October 28, 2005

Fund in Focus: Touchstone Micro-Cap Growth Fund

Micro-Caps On the Radar

With the emergence of the Russell Microcap Index this summer, the first index of its kind, the somewhat ignored micro-cap sector may finally attract some interest from investors. One of the newest entrants into this space, the Touchstone Micro-Cap Growth Fund/A (TAMCX), focuses on attractively valued stocks delivering high earnings growth.

Portfolio managers O. Thomas Barry III and Stephen Shipman of Bjurman, Barry & Associates use a proprietary quantitative research process to screen a universe of about 1,900 stocks -- with market caps between $30 million and $300 million -- and whittle them down to ultimately form a portfolio of between 70 and 90 holdings.

The $64.3-million fund gained 22.0% for the 12-month period ended September 30, versus a 17.8% for the average small-cap blend fund. Launched in June 2004, the fund does not have the three years of operation necessary to receive a Star ranking from Standard & Poor's.

The drawbacks inherent in micro-cap investing are well known: Shares of these firms are often illiquid and volatile. To address these risks, Bjurman, Barry & Associates seeks strong diversification. No individual holding can represent more than 5% of the fund's total assets, and no industry, as opposed to sector, can account for more than 15% of the pie.

On the other hand, Shipman noted, micro-caps offer great advantages as well. Since most micro-sized firms remain unknown to the general public and receive little coverage from Wall Street, they tend to be inefficiently priced. As a result, micro-caps can climb dramatically in value in a relatively short time, typically driven by rapid earnings growth.

As of September 30, the fund's top sectors were health care, 27.2%; information technology, 23.4%; industrials, 19.9%; consumer discretionary, 15.7%; and consumer staples, 7.5%. There is very little exposure to financials and energy. Health care and information technology dominate the fund, Shipman said, because they represent the fastest growing segments of the economy.

The ten largest holdings as of that date: NutriSystem Inc. (NTRI), 2.9%; Hansen Natural (HANS), 2.6%; Forward Industries (FORD), 2.6%; Dynamic Materials (BOOM), 2.4%; IRIS International (IRIS), 2.3%; LoJack Corp. (LOJN), 2.3%; American Dental Partners Inc. (ADPI), 2.2%; CNS Inc. (CNXS), 2.1%; True Religion Apparel Inc. (TRLG), 2.1%; and Charles & Colvard Ltd. (CTHR), 2.1%.

One of the fund's top holdings, Hansen Natural, a maker of health drinks, typifies the type of company the fund managers like to buy. "This is a true winner. Its market cap has soared from about $250 million to nearly $1 billion now," Shipman said. "Hansen's 'sports energy' drinks have become so popular that now even Coke and Pepsi are getting involved in this business." Hansen's stock price has more than doubled since the year began.

Another favorite stock, Iris International, manufactures software for the imaging of microscopic surgical procedures. "Last year, Iris earned $0.25/share, and its bottom-line is expected to grow by 40%," he said. The company's shares have also doubled year-to-date.

In conjunction with the bottom-up stock selection process, the managers use a macroeconomic overlay to identify certain industries to avoid. For example, Shipman cited, when New York Attorney General Eliott Spitzer uncovered problems at Marsh & McLennan (MMC) and went after the insurance industry, the fund unloaded its small-cap insurance holdings. "Changes in the regulatory, legal or political climates can often hurt smaller-cap stocks," Shipman said.

Bjurman, Barry is quick to sell a stock that it sours on; the fund had a 101% turnover rate in its first year of operation. A stock will be unloaded when its market-cap reaches $1.5 billion, no matter how good it is doing. (The fund currently has an average market cap of $272 million). Shipman said the firm will dispose a company if it posts a disappointing earnings report, if its price falls 15% from its recent peak, or if it becomes overvalued relative to future growth prospects.

The fund recently sold off CryptoLogic Inc. (CRYP), which is involved in software security for Internet gaming. "It's a 30%-35% annual earnings grower, but in August the company announced that it would miss its profit targets by a substantial margin," Shipman said. "We sold it at prices ranging from $20 - $17. It has since dropped to about $16." Shipman explained that when a micro-cap company posts an earnings warning, "it's usually time to get out."

While the introduction of Russell Investment's new Microcap Index is a welcome development, the fund will likely not use it as its benchmark until it has a longer history. Ironically, as investors become more aware of micro-caps, the sector may lose some of the inefficiency that makes it appealing.

However, Shipman, whose fund currently uses the Russell 2000 Growth Index as a benchmark, noted that the new Russell Microcap Index is not a close match to the stocks in his portfolio. "The Microcap Index took the 1,000 smallest companies of the Russell 2000 Index, and next smallest 1000 stocks by market cap," he said. "Consequently, about 46% of companies in that index are between $300 million and $500 million in market-cap. So, there's still a lot of opportunity for the companies we are mandated to buy, that is those with market caps below $300 million."

For comparison, the Russell 2000 Growth Index rose 18.0% for the one-year period ended September 30, versus a 17.0% gain for the Russell Microcap Index.

"Micro-caps are a barometer for risk-taking among U.S. investors," he said. "The smaller entrepreneurial companies tend to flourish when tax rates are low, thereby encouraging risk-taking. We have seen historic low taxes on capital gains, and if we get an extension on these low rates, that would be even better for small- and mid-cap stocks."

However, Shipman cautioned that the Fed's policy on credit tightening may hurt smaller companies. Shipman added that the most favorable environment for micro-caps lies with the "stability of purchasing power, as represented by stable commodity prices, which we don't have now. If we get signs of inflation, or even deflation, that will result in a bad environment for micro-caps."

Contact Bob Keane with questions or comments at: bkeane@investmentadvisor.com.

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