From the April 2006 issue of Wealth Manager Web • Subscribe!

Small Packages

The smart money in 2006 is on small and micro cap stocks--at least that is the consensus among a large part of the investment community.

Both personal financial advisors and portfolio managers are turning their attention, and shifting their allocations, to some of the smallest listed stocks available, particularly those classified as growth. Despite some doubts that smaller stocks can maintain their three-year run as the strongest performing asset class, many industry observers believe they remain a strong bet for the near-term future.

"On a relative basis, over the last several years, small-cap growth stocks have lagged small-cap value stocks--whether it was in the S&P 600 or in the Russell 2000. And the argument many people are making is that small-cap stocks are over extended and that the cycle is over," says Ed Vroom, co-manager of the Hallmark Small-Cap Growth Fund. But while he admits that thinking may prove true for the value portion of the small-cap world, Vroom believes there is still significant potential within the growth portion of the small- and micro-cap sectors. "If you look at it from a valuation basis, there are compelling fundamentals that show that small-cap growth could very well be the best performing area in the market over the next 12 to 18 months," he says. And he's not alone in his thinking.

Though many investors were understandably skeptical of smaller stocks after the explosion of the bubble, Helen Modly, a CFP and executive vice president of Middleburg, Va.-based Focus Wealth Management, says that sentiment has since waned. Over the last few years, she says there has been a noticeable increase in her clients' willingness to embrace the risks of small- and micro-cap stocks for the likelihood that those securities could ultimately generate higher returns within their portfolios.

"Five years ago most investors and clients didn't really understand why it was important to be diversified. They bought into it intellectually, but not really emotionally because they wanted big, fat, familiar names in their portfolios," says Modly. Moving forward, however, she notes that in recessionary environments, small caps have traditionally been more volatile, while they have often led the way in periods of growth, since smaller companies tend to react more quickly. "It really just depends on whose crystal ball you're looking into," says Modly.

When it comes to the particular segments within the small- and micro-cap asset classes that are most attractive at the moment, fund managers point to energy and oil, pharmaceuticals, biotechnology and basic material providers, such as steel companies. Technology companies have also begun moving back into favor.

"Though the tech sector has lagged for a while, there are interesting opportunities in the semiconductor area, the Internet and related areas, and capital spending in the information technology and communication area appears to be picking up," says Richard Driehaus, chairman and founder of Driehaus Capital Management LLC, which has roughly $2.6 billion under management. While many investors remain focused on larger technology companies, a number of technology companies that restructured and rebalanced themselves over the last few years have begun to see increased demand, and Driehaus believes they are poised for significant earnings growth and margin expansion. "Many of these older stocks are still down 70 percent to 90 percent from their highs, but they are now facing better prospects than they have in a dozen years," he says.

Outside of technology, another area within the small cap universe that has caught his attention is alternative energy sources such as solar and wind power providers. Based on new initiatives under way in California, coupled with the attention President Bush recently devoted to the issue in his State of the Union address, Driehaus says the basic economics of energy are driving investment interest in alternative energy sources, particularly as they have become more viable.

Kirin Smith, a small-cap portfolio manager with Manhattan-based Robotti & Co., is also focusing on the energy sector as a source of small caps with strong growth potential. "There are still plenty of companies that have strong balance sheets, but have yet to be recognized by the community," says Smith. He points to companies such as Harken Energy Corp., an American Stock Exchange-listed security, and Altex Industries Inc., an OTC stock, as two such examples.

On average, though the definitions vary, the universe of small-cap stocks includes companies with market capitalizations between $300 million and $2 billion, while the world of microcaps encompasses businesses with market capitalizations between $50 million and $300 million.

Not surprisingly, many of these companies tend to fall below the radar screens of most investors and are often found on alternative marketplaces such as the Pink Sheets and the OTC marketplace. Recently, however, these alternative marketplaces have begun attracting more attention, as escalating compliance costs resulting from heightened regulations such as Sarbanes-Oxley have spurred more and more small public companies to de-register and take themselves private. And although small companies have been given a temporary reprieve until the end of 2007 to conform Sarbanes Oxley oversight, fund managers expect that still more of them will make the move. "Many companies that have de-registered are moving to the bulletin boards, so we're finding a lot of value there," says Smith.

But not all small- and micro-cap stocks are a good investment. With so much attention surrounding the strong performance of smaller companies at the moment, the valuations for many of these stocks have soared. As that happened, the market caps of some companies were pushed into the mid-cap range, forcing many small- and micro-cap portfolio managers to unload stocks that no longer fit their investment criteria. Faced with this very problem, Eric Cinnamond, a CFA and small-cap portfolio manager for Intrepid Capital Management, recently unloaded a number of stocks within his portfolio, leaving him with a significant amount of cash on hand. But when it comes to identifying new stocks to invest in, he says it has been difficult to find promising opportunities because he believes the overly-acquisitive environment within the private equity community has pushed the valuations of too many smaller companies up to unrealistic levels.

"The private equity funds and the large-cap companies that are making a lot of acquisitions right now are paying relatively expensive multiples. It should make people more leery, but instead it has caused even more excitement," says Cinnamond. "You've got to know where you are in the earnings cycle for many of these companies. I think valuations in small-cap land are very important right now, and you have to be extremely selective." For his part, Cinnamond says he has been focusing on companies in the micro-cap range, a group which he believes houses the best investment opportunities at the moment.

Focus Wealth Management's Modly agrees, adding that she has been actively working to provide her clients exposure to some of the smallest stocks available. But since her firm does not invest in individual stocks, she says accessing micro-caps can be somewhat difficult, particularly since the most widely available small cap indexes, such as the Russell 200, have very limited microcap exposure. And when it comes to clients who remain leery of venturing into micro territory, she's quick to inform them that "even when you're talking about really small stocks, you're still talking about a company that's big enough to be listed on a major U.S. exchange, so it's not the dry cleaner down the street."

For Stephen Shipman, co-manager of the Touchstone Micro-Cap Growth Fund, there is no question about the value of small stocks in a portfolio. "All wealth is created by risk taking, but the average Joe can't get into that private equity or VC fund. So their component of risk must at some point in time be small- and micro- cap stocks," he says, adding that the current economic environment makes these stocks particularly attractive. "One condition through history where risk taking has flourished has been low taxes. So, the fiscal environment for risk taking right now is extremely good, assuming we're going to continue the passage of the tax bill," he says.

Beyond current economic conditions, Shipman believes the simple number of U.S. companies that fall within the small- and micro-cap asset classes makes them a crucial investment for any balanced portfolio. Though he estimates that small and microcap companies only comprise about 7 percent of the entire capitalization of U.S. equities, he says that group makes up more than 85 percent of public company names.

For many financial advisors, that exposure to such a large number of companies and industries is key for their clients' portfolios--particularly advisors reliant on more passive management approaches. William Cuthbertson, a CFA and principal of The Fiscalis Group Inc., is a major advocate of a longer-term investment strategy. When it comes to financial advisors who focus on the latest strong sector and try to time the market, he believes the approach is usually doomed, particularly since most investors end up chasing trends that may have already turned down. To that point, Cuthbertson says he has taken on a few new clients who missed virtually all the gains experienced by small and microcaps over the last couple of years because their portfolios were too centered around U.S. large caps.

"Active management has repeatedly been shown to fall behind a more passive approach," says Cuthbertson. "If you look at the studies S&P does on the active index strategy, last year was the first in quite a long time for any single year that the actively managed portfolios beat out the indexes."

To Veena Kutler's way of thinking, however, nothing lasts forever, and the winds are definitely poised to change for small and microcaps. "It's been a really nice run, but trees don't grow to the sky. When something has gone up as long as the small- cap market has, there's a turning point," says Kutler, a CFA and principal of Bethesda, Md.-based Mosaic Wealth Management, who advocates a bit more active approach to portfolio management. Anticipating that turning point in the near future, Kutler says she has begun reducing the target allocation for her clients' portfolios away from small caps and more towards large U.S. companies and international stocks. "Markets tend to be cyclical and asset classes tend to come in and out of favor. So after they've done well for a long time, then something else tends to do well instead," she says.

One reason she believes this change will take place is rising interest rates. Unlike large-cap companies that can tap the capital markets, she believes rising interest rates will quickly take a toll on small companies that depend on borrowed funding in order to build their businesses.

For Ron Rhoades, director of research for Hernando, Fla.-based Joseph Capital Management, LLC, the current economic climate is not a major factor when it comes to the importance of maintaining exposure to small- and micro-cap stocks. "Economists find it hard to tell us where we've been, much less where we are going," says Rhoades. "While we generally believe in reversion to the mean, we have not uncovered any reliable indicators or compelling academic evidence which concludes that tactical asset allocation methods can be utilized to adjust a portfolio to consistently take advantage of differences in economic cycles and relative asset class valuations," he says. Instead, Rhoades believes over-weighting of small and microcap stocks plays an important role in nearly every investor's portfolio and is likely to lead to higher long-term returns, as long as the individual is aware that such strong returns can be cyclical, that their exposure to the asset classes is diversified and that they willingly accept the increased volatility these stocks can also entail.

Sherman Doll, a partner with Walnut Creek, Calif.-based Capital Performance Advisors, agrees. "We see nothing in the long term that suggests that, on average, small caps won't continue to beat large caps," he says. "It's never good to just look at an asset class in isolation, because an investor should never invest in just one asset class. A better question is how the asset class works in concert with the other asset classes in a portfolio."

Britt Erica Tunick is a writer who specializes in financial topics.

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