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Micro-cap fund successes
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September 9, 1999: 12:11 p.m. ET
Some fund managers search for tiny stocks before they start growing
By Staff Writer Martine Costello
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NEW YORK (CNNfn) - As most of the investing world drifts towards the easy home runs with blue chip stocks like Microsoft and IBM, fund manager Bob Kern is happy to make his life more complicated.
Kern, of the Fremont U.S. Micro-Cap Fund, digs through more than 5,000 micro-cap stocks amid losers that could torch his portfolio for undiscovered winners that could quadruple in value.
"The challenge is finding the right opportunity within this huge universe of stocks," Kern said. "Investment mistakes are so costly in the micro-cap area … it makes it even more of a challenge to be right."
Small stocks, big returns
Micro-cap stocks are the fastest-growing companies that nobody knows about. They are thinly traded shares, with a market capitalization of up to about $500 million. They often sell in over-the-counter markets rather than an exchange like the New York Stock Exchange or the Nasdaq.
A winner can increase 1,000 percent in a matter of months when Wall Street catches on. A loser can end up all but impossible to unload.
"You want to find micro-cap companies early in their growth cycles," Kern said. His fund, with $233 million in assets, is up 40.4 percent year to date as of Aug. 31, according to Chicago fund researcher Morningstar.
While micro-cap funds missed out on the stellar gains of the S&P 500 in recent years, they have been experiencing a healthy rebound this year.
The 60 micro-cap funds tracked by Morningstar had average year-to-date returns through Aug. 31 of 8.19 percent, compared with 7.98 percent for mid-cap stock funds; 7.18 percent for large cap stock funds; and 6.79 percent for small-cap stock funds.
"You see some very good stock pickers out there," said Richard Hefter, editor of Microcap1000.com, a Web site that tracks stocks in the sector. Microcap1000.com's model portfolio of 15 stocks is up about 80 percent year to date as of Wednesday, he said.
Among mutual funds, the top performer in the category is the Van Wagoner Micro-Cap Fund, up 100.4 percent year to date through Aug. 31, according to Morningstar.
Raiford Garrabrant, analyst and portfolio manager at the Van Wagoner fund, thinks the sector turned around in the past year in part because people finally started to notice the disparity in valuations between the biggest and smallest companies.
(The valuation, or price-earnings multiple, is the stock price divided by the earnings-per-share. Microsoft's p/e is 66, while micro-cap stocks can have valuations in the teens).
"Valuations are a big part of it -- the fact that the sector was ignored for so long," Garrabrant said.
Rai Reyes, co-portfolio manager of the RS MicroCap Growth Fund, thinks micro-caps could be on the verge of a big turnaround as Internet stocks falter and large caps start to stall.
"People are beginning to look for other opportunities," Reyes said. "It doesn't take very much money to flow into the micro-cap sector to make the stocks work."
The RS fund, with $85 million in assets, is up 17.3 percent year to date as of Aug. 31, Morningstar said.
How they do it
Reyes looks for several key ingredients: a great management team; a sustainable competitive advantage; and a growth rate of 20 percent or greater a year.
"You look at their track record, their credentials, and you meet with them," Reyes said. "When you buy these small companies, it's the management you're buying."
Kern, of the Fremont fund, said thorough research is crucial to finding micro-caps.
One of the Fremont fund's top holdings is Emulex (EMLX), which designs special "fibre channel technology" for high-speed storage networks. Kern started buying the stock at 12, and it closed Wednesday at 88-3/4.
Garrabrant said one of the biggest successes at the Van Wagoner fund is its investment in Exodus Communications (EXDS), which hosts Web sites for large "dot-com" companies like Lycos and CBS Sportsline, provides round-the-clock monitoring and bandwidth.
Exodus went public in early 1998, had an early bump in price, then languished through the summer. The Van Wagoner fund started buying the stock at 6-1/2 that August. By September, "you couldn't give the stock away." The fund bought more shares. Not long after that, the stock started soaring. It split twice, and hit a 52-week high of 89-3/4. The stock closed Wednesday at 72.
"They have one of the best business models in the Internet space," Garrabrant said. "They've been growing at a rate of 40 percent a quarter."
Garrabrant disagrees with Morningstar's assessment that the fund is a "highly speculative play," but acknowledges volatility.
"I can't argue with the fact that our returns are volatile," Garrabrant said. "that comes with investing in companies at the leading edge. The performance comes in short, powerful doses."
A cautious outlook
Garrabrant thinks the sector could experience some choppiness in the next few months because of interest-rate fears and rising valuations, but he remains bullish.
"We have a little more caution and defensiveness in the portfolio given how far things have run," Garrabrant said. "But generally we're happy about what we're hearing from the companies. … The bottom line is the fundamentals are more favorable with the companies we've invested in."
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