50 small-cap stocks that rock

(FORTUNE Small Business) -- Call it the rally that wouldn't quit. After nearly six years of spiffy performance, small-cap stocks headed into 2005 were facing a wave of dire predictions. The widespread view of market seers: Small-cap prices were too rich, the Johnny-come-lately fans too many, the bargains too few. Yet small caps sailed through 2005, besting their larger-cap peers by a wide margin. For the 12 months ended May 1, 2006, the Russell 2000 index of small-cap stocks returned 31.5%, compared with 14.4% for the Standard & Poor's 500 index of large-company stocks.

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The longer view is even more impressive: Since March 2000 (the official start of this rally, when small caps bottomed out relative to their large-cap peers), the Russell 2000 index has posted an average annual return of 7.3%, vs. -0.6% for the S&P 500. Why? Analysts point to the superior earnings growth of the smaller companies and to their allure as takeover targets.

Yet even as small-cap fund managers count their gains, they are voicing cautions. Observes John Montgomery of Bridgeway Capital Management, where he co-manages ten funds with assets totaling $2.7 billion: "As a group, value in small caps is much harder to come by." Take those as words from one who knows a good value. Among the ten money managers polled by FSB at this time last year, Montgomery stole the show: His five stock picks rose, on average, 103% over the 12 months, soundly defeating the Russell 2000. (In the aggregate, the 50 companies our managers recommended last year returned 46.7%.)

But the success of small-cap mutual funds has a price. Since the beginning of 2005, more than 30 such funds have closed their doors to new investors, bringing the total number of shuttered small-cap offerings to 103 out of a total of 597 funds, according to Morningstar. (All the funds listed on page 47 are open to new investors.) And small-cap stocks are becoming expensive - the average price/earnings ratio for the Russell 2000 index is about 28, compared with 18 for the S&P 500.

Take heart, though. The fund managers featured here may see fewer great investing opportunities, but they say they're still finding winners.

This is an excerpt from a FSB magazine feature "Little Stocks That Rock."

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