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SO YOU'RE READY TO GET INTO SMALL CAPS?

If you're anything like me, you set an investment plan and vow to ignore the market.

Then, some time later, you discover you must've had your fingers crossed. That's exactly what happened a couple of weeks back when I noticed the recent awakening of small-company stocks. They're the ''small-cap'' crowd of companies with market values of $250 million to $1 billion, and they've trailed big-company stocks since 1993. Lately, though, the small have been gaining on the big, making me wonder how to exploit their resurgence.

My first call was to Prudential Securities' small-stock specialist, Claudia E. Mott. And nearly the first word from her was ''diversify,'' because small stocks are the least stable group. If (like me) you don't have the time to manage a dozen or more small stocks directly, that spells mutual fund. Trouble is, the fund analysts at Morningstar count 539 small-stock choices, and picking one can be daunting.

Unless, that is, you have a computer. So, after consulting with Mott and others, I asked Morningstar to help build a simple computer program. The aim: to pinpoint a few good prospects. To make the cut, we first demanded experience, so every fund had to be under the same management for at least five years. Among other criteria, we also ruled out funds with high expenses and fees, and we preferred smaller, easier-to-manage funds. (Investors who are savvy users of personal computers can do similar performance screening on their own, using Morningstar's or Ascent software, $45, trial, 800 735-0700.)

After Morningstar poured its data through our criteria screen, we had a tidy list of 35 funds, divided about evenly among funds following a growth-stock strategy (investing primarily in stocks that are expanding rapidly), a value-investing strategy (investing in solid companies that are nonetheless undervalued or out of favor), and ''blend'' funds that mix the two approaches. From there, we ranked the funds by aftertax performance and checked to see which are readily available. In the end, we isolated four small-company funds, one in each category, plus a passively managed index fund.

STYLE COUNTS. I wouldn't just go ahead and pick any of the four, though. First, ask yourself how you would feel putting $5,000 in a growth fund and seeing it sink swiftly to $3,750. That kind of wicked downturn is common in small growth-stock investing, and it has been precisely the case for many high-profile growth funds in the past year, whereas value funds move more moderately. So timid investors should stick to value funds, which hold up better in down markets.

Among growth funds, Oberweis Emerging Growth stood out because it's still small (less than $180 million in assets) and has done a good job of limiting taxable distributions. It had an impressive aftertax average annual total return of 15.66% for the five years ended on May 31, 1997--as good as the pretax return of most small-cap funds. Oberweis holds lots of volatile positions, 150 or so, and doesn't blanch at such jumpy stocks as teen retailer Gadzooks.

Although Morningstar lists the next finisher, Managers Special Equity, in the growth category, its investing style is actually closer to a blend fund. The fund's trick is to split its $372 million among three independent stock pickers: growth investor Gary Pilgrim, value devotee Andrew Knuth, and Timothy Ebright, who looks for little growth stocks that have run into trouble but may well turn around. The results are impressive: Managers Special Equity is up an annual average of 15.36% after taxes over five years.

LAND GRAB. High above the other finishers in the value category is Longleaf Partners Small Cap, with a tax-adjusted five-year annual average total return of 16.72%. This fund tends to take heftier positions in only about 30 companies, and lately, Longleaf has been placing chunks of its $444 million in a variety of real estate investments, such as San Francisco property manager and developer Catellus Development. If cash is tight or you simply don't want to put up the $10,000 minimum initial investment that Longleaf demands, runner-up Royce Premier (800 221-4268)--one of only 7% of all mutual funds that earned three up-arrows in BUSINESS WEEK's 1997 Mutual Fund Scoreboard (BW--Feb. 3)--is worth looking into. It requires an initial investment of only $2,000.

For investors who prefer passive management, there's Vanguard Index Small-Cap Stock, which tracks the Russell 2000 list of small-company stocks. As with other index funds, it's cheap on expenses and taxable distributions, and figures to be a steady, if unspectacular, performer that has beaten 54% of all small-cap funds since May, 1992.

In the end, finding four small-cap funds to focus on didn't interrupt my existing plan. But if I come upon some fresh funds to put to work, I've got a much clearer sense now of what to do.

Robert Barker



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Updated June 23, 1997 by bwwebmaster
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