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Thinking Tiny

Small-company stocks continue to disappoint this year, as they have for the last five. Indeed, the Russell 2,000 index of small stocks has actually lost ground in 1998 through Monday--it’s down about a quarter of 1%, including dividends--while the total return of the Standard & Poor’s 500 index of blue-chip U.S. companies is a positive 19.2%.

But one segment of the small-cap universe is showing signs of promise: so-called micro-caps.

“If there’s any gold to be mined, it’s in the micro-cap zone--the bottom 20% or so of the small-cap universe,” says portfolio manager Chuck Royce, president of Royce Funds in New York.

Among these companies, usually categorized as those with market capitalizations (share price times number of shares outstanding) of $250 million or less, is potential for growth that tends to be overlooked on Wall Street, Royce says.

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Mutual funds that invest in micro-caps have outperformed the separate small-cap fund category in the last two calendar years--by 43% in 1997 and 19% in 1996, according to fund tracker Lipper Analytical Services.

What’s more, in both those years the average micro-cap fund actually beat the typical growth and growth-and-income portfolios, Lipper’s best proxies for large domestic stock funds.

Over the last 12 months, micro-caps have continued to outclass small-cap portfolios, advancing 13.8% through Thursday, versus 9.3% for small caps.

Of course, given that large companies still clearly are driving the bull market, why should you even bother with these tiny companies? Especially so far this year, when the average micro-cap fund has gained only about a quarter of what the S&P; 500 has?

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Well, if you believe that small-cap stocks will eventually rally, every catalyst that would spur such a run would, in theory, propel micro-caps that much further.

Consider earnings momentum. One of the reasons some Wall Street strategists think small caps will eventually rebound--and perhaps even overtake the large caps (something that hasn’t happened since the Bush administration)--is that small companies are less exposed to foreign markets, namely Asia.

About 30 cents of every dollar the typical large U.S. company makes in sales comes from overseas, says Satya Pradhuman, Merrill Lynch’s director of small-cap research.

By contrast, the typical small company generates only 10% of its sales in foreign markets. And micro-caps are even less exposed.

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At the same time, smaller stocks also are cheaper than large ones by many valuation measures.

According to Schroder & Co. emerging-growth strategist Dan Coker, small companies, as measured by the Russell 2,000 index, are trading at roughly 17 times their estimated 1999 earnings per share. That’s a 19% discount to the S&P;'s price-to-earnings ratio.

Notes Coker: “This is the best [biggest discount] it’s been in a long time--even better than 1990.” That year marked the start of the last great small-cap rally, which lasted through 1993.

Micro-caps are trading at an even deeper discount: Excluding companies with negative earnings, Coker says micro-caps, measured by the Schroder’s Micro-Cap index of 3,700 stocks, are trading at just over 13 times 1999 estimated earnings per share.

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Finally, the smaller a company is, the greater the likelihood that Wall Street will overlook it. And for stock pickers, undiscovered companies have the best potential for high growth.

Coker estimates that 98% of the companies in the Russell 2,000 now have at least one analyst covering them. The average small-cap company is covered by 5.1 analysts, he says.

But only 60% of micro-cap stocks are being followed at all. And the average micro-cap has only 1.7 analysts.

That’s about the same level of neglect that analysts showed the broader small-cap universe back in 1990.

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That’s why Coker believes “micro-caps today are like the small caps of 1990.”

Of course, there is a reason micro-caps are cheaper than large stocks: Smaller firms naturally are far riskier than large caps, and many ultimately will stumble or fail.

So rather than choose them yourself, you’re better off going with a professionally managed micro-cap mutual fund, where risk can be diffused among dozens or more holdings.

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To identify some promising funds that invest in micro-cap companies, we began with fund tracker Morningstar Inc.'s database of 630 domestic small- and micro-cap funds. To find the true micro-caps, we screened out those funds whose median market caps exceeded $250 million. This left us with 61 portfolios.

However, some of the most promising small- and micro-cap funds--such as N/I Numeric Investors Micro and Wasatch Micro-Cap--recently closed their doors to new investors, on the premise that it’s difficult to manage a micro-cap portfolio if its asset base grows too large or too fast.

So we screened out all funds that either are closed to new investors or have placed restrictions on them. And on that same premise, we also screened out funds that had more than $250 million in net assets under management. This took us down to 42 funds.

Typically, investors should wait for a fund to have at least a three-year track record. But in the micro-cap category, “you’d almost prefer a younger fund to an older one,” argues Sheldon Jacobs, editor of the No-Load Fund Investor newsletter. “If a micro-cap fund is any good and it’s been around for three years, chances are it’s too big to produce great returns.”

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Instead of demanding solid three-year returns, which we would normally do, we eliminated those funds that failed to beat the Russell 2,000 on a year-to-date and 12-month basis through the end of June.

And because decent returns are hard to come by in this sector--and because we wanted to hang on to as much of those returns as possible--we decided to throw out all the load funds (those with sales charges) on our list. This left us with six names.

Two of the funds, Royce Micro-Cap and Royce Low-Priced Stock ([800] 221-4268) are run by Chuck Royce, among the most experienced small-cap managers around.

His Micro-Cap fund, which invests in companies with market caps below $300 million, is 26% less risky than the typical micro-cap fund, according to Morningstar. Yet its annualized returns over the last five years are 11% greater than its peers.

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How does Royce do it? By limiting his investments to companies with strong balance sheets and above-average return on assets--a measure of profitability based on a company’s size. He also avoids risky, cutting-edge technology companies.

“We don’t try to find magic-bullet companies with whiz-bang patents,” Royce says. “We want real companies that we can rely on.” That means his tech exposure tends to come from firms like Richardson Electronics, an Illinois-based distributor of electron tubes, microwave components and semiconductors whose shares have advanced more than 50% since last August.

While Royce’s micro-cap fund is up just 2.3% so far this year, that’s still better than the Russell 2,000. And the fund has delivered annualized returns of 15.1% over the last five years.

Royce’s Low-Priced portfolio, on the other hand, isn’t a micro-cap fund by design. But it tends to find tiny companies as it searches for stocks trading at $15 per share or less. Indeed, at the end of June, its median market cap was $171 million--$17 million less than Royce Micro-Cap’s. Over the last 12 months, the fund has gained 19.1%.

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Unlike Royce, David Evans and Rai Reyes are primarily focused on growth. Their fund, Robertson Stephens MicroCap Growth ([800] 766-3863), looks for companies with market caps between $50 million and $250 million that are poised to grow revenue and earnings 20% or more a year for at least the next three to five years.

This screen tends to deliver high-tech, health-care and retail names. Recently, 87% of the fund’s assets were invested in those three industries, as well as the services sector.

One of Reyes’ favorite companies right now is American Coin Merchandising Inc., with $59 million in annual sales. This Boulder, Colo., company owns and operates those “skill crane” machines you see in restaurants and supermarkets. You know the ones--you drop in a few quarters and try to pick up stuffed animals or toys in a bin.

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Though it may surprise you, this business’ earnings and sales are growing more than 25% a year, Reyes says. And its margins are due to expand, since the toys its machines dispense are made in Asia, he says.

Robertson Stephens says it will close MicroCap Growth to new investors once it reaches $250 million in assets. It’s at about $125 million now.

You probably haven’t heard of one of the other growth funds that survived our screen: Bjurman Micro-Cap Growth ([800] 227-7264).

The portfolio, managed by George D. Bjurman & Associates in Los Angeles, was launched in March 1997 and has less than $10 million in assets. It’s too small to make most newspaper fund lists. (Obviously, you should approach such a tiny, young fund with caution.)

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Yet its stunning 28.9% one-year return through Thursday is hard to ignore. Through the end of June, the fund delivered the best one-year return of any micro-cap portfolio.

The fund starts from a universe of 1,900 companies with market caps between $30 million and $300 million. Then it applies five computer models that judge companies based on earnings growth, earnings strength and earnings revisions. The models also search for stocks undervalued relative to the underlying company’s growth rates and cash flow.

Meanwhile, Safeco Small Company Stock ([800] 426-6730) is a hard fund to pigeonhole. It’s not a growth fund. Nor is it strictly value-oriented. In fact, it’s technically not even a micro-cap portfolio--though this small-cap fund’s median market cap is a low $169 million.

Yet with 12-month returns of 19.2% through Thursday, Small Company Stock has certainly been performing.

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Fund manager Greg Eisen looks for small companies in industries he favors. Currently, this includes the technology and financial sectors. He also likes companies that are trading at a discount to their growth rates.

For instance, his portfolio’s so-called PEG ratio--its price-to-earnings ratio divided by its earnings growth rate--is currently about 0.6. Typically a PEG ratio below 1 indicates good value, because the fund would be buying companies whose earnings are growing faster than their P/E multiples.

By comparison, the PEG ratio of the S&P; 600 index of small-cap stocks is 0.9. The S&P; 500’s PEG is a whopping 3.7.

You can think of it this way: S&P; 500 stocks are six times as expensive to buy, in relative terms, as companies in Eisen’s portfolio.

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Shadow Stock Fund ([800] 422-2766), which has beaten the average micro-cap fund over the last one, three, five and 10 years, follows a simple academic premise:

Tiny, undervalued and overlooked companies that trade in the “shadows” of the larger stock market will, given time, outperform the market.

The portfolio, managed by the Babson fund group, sticks with stocks with market caps of $20 million to $200 million. The fund seeks neglected stocks. So if institutional shareholders own more than 25% of a company, the fund won’t buy. Nor will it buy shares trading at more than 1.5 times book value. (Book value measures a company’s net worth by taking its assets and subtracting out its intangible assets and liabilities. Taking a stock’s price and measuring it against book value is a classic technique in value investing.)

To make sure it invests in only stable companies, the fund also screens out firms that haven’t earned at least $1 million a year for the last three years, says co-manager Nick Whitridge, who also manages the highly regarded Babson Value fund.

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Shadow Stock isn’t loaded with household names, but you’ve probably heard of one of this fund’s winners: Winnebago Industries. Shares of this recreational vehicle maker, with annual sales of $438 million, are up more than 70% since November.

Fund Strategies considers tactics used to choose mutual funds. Times staff writer Paul J. Lim can be reached at paul.lim@latimes.com.

* FINDING WINNERS: A conversation with the editor of the highly rated OTC Insight newsletter. D9

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The Mighty Micro-Caps

While they still badly trail the S&P; 500 so far this year, these six micro-cap funds are outrunning the Russell 2,000 index of small company stocks. Year-to-date returns through Thursday:

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YTD 1-yr. Med. mkt. Assets Fund Name tot. ret. tot. ret. cap (mil.) (mil.) Bjurman Micro-Cap Growth 16.8% 28.9% $205 $7 Safeco Small Co. 8.6 19.2 169 57 Stock No Load Royce Low-Priced Stock 10.4 19.1 171 22 Shadow Stock 5.8 17.9 152 53 Robertson Stephens 4.0 12.3 151 123 MicroCap Gr. A Royce Micro-Cap 2.3 11.6 188 209 S&P; 500 18.4 23.1 Average micro-cap 5.3 13.8 Russell 2000 1.9 9.7

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Fund Name 800 number Bjurman Micro-Cap Growth 227-7264 Safeco Small Co. 426-6730 Stock No Load Royce Low-Priced Stock 221-4268 Shadow Stock 422-2766 Robertson Stephens 766-3863 MicroCap Gr. A Royce Micro-Cap 221-4268 S&P; 500 Average micro-cap Russell 2000

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Source: Lipper Analytical Services


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