Smallest Stocks Showing Big Gains

Small-company stocks this year are again off to a poor start. That is, except for the smallest of the small--shares known as micro-caps.

The average micro-cap stock mutual fund gained 3.8% in January, according to Lipper Analytical Services.

That was 10 times better than the performance of the average small-cap fund during the month. And more important, it nearly matched the performance of the Standard & Poor’s 500 index of blue-chip stocks, which continues to lead this bull market.

Small-cap stocks are generally defined as companies with market capitalizations (stock price times number of shares outstanding) of $1 billion or less, while micro-caps are those with market-caps of $300 million or less.

“The smaller of the smaller are clearly doing better,” said Jay Matulich, chairman of MicroCap1000.com, a Santa Monica-based research firm that offers information, over the Internet, on publicly traded micro-cap stocks.

This relative outperformance represents more than a short-term blip. Over the last 12 months the typical micro-cap fund has advanced 6.1%, versus 1.8% for the average small-cap fund and a loss of 0.5% for the Russell 2,000 index of small-company shares.

And over the last three years, micro-cap funds have delivered average annual gains of 16.4%--a return one-third higher than the Russell 2,000, Lipper says.

That still trails blue-chip returns, however. And analysts note that, by definition, micro-caps can be extremely risky securities.

In any case, exactly why micro-caps have outperformed small-caps isn’t entirely clear, though micro-cap fund managers and analysts have their opinions.

One possible explanation is that micro-cap funds tend to be smaller not just in terms of the size of the stocks they buy, but in terms of their assets.

Having a smaller pool of money to invest makes it easier for fund managers to preserve gains made on a handful of winning stocks, argues Dan Coker, author of “Mastering Microcaps: Strategies, Trends, and Stock Selection” (Bloomberg Press).

For that reason, many successful micro-cap funds are electing to close their doors to new investment once they hit $100 million in assets. Jim Oberweis, manager of the $30-million Oberweis Micro-Cap fund in North Aurora, Ill., has already decided to close his fund once its asset base reaches $60 million.

There may, of course, be other reasons why micro-caps are doing so well. Thomas Barry, manager of the $10.5 million Bjurman Micro-Cap Growth fund in Los Angeles, believes investors are finally noticing the strong earnings growth potential of many micro-cap firms.

He notes, for instance, that “micro-caps have little to no international exposure,” an important consideration at a time when a strong dollar and Brazil’s recent currency devaluation continue to threaten U.S. exporters.

Often, the larger a company is, the greater its reliance on foreign sales. Indeed, while the typical large company generates 30% of its sales overseas, only 10% of the typical small-cap company’s sales come from foreign markets.

Micro-cap firms are even less-exposed--which is another way of saying their fortunes are tied almost exclusively to the robust U.S. economy.

According to research firm First Call Corp., Wall Street analysts expect earnings of the Russell 2,000 companies to rise 14.6% a year, on average, for the next five years, while S&P; 500 companies’ earnings are expected to grow 12.8% a year in that period.

Prudential Securities small-cap analyst Claudia Mott notes that, despite faster expected earnings growth, smaller stocks in general are trading for much lower price-to-earnings ratios than blue chips. That relative value may be even more pronounced among micro-caps, she says.

That wouldn’t be a surprise, Coker says: The micro-cap sector is little-covered by Wall Street. And that just means there are more market pricing “inefficiencies” for fund managers to discover and exploit--which may account for the stocks’ recent strength.

The small-cap market used to be considered inefficient as well, “but the information is much better today,” Coker says. Indeed, the average small-cap stock now is covered by 5.1 Wall Street analysts.

By comparison, about 40% of all micro-cap stocks aren’t covered by a single analyst, he says.

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Mighty Midgets

Here are the top-performing “micro-cap” stock mutual funds over the last 12 months, out of 56 such funds tracked by Lipper Analytical. Micro-cap stocks are the smallest of the nation’s small stocks.

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YTD 1-year 3-yr. return, Fund Name total return total return annualized Schroder Micro Cap +4.4% +70.7% NA Oppenheimer Enterprise +8.7 +44.8 +30.4% Brazos/JMIC Micro Cap Growth +3.6 +36.2 NA Van Wagoner Micro-Cap +16.0 +36.0 +6.8 N/I Numeric Investors Micro Cap +2.1 +22.3 NA Wasatch Micro-Cap +3.8 +20.6 +24.6 PBHG Limited +3.5 +18.5 NA Fremont Institutional U.S. Micro-Cap +9.7 +18.4 NA Bjurman Micro-Cap Growth +1.1 +14.9 NA Nicholas Applegate Mini-Cap +2.9 +13.4 +23.6 Oberweis Micro-Cap +4.7 +10.0 +13.3 Avg. micro-cap fund +3.8 +6.1 +16.4 Avg. small-cap fund +0.4 +1.8 +13.0 Russell 2,000 Index +1.3 --0.5 +12.2

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Note: Return figures through 1/31

NA = not available; fund didn’t exist for entire period.

Source: Lipper Analytical Services