Micro-Scoping

L.A. Times Archives

Nov. 18, 1997 12 AM PT

Robert Kern has been putting up some big numbers with little companies. His Fremont U.S. Micro-Cap Fund has more than doubled in value over the three years ended Oct. 31. It’s one of about three dozen funds that focus on tiny stocks, which make up the most volatile and overlooked sector of the domestic market. Researcher Morningstar Inc. of Chicago gives the Fremont fund a top five-star rating.

Although micro-cap mutual funds are fairly new, Kern has been targeting the market’s minnows since the early 1980s and small stocks generally since the 1960s, when he broke into the investment business as a research analyst and portfolio manager with Chase Manhattan Bank.

Kern later switched to Morgan Grenfell before founding his own firm, Kern Capital Management, where he was joined by his son David, now 33, the former manager of the Founders Discovery Fund. The senior Kern, 61, has been running Fremont U.S. Micro-Cap since its inception in mid-1994.

Fremont is a San Francisco fund family that grew out of Bechtel Corp.’s profit-sharing plan, and it still is owned by the privately held engineering company.

Kern grew up in Factoryville, Pa., which he says doesn’t have much of an industrial base but does enjoy some notoriety as the hometown of baseball legend Christy Matthews. Even today, Kern, who works in New York, spends weekends at his Pennsylvania home. He spoke last week to Russ Wiles, who writes about mutual funds for The Times.

Times: The fund has gotten off to a good start during its brief three-year tenure. What’s your approach?

Kern: We’re growth-oriented, using fundamental research as a foundation. We focus on economic sectors where the level of innovation is highest. We strongly believe that for micro-cap companies to be successful, they need to be innovators. You can’t be a “me-too” small company competing against giants. We like to find companies that are leaders, even dominant, in niche product areas.

Times: How do you define micro-caps?

Kern: We define them as occupying the bottom 5% of the U.S. stock market, based on market capitalization. We disregard companies whose shares are worth less than $10 million, because we can’t buy much stock in these companies yet we still have to do the same amount of research. So of the remaining firms worth at least $10 million, we focus on those in the bottom 5%. Companies worth $410 million each make up the upper ceiling of that bottom 5%.

In terms of numbers, there are more than 4,600 micro-caps with capitalizations between $10 million and $410 million, or two-thirds of all stocks in the U.S. So it’s a huge universe, with ample stock-selection opportunities.

Times: How do you minimize the risks of investing in small companies?

Kern: Basically, we evaluate companies with the aim of answering three questions: How good is the business? How good is management? How much is the business worth? We also control risk by diversifying within the portfolio and by attempting to minimize our transaction costs.

Times: In which sectors is innovation greatest?

Kern: The four areas we concentrate on are technology, health-care, consumer and service companies. That doesn’t mean there isn’t innovation going on elsewhere, such as in the financial, energy or transportation industries, but our primary focus is on the four areas I mentioned. This ties in nicely with what’s going on with private venture capitalists, who also are extending financing primarily to companies in [those areas].

Specifically, we have 26% of the fund in technology stocks, 18% in service companies, 15% in consumer stocks and 10% in health care. Companies in other sectors comprise 21%, leaving the remaining 10% in cash.

Times: Do you invest in initial public offerings?

Kern: Yes, but selectively. In some cases, we follow companies before the IPO stage if we think they’re attractive. We want to keep our awareness high.

Times: What, exactly, do you mean by fundamental research?

Kern: We look at financial information--the income statement and balance sheet--and the competitive position of the company. And we visit companies, which allows us to judge management. One advantage of doing micro-cap research is that these companies are relatively small, with only a few key decision makers. That makes it easier to talk directly to the people who will be responsible for a business’ success or lack of success.

Times: What are some examples of stocks you currently like?

Kern: One representative holding is Channell Commercial (ticker symbol: CHNL) in Temecula, Calif., and another is Richey Electronics (RCHY) in Garden Grove.

Channell manufactures the environmental enclosures into which the electronics associated with broad-band communications are housed. More electronics are being housed closer to homes and small businesses, and you need to protect this equipment. Channell is a major beneficiary of the trend toward more broad-band communications in the home and small office. There’s a battle shaping up between the telephone and cable companies regarding who’s going to bring you all the services associated with greater bandwidth and greater access speed on the Internet. Channell is supplying ammunition to both sides.

Richey Electronics distributes passive electronic components, primarily connectors. The company sells products from eight of the 10 connector manufacturers on a national basis. Connectors are some of the broadest-based components, used in products ranging from appliances to computers. One of our larger holdings is MDSI Mobile Data Solutions (MDSIF), which is in the business of providing software and systems to automate field-service work crews such as those at utility and telephone companies. Both utilities and telephone companies primarily had been monopolies, but now they’re opening up to competition, so service will become more important. If you have ever tried to get an installer to come to your home, you realize the problem with scheduling--never knowing when they’re going to show up. The automation that Mobile Data Solutions provides also helps to reduce costs.

Another representative holding is Specialty Teleconstructors (SCTR), a leading company involved in the build-out of antenna and base station infrastructure for personal communications systems and cellular.

Times: It sounds as if the fund owns a lot of technology stocks.

Kern: This is the sector I’m responsible for. My son follows computer software and health care. Judy Finger is our consumer expert. All three of us get involved with service companies.

Times: Do you buy many foreign stocks?

Kern: Some of the companies are headquartered outside of the United States. For example, Mobile Data Solutions is based near Vancouver, British Columbia. But the vast majority are here in the U.S. If not, they’re doing most of their business here.

Times: Many micro-cap funds already have shut their doors to new shareholders because of large size. Your fund has $165 million in assets. Are there any plans to close it when assets rise to a certain level?

Kern: Not at present. With six investment professionals, we can ramp the assets considerably before we have to close the fund. But there may come a point when that would be appropriate. We’ve talked about closing at $300 million, but that’s not cast in stone. It depends a lot on the state of the market. We would be less inclined to close the fund if the market was down and there were a lot of opportunities.

Times: Given the risks involved and the research that’s necessary, are most people better off sticking with a micro-cap fund than trying to pick individual stocks?

Kern: I think so. There are a lot of challenges. When I told you how big the micro-cap universe is, you might have concluded that there are a lot of unsuccessful companies, and it’s true. This is where research comes in, for sorting out the unsuccessful companies from the successful ones.

Times: Are we currently in a good climate for micro-cap stocks?

Kern: I think so, if you’re willing to take a long-term approach.

There are several driving forces that will focus investor attention on successful micro-cap companies. One is that the leadership of large U.S. companies is being questioned in terms of their future earnings growth prospects. We’re seeing slower growth for many of these firms, partly because they have large international exposure. A second factor reflects what has happened recently in world markets, with the emerging nations in particular. People had looked for appreciation opportunities in those areas of the world because their economies were growing faster. I think some of those investors now will focus on the U.S. market, given the problems in emerging nations, especially in the Far East and South America.

Times: The fund’s performance this year has been weaker relative to other micro-cap funds than in 1995 or 1996. Any explanation?

Kern: Our cash reserves have been a bit high, which detracted from our performance earlier in the year. In October, technology stocks were the ones that took the biggest hit at our fund and many others. We have roughly 26% of our portfolio in technology stocks, and they were down about 18% for the month.

Times: Compared with large stocks, micro-caps overall have performed much better since the second quarter. Does this suggest the long bull market might still have legs?

Kern: I’m not a market forecaster. But I think a broadening of the market is healthy. I don’t think it was healthy when all of the focus, attention and performance was concentrated in a relative handful of large stocks. There are a lot of micro-cap managements out there doing an outstanding job of running their businesses and building long-term value for shareholders.

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Fremont U.S. Micro-Cap Fund

Strategy: Seeks long-term capital appreciation by investing in stocks with market capitalizations of $10 million to about $400 million.

VITAL STATISTICS

Year-to-date ret. through Oct. 31: 12.6%

YTD ret., avg. small-cap growth fund: +17.6

1-year return: +28.8

1-year ret. avg. small-cap growth fund: +19.2

1-year return: +28.8

1-year ret. avg. small-cap growth fund: +19.2

Five biggest holdings as of Oct. 31:

1. Saga Communications