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Micro caps' secret success
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July 23, 1999: 7:14 a.m. ET
Finding good small stocks can be tricky, but the search may be worthwhile
By Staff Writer Nicole Jacoby
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NEW YORK (CNNfn) - It's common investor sense. In the midst of a housing boom, you snap up shares of Home Depot. And when the travel industry is flying high, Boeing stock is probably a good idea.
But behind almost every great blue chip, there are scores of great small companies -- known to investors as micro caps -- helping these larger companies keep it together.
"Take Boeing. The company does not manufacture one piece on an airplane," said Dan Coker, an independent investor and author of "Mastering Micro Caps." "But it has thousands of contractors and some of them are micro-cap companies."
Difficult to seek out and oft-neglected, micro-cap stocks can yield big gains if you've got a little patience and know where to look.
Defining micro caps
Micro caps can be difficult to categorize because various analysts define them in different ways. Generally speaking, micro-cap companies tend to have a market capitalization between $50 million and $300 million, although some analysts and fund managers put the range at a broader $10 million to $500 million.
Micro caps are sometimes confused with penny stocks, which are low-cost shares that are not listed on major exchanges and are usually traded over the counter. Penny stocks also sometimes have a fraudulent schemes associated with them.
The micro-cap universe is an extensive one, with more than 5,000 companies estimated falling into this asset class.
Looking at growth potential
While investors tend to be dazzled by the well-established reputations of celebrity issues, micro caps can be just as solid investments. That's because many of these companies are industry leaders, despite their relatively low market capitalization.
Photon Dynamics (PHTN), for instance, is only one of a handful few companies in the world that supply testing systems for flat-panel computer and television displays. The $101-million company trades at about $13.
Similarly, $130-million Information Resource Engineering (IREG) is a front-runner in the high-level network encryption sector, recently trading at $24. The company's clients include Citibank, J.P Morgan & Co., and the Federal Reserve Bank among other U.S. government agencies.
But finding these industry leaders is no easy task.
"I think it very difficult for individual investors to be aware of a huge number of micro cap firms," said Bob Kern, chief executive officer at Kern Capital Management.
Ironically, it is precisely the vastness and inefficiency of this asset class that makes this sector so potentially lucrative.
"Research coverage is very thin," said Satya Pradhuman, Merrill Lynch's director of small cap research. ".. so this is a truly small, undiscovered segment of stocks."
In other words, because micro caps are not as closely tracked as large caps, and because there are more of them, more hidden gems may exist.
Assessing gains
The gains of micro caps have been impressive when compared to their bigger and more popular Fortune 500 counterparts, especially over the long run.
Micro caps have outperformed large caps by about 5 percent over a 20-year period, according to data supplied by Merrill Lynch. The investment bank estimates micro caps jumped about 19 percent annually in that time frame, compared with a 14 percent leap by large caps.
Micro caps perform particularly well when larger shares falter. During the large-stock bear market between 1974 and 1982, micro caps saw average annual returns of 37.04 percent, far above the 12.01 percent realized by large caps. (See chart)
But of course, no asset class is infallible. From 1982 to 1990, micro caps experienced a meager average annual return of 2.72 percent while large caps shot up 15.27 percent. And just last year, micro caps struggled to stay on top, with gains of under 3 percent.
Reading between the numbers
But the data regarding micro caps can be deceptive. Because the asset class is so large and so variously defined, finding a representative benchmark is nearly impossible.
"There is a broader range of performance than in any other asset class," said Kern. "That's because there is very little commonality between portfolios (focusing on micro caps.)"
In addition, micro caps tend to be somewhat illiquid and fairly temperamental, making it difficult to ascertain short-term trends.
"The asset class generally over the long haul has outperformed the market as a whole. However, it also tends to be more volatile and the cycles of outperformance can be pretty severe," Pradhuman said.
Consequently, micro caps are generally considered a higher-risk, long-term investment.
Winning with micro caps
There are advantages to micro cap stocks despite the risk associated with them.
For one, micro caps tend to be less susceptible to larger macro-economic disturbances and to overseas market turbulence because they are rarely competing with international companies.
Micro caps also have great growth potential, sometimes ascending to small, mid or even large cap status, as blue chip bigwigs Wal-Mart Stores (WMT) and Cisco Systems (CSCO) did. Both companies came onto the trading scene as micro caps and now have market capitalizations of around $200 billion.
Of course, the wildly successful ascent of Wal-Mart and Cisco is not typical, but rewarding growth is a real possibility if you choose carefully.
"You can't look at a company in the micro-cap stage and say: 'This is the next Wal-Mart,'" said Coker.
But you can do intensive research to find innovative companies with solid business plans or demonstrated market leadership.
"I think there is way too much emphasis placed on asset class… I really prefer to look at it as the investment opportunity within an asset class," said Kern. "For longer-term success, you have to find the companies that will grow much larger... that's where the value occurs."
To maximize profits and minimize risk, several analysts recommend diversifying micro-cap holdings, even if they are part of a larger, broad portfolio. Others don't recommend taking on micro-caps by themselves.
"Investors should recognize the tremendous opportunity presented by the inefficiencies (in this asset class)," said Kern, whose U.S. Micro-Cap Fremont Fund is up 44 percent year-to-date and has seen average annual returns upwards of 28 percent since its inception five years ago.
But that opportunity requires a lot of fundamental research. "The best way to capture that is through an investment professional," said Kern.
Best of the bunch
Kern, whose fund tends to focus on the technology, health, consumer and service sectors, does have a few tips for investors, though.
His favorite micro-cap stocks include Emulex Corp. (EMLX), a leading supplier of fiber channel technology that Kern says may see "dramatic increases" later this summer. He also favors Photon Dynamics.
Coker's picks include motor home manufacturers National R.V. Holdings (NVH) and Rent-Way Inc. (RWY).
"The prime age of R.V. users is 50 to 65. The baby boomers are getting there," Coker only half-jokes.
Coker also likes kitchen cabinet maker American Woodmark (AMWD) and personal care products company Helen of Troy (HELE).
But investors would be remiss in limiting themselves to these choices, the author says.
"There are dozens and dozens of these companies," said Coker. "In large caps, the choices are much more limited." 
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