Double-Digit Growth Makes Smallest Stocks All the Rage
Micro-cap funds, which hold the smallest of the small stocks, are the hottest little thing in the mutual fund business these days.
Twenty-eight of the 38 funds Morningstar Inc. classifies as micro-cap have posted double-digit gains so far in 2001, while large-stock growth funds, the mainstay of many a portfolio, are down 19% as a group year-to-date. Boston Partners Small Cap Value, Schroder Ultra and Franklin MicroCap Value have each soared more than 35% this year, leaving some fund investors to ask: “What bear market?”
Going with the stock market’s strength, investors poured far more cash than ever into micro-cap funds in the year’s first half, according to Lipper Inc. Through June, micro-cap funds reaped a net $1.5 billion, lifting their total asset level to $8.1 billion, Lipper said. Net flows measure new cash from investors minus redemptions.
The cash stampede has spurred managers to close many of the funds to new investors in an effort to keep asset levels manageable. Wasatch Advisors Inc., for instance, not only shut its Wasatch Small Cap Value fund to new investors Tuesday, but also closed Wasatch Micro Cap--already off-limits to new customers--to new money from existing shareholders.
The reason micro-cap funds are atop the world is simple: The market has basically inverted over the last two years. After virtually ignoring smaller stocks through the bull market of the late 1990s, investors have been flocking to them and dumping large stocks.
A.G. Edwards & Sons Inc. market strategist Al Goldman recently noted that capitalization- and price-weighted indexes such as the Standard & Poor’s 500, the Nasdaq composite and the Dow Jones industrial average have masked a stealth bull market among smaller stocks.
Through July 17, for example, Nasdaq was down more than 10% for the year, dragged underwater by big tech names. But if every stock were weighted equally, the index would have been up nearly 20%, Goldman said.
Investors intrigued by the performance of micro-cap funds might be asking: Just what are they? How do they fit into one’s portfolio? And can their sizzling returns persist?
To start with, there is no official definition of “micro-cap.”
Jim Oberweis, manager of the Oberweis Micro-Cap fund, takes a stricter view than many, defining micro-caps as stocks under $100 million in market capitalization (that’s the share price multiplied by the number of shares outstanding) at the time of purchase. Other definitions have market cap ceilings ranging from $250 million to $500 million.
Whitney George, manager of Royce Micro-Cap, said the need for a micro-cap category emerged in the early 1990s as the definition of a “small-cap” stock kept rising.
“Small-cap used to be $300 million [market cap] and less, then it became $1 billion, and now it can be $2 billion,” he said.
George’s fund sets the micro-cap ceiling at $400 million, a recent change from $300 million. He said he doesn’t want to sell winning stocks prematurely--triggering capital gains--just because their market caps have ballooned because of price appreciation.
Morningstar, for its part, defines micro-caps as stocks with a capitalization below the stock market’s 2,500 biggest.
What kind of companies are you likely to find in a micro-cap fund’s portfolio? According to Morningstar, Royce Micro-Cap recently owned such stocks as Ocular Sciences Inc., a contact lens maker with $177 million in sales last year and a 80% market return year-to-date, and Navigators Group Inc., a global insurance holding company with $120 million in revenue and a 46% return this year.
Among Oberweis’ holdings were gourmet cheese maker Suprema Specialties Inc., which had $278 million in sales last year and whose stock is up 90% this year, and Headwaters Inc., a synthetic fuels maker with $27 million in sales and an eye-popping 2001 return of 346%.
As with most fund groups, sectors weightings--the percentage amount of its assets a fund invests in various industry sectors--vary widely among micro-cap funds. For example, Pacific Advisors Small Cap’s top sectors are industrial stocks (22%), services (18%) and tech (13%), according to Morningstar, while Oberweis has 41% of its assets in tech, 14% in health care and 13% in services.
Because micro-caps are small--no matter where the line is drawn--they can be risky.
“There’s more likelihood that these companies will depend on one product, one service, one executive or even one major customer,” said Preston Athey, manager of T. Rowe Price Small-Cap Value, which has about 30% of its assets in micro-caps. “There’s a greater danger of a company going out of business.”
But risk can bring reward.
“Historically, small-cap stocks do better than large-caps over time, which only makes sense,” said John Montgomery, manager of Bridgeway Micro-Cap Limited and other small-cap funds. “Riskier investments should command a premium.”
Many micro-cap funds, including Montgomery’s, spread that risk around by holding 80 or more names. George said he likes to have 150 stocks in his portfolio, and Athey’s fund recently held 200.
For investors, micro-caps can provide the ideal portfolio counterweight to large-cap stocks, according to a recent report by Satya Pradhuman, small-cap research director at Merrill Lynch & Co. Over the last 25 years, a mix of 85% large-caps and 15% micro-caps offered one of the best risk-reward profiles, Pradhuman said, meaning high returns with relatively low volatility.
Morningstar’s chief fund analyst, Russel Kinnel, also thinks micro-cap funds can have their place in a portfolio.
“I wouldn’t be buying with both fists, especially after such a smoking run,” Kinnel said, “but micro-caps are so quirky and act so differently from the rest of the market that they genuinely offer diversification.”
Though investors should not expect the funds to keep delivering monster returns, micro-cap managers said they think the market could continue favoring smaller stocks for a year or two more.
“We’ve got excellent wind conditions,” George said, noting that small-caps have done well since 1999 and “value” stocks since early 2000. Royce’s funds favor value stocks, or those with cheap prices relative to company fundamentals such as earnings.
Montgomery also thinks the small-cap run still has steam.
“After they were left behind so badly for so long in the late ‘90s, the normal cycle of catching up means there is probably farther to go,” he said.
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Mighty Micro-Caps
Riding the strength of small-cap stocks, micro-cap mutual funds have enjoyed a banner year. The biggest gainers:
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Fund Year-to-date return Boston Partners Small Cap Value +40.2% Schroder Ultra +39.1 Franklin MicroCap Value +37.6 Wasatch Small Cap Value +32.4 Perritt Micro Cap Opportunity +31.2 Bridgeway Micro-Cap Limited +27.8 Wasatch Micro Cap +26.9 Bridgeway Ultra-Small Company +25.4 Berwyn +24.9 Heartland Value +24.7 S&P; 500 index -7.6
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Strong performance led to the highest net cash inflow on record for the micro-cap fund category in the year’s first six months:
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Net cash inflow or outflow to micro-cap funds, in billions
2nd half ‘96: .04
1st half ‘97: .12
2nd half ‘97: .35
1st half ‘98: .16
2nd half ‘98: -.01
1st half ‘99: -.01
2nd half ‘99: .39
1st half ‘00: .46
2nd half ‘00: .10
1st half ‘01: $1.54
Sources: Morningstar Inc., Bloomberg News, Lipper Inc.
Micro-Cap Takes the Lead
Micro-cap stock mutual funds have posted strong gains this year, on average, while most other key fund categories are in the red. A sampling of fund sector returns:
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Average total return, Category year-to-date through Friday Micro-cap +15% Small-cap value +12% Precious metals +8% Large-cap value -2% Small-cap growth -8% Natural resources -8% Health-care -13% Large-cap growth -19% Technology -34%
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Source: Morningstar Inc.
