only four months on average. Adams Harkness Small Cap Growth has produced a solid 16.8% annualized return since its February, 2004, inception, compared with 12.5% for its benchmark Russell 2000 Growth Index and 12.2% for the average small-cap growth fund.

FORWARD HOOVER MINI-CAP In many ways, Irene Hoover's experience was the opposite of Lisanti's. In 1999, when many managers scored triple-digit gains by trading dot-com stocks, her Forward Hoover Small Cap Equity Fund lagged badly, gaining only 7%. But in five of the next six years it beat its small-cap growth peers. Today that fund manages more than $400 million, so the better Hoover play is Forward Hoover Mini-Cap Fund with $45 million in assets.

Hoover attributes her success in recent years to not overpaying for stocks. "We have very specific price targets for each company," she says. "If a stock runs up quickly, we will sell." Indeed, the turnover ratio for Mini-Cap Fund is 277%, all the more reason to be glad she has room in this fund to trade.

By Lewis Braham

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