Micro-Cap Mutual Funds: Searching for the Future Giants

    by John Markese

    Micro Cap Mutual Funds: Searching For The Future Giants Splash image

    The mutual funds that concentrate in the smallest stocks, often called either micro-cap stocks or emerging stocks, often provide entry to an interesting and rewarding market segment.

    The smallest stocks by market capitalization—market price per share of common stock times the number of shares outstanding—are probably not as small as you would think. They are all listed on the Nasdaq, American or New York Stock Exchange and most have market caps of greater than $200 million. Why even consider this investment niche?

    New products, services, and technologies often emerge from small companies, although the largest companies can do the same. But with small companies, the promise of the concept is a pure play, not just one idea in a very large stable where individual success can be easily lost when all the numbers are tallied.

    These micro-sized stocks also tend to have less institutional ownership on average than stocks with small, medium, large and giant capitalizations. With less institutional ownership comes less scrutiny—Wall Street research tends to ignore these stocks, and therefore, there may be more undiscovered values.

    However, with less scrutiny, shorter track records, newer products or services and probably not the strong balance sheets of the mature giant-cap stocks—think greater than $50 billion in market capitalizations—micro-cap stocks are clearly individually riskier: Greater promise, greater risk.

    But solid academic research based on the returns of micro-cap stocks has found that portfolios of small-cap stocks outperform larger stocks after adjusting for risk differences.

    A mutual fund holding 40 or so stocks mitigates the individual stock risks. This is the magic of diversification. And the nature of these micro-cap stocks makes them less correlated with the large-cap stocks that dominate the market and the indexes because of their elephantine capitalizations. A micro-cap fund, when added to a portfolio of larger-cap funds, is almost certain to reduce the overall risk of the portfolio.

    Defining the Caps

    The definition of a micro-cap stock—and, for that matter, a micro-cap stock mutual fund—is not fixed, but changes with market behavior and the decisions of mutual fund portfolio managers.

    At the end of 2002, Morningstar defined a micro-cap stock as a stock with a capitalization of less than $343 million. However, over the last three years as markets have gyrated, this cut-off has been as high as $421 million and as low as $203 million.

    What constitutes a micro-cap stock fund is more elusive and every bit as variable as the individual micro-cap stock cut-off. Table 1 ranks domestic, non-sector stock funds by the percentage of the mutual fund’s portfolio that is invested in micro-cap stocks. The highest micro-cap stock component, Babson Shadow Stock Fund, has 86% invested in micro-cap stocks and the lowest, Brazos Micro Cap, has 26% invested in micro caps.

    What percentage invested in micro-cap stocks defines a micro-cap fund? Well, Brazos subscribes to 26% and calls itself micro-cap, but the top four funds on this list average over 70% in micro-cap stock investments.

    The median (mid-point) market cap for all stocks held in these funds is also listed in the table. While the highest is $476 million (T. Rowe Price Small Cap Value), the four funds with the highest concentration of micro-cap stocks have median market cap holdings of around $200 million. None of these funds have any giant-cap stock holdings, there are insignificant large-cap holdings for only a few, and medium-cap stocks are held increasingly but not significantly as the list moves toward lower micro cap. However, for most of these funds, small-cap stocks (between $343 million and $1.296 billion in individual stock capitalization) are as important an investment as micro-cap stock holdings. Translation: The top of this list is micro cap and the bottom is small/micro cap.

    The number of stocks held by each fund is a function of how close to micro-cap the stocks are that are held, and how much is invested in the fund. The Babson Shadow Stock Fund, with $87 million in assets and the smallest median market cap at $179 million, holds 275 stocks, investing just over $300,000 in each.

    The smaller the cap of a stock, the less liquid the market in that stock. Big positions are hard for a mutual fund to acquire without pushing the price up. Large positions are also hard to liquidate on short notice without slamming the stocks.

    The largest median market-cap fund, T. Rowe Price Small Cap Value at $476 million, has less total stocks in its portfolio than the Babson Fund, but averages over $10 million per investment. A large fund asset base and the smallest of micro-cap stocks simply don’t mix. That is why the T. Rowe Price fund is closed to new investors. They can’t take any more money and still accomplish their investment objective.

    Interestingly, the majority of these funds tend to use a value approach to stock selection—low price-earnings ratios and low price-to-book value ratios are typical. But considering that these firms often have low analyst coverage and institutional interest, their tendency to be value stocks shouldn’t be too surprising.

    Macro Performance

    Small-cap value funds have also been one of the few star categories for stock funds over the last few years.

    And that gets us to performance. Table 1 reports total returns for each fund for the last three years individually and the three- and five-year compound annual returns.

    At the bottom of Table 1 are index funds representing all the cap sizes for comparison. These index funds are passively managed and incur extremely low costs compared to the actively managed funds—as indicated by their expense ratios.

    While the overall performance of the micro-cap funds compared to the index funds is relatively strong over the last five years, there are a few exceptions.

    The worst performer over the last five years was by Van Wagoner Emerging Growth with a –13.7% compound annual return. A closer look at this fund reveals that it tends to concentrate in small technology stocks. Recently, over 90% of the portfolio was committed to information software firms and traded rapidly. In short, this is a high-risk, non-diversified fund, incurring high expenses (a 1.84% expense ratio) and high risk. The risk index of 4.47 is enormous compared to the 0.89 index of the T. Rowe Price Small Cap Value fund. A risk index of 1.00 would be the median total risk of all mutual funds. However, the index funds make the point that the smaller the stock capitalization, the greater the variability of return. And micro-cap stock funds are the smallest of the small.

    The Macro-Cap Advantage

    If you don’t want to put together a portfolio of 20 or 30 micro-cap stocks yourself, here is why you should consider a micro-cap fund:

    • The micro-cap stock arena doesn’t have as much attention devoted to it as larger-cap stocks. As a result, an active micro-cap fund manager has a greater chance of adding significant value.

    • A substantial body of research exists that supports the notion that micro-cap stocks outperform large-cap stocks over the long term, even after adjusting for risk differences.

    • Micro-cap stocks do not track the overall market perfectly, adding to portfolio diversification.

    • New and successful industries, products and services are often developed by micro-cap firms that eventually evolve into large-cap stocks. Here is what to look for in a micro-cap stock fund. Get the prospectus and annual report and make sure the fund has:

    • A diversified portfolio with no heavy investment (more than 25% of the portfolio) in any one industry;

    • A five-year performance history that compares favorably to a small-cap index fund;

    • No more than $1 billion in assets;

    • A risk index no higher than 2.0;

    • Less than 1.75% expense ratio;

    • A significant concentration in micro-cap stocks, at least 25%, and at least 80% in small-cap and micro-cap stocks combined as a percentage of portfolio value; and

    • A median market-cap size of less than $500 million.
    Just remember, while all the giant stocks of today were once small, not all micro-cap stocks grow into giants. Diversify.

    John Markese is president of AAII.

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