Big Returns In The Smallest Packages

Micro-cap funds can produce an oversized payoff for investors

Over the years, stocks have been great investments. Ibbotson Associates in Chicago calculates that $1 invested in large company stocks at the end of 1925 would have grown to $2,284.79 by the end of 2003, assuming that no taxes were levied and dividends were reinvested. Not bad.

The numbers for small company stocks are better — much better. According to Ibbotson, over that same time period, your $1 would have grown to a staggering $10,953.94.

In Wall Street-speak, a company’s market capitalization is the total value of its shares. The small company stocks Ibbotson tracks are in the bottom 20% in terms of market cap. While a corporate giant, such as General Electric, has a market cap of more than $300 billion, an example of a micro-cap would be PetMed Express, a company that provides medical care for pets and has a market cap of around $139 million.

Historically, the top performers have been micro-caps. “They’ve been spectacular performers in the past three or four years,” says Laura Lutton, an analyst at mutual fund research company Morningstar. “When the economy was struggling, smaller and more nimble companies were more likely to keep growing, and their stocks did nicely.”

The Littlest Leaders
Indeed, of all the diversified U.S. stock funds tracked by Morningstar, the best three-year return through the first quarter of 2004 was posted by Bridgeway Ultra-Small Company Market (BRSIX), which gained more than 40% per year. Others in the top 10 included Oberweis Micro Cap (OBMCX), Perritt Micro Cap Opportunities (PRCGX), and Fifth Third Micro Cap Value (MXSAX), all of which had annual returns between 25% and 30%. Says Lutton, “Funds in this category have done so well that we question how long they can continue to be leaders. Investing in such small companies can be extremely risky with the potential for painful losses, so I wouldn’t make them a core holding. Nevertheless, they can deliver large gains, too. For many micro-cap funds, the past performance has been so strong that they could play a small role in a diversified portfolio.”

Similarly, Ron Pearson, president and CEO of Beach Financial Advisory Service in Virginia Beach, Virginia, says that investors should limit micro-cap fund holdings to less than 5% of their portfolio: “[With that percentage], you reduce the risks of investing in micro-caps. At the same time, outstanding performance there could make a positive difference for your overall returns.”

According to Pearson, the good news is that good micro-cap managers generally do well year after year: “They know how to find good companies in an area of the market where not many people are looking.” The bad news? Most micro-cap funds try to avoid growing too large so they frequently close to new investors after they’ve successfully attracted substantial capital.

Where to invest
Those looking to invest in microcaps now must find a fund that’s open to new investors. As of this writing, such funds included Gartmore Micro Cap Equity (GMEAX), which was up 93% in 2003, and Satuit Capital Micro Cap (SATMX), which rose 63%.

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