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Thinking Tiny

Overlooked Micro-Caps Are Cheaper Than Larger Stocks and Have Great Potential in a Small-Cap Rally

July 28, 1998|PAUL J. LIM

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.

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?

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.

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.

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.

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.

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