The mouse roared in 2000 as the smallest stocks, known as microcaps, outperformed their larger brethren.
Microcap funds, which generally fall somewhere between the Russell 2000 and obscurity when it comes to analyst coverage, returned 5.45% in 2000, according to Lipper Inc., Summit, N.J. With an annualized return of 18.9%, microcap funds also have the best three-year track record.
The asset class outperformed small-cap and midcap funds, which returned 3.29% and 4.38%, respectively, in 2000. For the three-year period ended Dec. 31, small caps returned 9.6%, and midcaps, 17.2%, compounded annually.
One of the reasons microcaps outperformed in 2000 was they generally had lower valuations. "If you looked at the market six, nine, 12 months ago, that was about the only part of the market that was priced at a premium that showed value," said Michael Flynn, president of Stratford Advisory Group, Chicago.
Bob Marren, manager of the microcap portfolio at Duncan-Hurst Capital Management Inc., San Diego, said microcap stocks have valuations that typically are 30% lower than small-cap stocks "Because of this 30% discount that microcap stocks have, they didn't have to go through that same painful revaluation process that other stocks did," he said.
The $120 million Duncan-Hurst portfolio returned 18% in a year when its benchmark, the Russell 2000 Growth index, returned -22%.
"We acted more like a value portfolio in 2000," said Mr. Marren, because the growth stocks in which he invests have lower valuations and lower price-earnings ratios. The strategy calls for buying stocks with market caps of $300 million or less and selling them when they reach up to $1 billion.
At 50% capacity
Mr. Marren said the portfolio now stands at $120 million, which is about 50% capacity. He said he probably would close it to new investors when it reaches $250 million to $300 million. Otherwise, he said, he wouldn't be able to buy less liquid names and would get forced up market.
Most of his investors are existing clients who peel off a portion of their small-cap mandate. He said he doesn't see many requests for proposals for microcap portfolios.
Since the microcap market is so illiquid and so overlooked, William Schneider, president of DiMeo Schneider and Associates, Chicago, said the value/growth distinction isn't as important as in larger-cap areast as the market cap size spreads.
And, despite strong performance, consultants say there's not a large demand for microcap portfolios among institutional investors. In fact, Mr. Schneider said his firm is one of the few consultants that beat the drum for them.
"If someone takes some leadership and starts pounding the table for these things, eventually the rest of the world catches up and they become arrows in everyone's quivers," said Mr. Schneider. He said institutions needed convincing to diversify into international, small caps, and growth and value equities a decade or two ago.
Mr. Schneider said his firm recommends microcap funds primarily to defined benefit plans, where they can add value. "I view it almost as a way to add transportable alpha," said Mr. Schneider.
Brad Lawson, senior research analyst at Frank Russell Cos., Tacoma, Wash., said one of the reasons microcaps outperformed peers in a tough market was managers had a richer pond in which to fish. The smaller the market in terms of market-cap size, the more inefficient the market gets, said Mr. Lawson. The more inefficient the market is, the easier it is to find good stock and add value .
Also, he said, there was less volatility in the microcap market last year because most large investors aren't investing in that area.
Not so rocky
Most people would think the smaller the market cap, the more rocky the returns, said Mr. Lawson, but he believes that microcap returns are often less rocky than small-cap returns. "Microcap managers' returns are somewhat less volatile than small-cap managers' returns," said Mr. Lawson. "They're kind of flying below the radar screen," he added, which was a good thing in 2000.
Brian Gerber, portfolio manager of the Brazos Microcap Portfolio, said the key to finding good small companies is research. "It's generally a function of knowing your industries," said Mr. Gerber. Brazos is the mutual fund arm of John McStay Investment Counsel, Dallas.
Most of the companies in his $180 million portfolio can be found in the Russell 2000 index, but they don't get a lot of analyst coverage. Because there's not a lot of analyst coverage, he said it's important to get out in the field and visit as many companies, competitors and conferences as possible. After salaries, "travel is our second biggest expense," said Mr. Gerber.
Mr. Gerber said he finds a lot of investment opportunities with "orphans," or forgotten initial public offerings.
"Once all the road show of going public was over, at that point it was no longer an IPO, it was just another stock," said Mr. Gerber.
The Brazos Microcap Portfolio, which has institutional and retail assets, returned 18% in 2000.