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THE BEST BETS FOR SMALL-CAP DIEHARDS

Like the chagrined lover in Sheryl Crow's hit tune, ''My Favorite Mistake,'' legions of contrarians cling to small-company stocks despite their heartbreaking ways. Take Jeff Burger, a Sussex (Wis.) engineer, whose stake in T. Rowe Price Small Cap Value Fund has disappointed him since 1996. Yet he holds on, believing small caps are plain cheap: ''It doesn't make any sense that people would want to pay more for a dollar of large-company earnings than for a dollar of small-company earnings.''

Now, at last, love may be requited. After plunging in the third quarter by 20%, more than twice as far as large caps, small-company stocks are taking wing. Since Oct. 8, the Russell 2000 index of small caps has surged 25%. Yet because of all the damage done earlier, the price-earnings ratio on small caps sank in October below that of large caps for the first time since 1990--and only the third time since 1979 (chart)--says Wilshire Associates, the Santa Monica (Calif.) investment research firm. The last two times that happened marked the start of long bull runs in small stocks.

If you suspect history is poised to repeat itself, you can pick stocks yourself or look for a mutual fund. For many, funds are the best bet, since diversifying risks is more important in volatile small stocks than in large. As if on cue, fund companies are launching small-cap funds and reopening established ones to new investors.

Which strategy is right for you depends on how you like your risk. The average new fund is riskier simply because it has no track record, says Matthew Muehlbauer, Value Line's mutual fund research chief. That makes sense to Paul Harvey, a reference librarian in Dedham, Mass., and owner of five small-cap funds. ''I'm inclined to want funds to be open three years before I invest,'' he says.

Seasoned funds present other worries. First, many with attractive track records may get too large too fast. ''They'll have a lot of money flooding in,'' says John Rekenthaler, Morningstar's research director, ''and size becomes self-defeating in the small-cap arena.'' Swollen funds have trouble putting enough of their assets to work in their best picks without kiting those stocks' prices or bumping up against rules on how much of any one company they can own. The result is underperformance. The second trouble is many established funds come with unrealized capital gains--a tax liability new investors would shoulder without having enjoyed the underlying profit.

HAPPY NEWS. None of this matters if you're investing in a tax-deferred retirement account. But if you aren't, there's some happy news: This year's market rout has left many funds with paper losses. At October's end, the average domestic small-cap fund in Morningstar's Principia data base had an unrealized loss of 6%. That's an opportunity to buy into several seasoned funds without the tax overhang. But take care: Some funds, including old standby Pennsylvania Mutual, still have serious tax exposures.

What should you do? We went looking for a few of the best possibilities. Among new funds, we sought those run by managers who have solid records with similar portfolios. For older funds, we used the Morningstar data base to isolate the few that have good, long records, yet aren't too large. We also kept an eye open for portfolios free of unrealized capital gains. Finally, we nixed funds with loads, high expense ratios, and minimum investments of more than $10,000. In the end, we came up with four new and four old funds (table).

The new funds are run in distinctly different styles. Opened in October, Forward Funds Small Capitalization Stock Fund is managed by an old-fashioned stock picker, San Francisco-based Irene Hoover. Before she quit a year ago to form her own firm, Hoover's Jurika & Voyles Mini-Cap Fund posted a 43% annual average total return--at the time, the best three-year record among diversified U.S. stock funds. Hoover believes small-cap stock prices often move randomly, so she's quick to sell stocks that get ahead of reasonable earnings prospects. She figures she can always buy the stock back cheaper later, something she has done often with the likes of regional broker Legg Mason and oil-service company Key Energy Group.

Recently, top holdings have included contractor Granite Construction and Westamerica Bancorp., both ''niche-dominant companies'' that enjoy some pricing power, strong cash flows, and little debt. ''I'm trying to find what I call baby blue chips,'' she says.

By contrast, the funds run by Numeric Investors in Cambridge, Mass., operate strictly by the numbers. Set to begin taking new money on Dec. 1, n/i numeric investors Small Cap Value Fund (next page) will rely on a computer model that searches constantly for the 120 or so best bets in a universe of 1,500. The n/i numeric investors Micro Cap, a similar, but closed, fund devoted to growth stocks, has handily beaten rivals: $10,000 invested in the fund at its June, 1996, launch grew to $14,439 through October, while the average comparable fund would have turned $10,000 into $9,284, Morningstar says.

One warning: Numeric expects the new fund to trade its stocks on average every four months or less. If the strategy is successful and generates plenty of short-term capital gains, shareholders can expect to be hit with a hefty tax bill.

SEASONED FUNDS. More familiar is the approach used by Vanguard to manage its new funds, one focused on value stocks and the second on growth companies. Both are index funds, designed to mimic a set list of stocks and capture the market's average return, while keeping costs at a minimum. They are overseen by 11-year indexing veteran George Sauter.

If you're not comfortable with a new fund, four seasoned ones with differing investing styles popped up on our screen. Like Numeric Investors, the managers at Eclipse Equity rely on computer models to search through some 4,000 stocks before settling on a list of more than 300. Unlike Numeric's model, Eclipse's places heavier emphasis on balance-sheet strength and doesn't hew rigidly to the industry weightings of some index. Recently, it has had heavier-than-average exposure to utilities, cyclicals, and such retail-sector stocks as Ryan's Family Steak Houses.

Managers Special Equity hands off its money to four stock pickers. Some favor value stocks, and others growth companies and micro caps. It recently had a portfolio of 305 holdings, with transportation gear lessor XTRA and radio station operator Emmis Communications atop the list.

With assets of $1.6 billion, Safeco Growth is on the big side for a small-cap fund. But manager Thomas Maguire has kept it from becoming unwieldy by building quirky portfolios. Not long ago, he owned mega cap Philip Morris along with little Family Golf Centers. Somehow, it works: In the nine years he has steered the fund, a $10,000 investment has grown to $35,511, while that much in the average rival would have grown to $29,744.

Wasatch Growth hasn't fared as well, in part because it has a 1.5% expense ratio --the highest of this group. Manager Samuel Stewart's fund also is stuffed with such tiny, no-name stocks as retailers Marks Bros. Jewelers and O'Reilly Automotive, a chain of parts stores in the Midwest. At $320 million, it has the lowest median market capitalization among the four funds. That means it may benefit more than the others if bulls keep charging into the small-cap arena, a prospect sure to soothe any small-cap investor's wounded heart.

By Robert Barker
EDITED BY AMY DUNKIN



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