Markets & Finance

Micro-Caps Under the Microscope


The much overlooked micro-cap stock sector has enjoyed a resurgence this year. One of the best-performing funds from this sector, Michael Corbett's Perritt Micro Cap Opportunities Fund (PRCGX), is up 29.4% year-to-date through May 29.

Corbett uses a proprietary screen to select a portfolio of 40 to 60 stocks that have value and growth characteristics.

For 2000, the fund edged up 6.2%, after declining 8.2% the prior year.

Corbett became lead manager of the fund in November 1999, having initially joined as co-manager in early 1996. The fund was launched in April 1988 by Gerald Perritt, who continues as co-manager.

Energy stocks currently represent the fund's largest sector. To minimize risk, no one sector occupies more than 25%-30% of fund assets, and no individual holding can represent more than 3% of the fund. One other key guideline: The fund will sell a stock when it reaches market-cap size of $1 billion.

Palash R. Ghosh of Standard & Poor's FundAdvisor recently spoke with Corbett about the fund's investing strategy and its recent portfolio moves. Edited excerpts from their conversation follow:

Q: How large is the fund currently?

A: We have just under $14 million in net assets, comprising about 62 stocks.

Q: What is your buy criteria? How do you select stocks for this fund?

A: We look for rapidly growing companies with market caps ranging between $20 million and $300 million which are trading at reasonable valuations -- that is, they possess price-to-sales, price-earnings and price-to-book ratios below the company's long-term annual growth rate. Then we use a proprietary nine-step screening process that deals with such items as improving balance sheets, among others, to filter our universe down to a portfolio of 40-60 stocks. Typically, stocks in the fund have demonstrated above average growth in revenues and/or earnings; have relatively low levels of long-term debt; high level of inside ownership, quality management.

Q: Do you regard the fund as a growth or value investor?

A: We like to have a mix of both growth and value. In the current market, we have a heavier emphasis on value stocks, currently accounting for about 70% of the portfolio.

Q: What is your benchmark?

A: There really is no appropriate index for micro-cap stocks, but the one that we use is the Russell 2000 Index, which comes the closest. Year to date through May 29, our fund is up 29.4% while the index is up 4.5%. In calendar 2000 we rose 6.2%, while the index slipped 3.0%. However, there are some significant differences between our fund and that index -- for example, the index has an average market cap of about approximately $580 million, while the fund's average market cap is only $110 million. Moreover, our fund's average p-e is 18.5, while the benchmark's p-e is about 22. Our average earnings growth rate is 24%, while for the index, that figure is around 15% or 16%.

Q: Why is there no appropriate benchmark for micro-cap funds?

A: I think it's because there's been little demand for it. Wall Street is simply not interested in micro-cap companies -- and this is compounded by the dismal performance that micro-cap stocks have suffered for most of the past 20 years.

Q: What are your largest holdings?

A: As of May 25, our five biggest positions were SFBC International (SFC), Headwaters Inc. (HDWR), ICT Group (ICTG), Suprema Specialties (CHEZ), and CryptoLogic Inc. (CRYP).

Q: Can you take one of your largest holdings and discuss how it illustrates your investment philosophy?

A: SFBC International is a contract research organization that conducts clinical trials and provides related services to pharmaceutical companies and biotechnology companies. SFBC went public last year when there really wasn't much interest in biotech-related issues. We bought some at the IPO, the price weakened, and we bought some more. It's a consistently profitable company, we expect they'll deliver above $0.80 a share this year and somewhere north of $1.00 a share next year. Thus they can generate annual growth of 25%-30% going forward. The stock's price has jumped threefold this year.

CryptoLogic Inc. is an Internet software company -- they make programs for those online gaming casinos and they actually dominate that industry.

Q: What are the largest industrial sectors in the fund?

A: Energy accounts for about 17%-18% of the portfolio, making it our largest sector. That's followed by business services (12%) and medical/health care (11%).

Q: How do you try to minimize the risk inherent in micro-cap investing?

A: We try to be broadly diversified. Typically, no one sector will occupy more than 25%-30% of the fund's assets. Moreover, an individual holding will not represent more than 3% of the fund. As our net assets increase, we will likely have a larger number of names in the fund -- perhaps 70-80 -- to provide more risk control. We also try to invest in stocks that are liquid. Many micro-cap companies are very thinly traded, and it's hard to sell them when you need to get out.

Q: How has your sector allocation changed, say, over the past year?

A: We've been adding a little more to both medical and energy stocks, and lowering our exposure to tech-related equities.

Q: How do micro-cap companies fundamentally differ from their small-cap counterparts?

A: I think the main difference is that most micro-cap companies don't need to be as well-capitalized. As such, they are completely off of most investors' "radar screens," and Wall Street doesn't care about them. As such, many micro-cap stocks are not priced according to their fundamentals.

Q: Can you give an example of a micro-cap stock that you think has been unfairly overlooked by Wall Street?

A: One of our largest holdings, TBC Corp. (TBCC) is a vertically integrated tire marketing and distribution company; they own Big O Tires and Tire Kingdom, among others. TBC will exceed $1 billion in sales this year, but the company's market-cap is only about $100 million. And consider that, in 10 years, it has doubled its revenues, but its stock price has declined from $20 to $8! This company is currently trading at a price that is one-tenth of its sales, trades at less than two times its cash-flow, and it has a p-e of only 6 -- and its stock price has actually doubled in the past six months! Despite these attractive numbers, most investors are not interested in something as "boring" as a tire company.

Q: What are your sell criteria?

A: We will sell when a company's market cap becomes too large to be considered micro-cap -- at present, we'll sell when it reaches about $1 billion in market-cap size. We will also dispose of a stock when its financial condition deteriorates or when its valuation becomes excessively high relative to its long-term growth prospects. We will not automatically get rid of a stock if it has a poor earnings quarter. If we determine it's a short-term problem, we will stick with it.

Q: Can you cite a stock you recently sold and why?

A: In the previous quarter, we sold Integrated Silicon Solution (ISSI), which develops SRAM/DRAM memory products. They posted weak profits and warned they'd probably be losing money over the next few quarters, so we sold.

Q: What is your annual turnover rate?

A: Our turnover rate is 40%-50%, which is quite low for micro-cap funds. There are some portfolios that have turnover as high as 100%.

Q: What is your outlook for micro-cap stocks for the remainder of the year?

A: Historically, small and micro-cap stocks tend to do well after a bubble bursts in the overall market. For example, after biotechs crashed in 1991-1992, smaller-cap stocks outperformed large-caps over the next three years by a 2-to-1 margin. Even more dramatic, in 1973-1974, the big-cap "Nifty-Fifty" stocks collapsed -- and, subsequently, small-caps outperformed large-caps by a 10-to-one margin for an eight- or nine-year period. So, I think that the market today, especially the Nasdaq-100, is in a similar state as those past bursts.

The question remains: even though micro-caps are still vastly undervalued, are investors in the mood to buy them? Cheap prices are not necessarily a catalyst for investors to be attracted to micro-caps. However, given micro-caps' high growth rates and cheap valuations, I think they will outperform, perhaps for several years. Earlier I cited TBC Corp. as a solid business that is growing its cash flow but which is ignored by the market. My expectation is that more investors will realize that these types of companies makes good sense as an investment.

Q: Aren't micro-cap companies often swallowed up by larger companies, and doesn't that benefit a fund like yours?

A: That actually hasn't been happening the past few years. Big corporations have been more infatuated in making monster merger deals. A few weeks ago, Procter & Gamble (PG) said it would buy Clairol, a consumer brand company, for something like $1.8 billion. Meanwhile, Clairol has sales of only about $700 million! Consider that one of our holdings, Helen of Troy (HELE), is a consumer brand stock with a market cap of only $240 million, but it has annual sales of $500 million! The big players don't want to buy Helen of Troy because they likely don't even know about it. It will take some time for Wall Street to realize the value of micro and small-cap companies.

Q: Does Perritt Capital have plans to launch any more mutual funds?

A: We'll close this fund after it reaches net assets of $75 million-$100 million, and then we may launch a new small-cap fund. From Standard & Poor's FundAdvisor


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