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A Lone Fund Shines at Investing in Tiny Firms

Cal-Maine Foods (CALM) is currently the nation’s largest producer of fresh shell eggs. But while its eggs are served on thousands of breakfast tables each morning, its stock ticker isn’t as well known. In fact, investors often have a hard time even finding the shares in the funds offered by their 401(k) plans.

That obscurity has nothing to do with Cal-Maine’s growth prospects or its balance sheet, both of which are decent at the moment. Rather it can be attributed to the company’s market capitalization — the number of outstanding shares times the current price. Cal-Maine is what some investors call a microcap stock ticker. With a market cap just shy of $500 million, the company’s stock ticker is a far cry from the multibillion-dollar stock ticker that fund managers are used to investing in. Indeed, because of their size, microcap companies are deemed risky and often struggle to garner any interest from Wall Street analysts and mutual fund managers.

That said, there is a niche within the mutual fund world that focuses on the market’s tiniest firms and this week we turn our spotlight on those offerings. In our fund screener tool we found an initial universe of 127 funds and share classes whose portfolios have a median market cap below $500 million. We narrowed that group by looking for funds that had top-tier performance track records over the trailing three- and five-year time periods and also charged low annual fees. That left us with just one fund, Berwyn (BERWX).

This is the only screen we do throughout the year that produces such a small number of finalists (there were two funds the last time we did this screen in April 2008). Drilling down a bit on our screening methodology will help explain that anomaly.

First off, there are really no concrete definitions for what constitutes microcap stock tickers and their close cousins, small caps. We usually define small caps as stock tickers with market capitalizations under $2 billion; microcaps start at under $500 million. However, we’ve seen the small cap cut off extended to $5 billion and managers who say microcaps are stock tickers with market caps under $250 million.

That means, by screening on median market cap, we actually pull in a lot of small-cap funds whose portfolios happen to be skewing toward the market’s tiniest firms. These funds don’t consider themselves microcap offerings. (Indeed, Berwyn is classified as a small-cap value fund by Lipper.) Their portfolios are probably valued that way because the economic downturn hit small caps just as hard as other parts of the market in 2008. Indeed, according to Lipper the average small-cap fund lost 37.2% last year, in line with the drop in S&P 500 index funds.

Microcaps do carry some risks. Their business can rise or fall on the back of a single product or see a devastating plunge in sales because a key customer defected to the competition. Not only that but microcap stock tickers, especially ones that trade under $1 a share, are prone to manipulation.

But just as there are some big risks, there’s also the potential for big benefits. Managers who do their homework can easily find diamonds in the rough. If the economy starts picking up, enterprising microcap firms could gain better access to cheap capital to help them grow. Meanwhile, if the stock ticker market shows signs of sustainable improvement it could embolden investors to take on more risk, helping to boost a company’s shares. The companies are also historically attractive acquisition targets. Another reason to invest in microcaps: It can diversify a portfolio heavily weighted in large-cap investments.

“Most investors are dramatically underweight microcaps,” says Mark Matson of Matson Money Advisors in Mason, Ohio. He’s given some of his clients’ portfolios as much as 15% exposure to the niche. “[Microcaps] aren’t correlated [to large caps] so they can reduce the volatility of the portfolio.”

Berwyn posted a loss of 27.1% last year, a poor performance but 10 percentage points ahead of its typical competitor. It pulled that off by avoiding firms with excessive debt like financials, according to Morningstar analyst Greg Carlson. The fund is off to a slow start in 2009 with a 4.2% loss through Thursday. But over the last decade it has returned an average annual 6.1%, better than half of its competitors.

We usually don’t dwell on funds that don’t make our cuts. But with just one finalist this week we thought we should mention a few offerings that missed inclusion. Bridgeway Ultra-Small Company Market (BRSIX) and Perritt MicroCap Opportunities (PRCGX) are run by two firms with long histories of investing in this space. Bridgeway had a terrible 2008, but has a much better long-term track record. As for the Perritt fund, all those fans of the egg business should take notice: It happens to be one of the few funds we found that had a position in Cal-Maine.

The Criteria: We searched for equity funds with portfolios that had a median market cap under $500 million. The funds were open to new money, required a minimum investment under $5,000 and charged an annual expense ratio less than 1.5%. The funds also had to have track records over the trailing three- and five-year time periods that put them in the top 40% of their peer group.

Profiting Off Tiny Companies
Ticker Name Year-to-Date Return (%) 3-Year Average Annual Return (%) 5-Year Average Annual Return (%) 10-Year Average Annual Return (%) Median Market Cap (In Millions) Expense Ratio (%)
Source: Lipper
Note: Data as of May 21, 2009
BERWX Berwyn -4.22 -10.75 -0.16 5.84 437 1.29

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