From the May 2006 issue of Investment Advisor • Subscribe!

May 1, 2006

When Smaller Equals Better

Perritt offers micro-cap growth tempered with value discipline

Over the long term, small-cap stocks have outperformed other investments. According to Ibbotson Associates, the hypothetical value of $1 invested at year-end 1925 in small company stocks was $13,706 at the end of 2005. The same dollar invested in large company stocks was worth $2,658 at the end of 2005. For that reason, many asset allocations include a portion of small-cap stocks in an investment portfolio that has a long time horizon, something that's critical when you consider that small caps can be volatile investments. Small-cap mutual funds can appear to have higher expenses because they typically have to divide expenses across a smaller asset pool, while a large-cap fund may spread expenses over billions in assets.

The $617 million Perritt MicroCap Opportunities Fund, (PRCGX), outperforms its peer group, with relatively low expenses, and no 12b-1 fee or load. Michael Corbett, president and lead portfolio manager, invests the fund in companies with a market cap of under $500 million. "We combine a quantitative approach along with good old-fashioned securities analysis," says Corbett. The fund is in a "soft close," meaning that it's closed to many new investors, but as of early April was accepting new investments from clients of registered investment advisors and certified financial planners, current shareholders, and certain others. Corbett and Dr. Gerald W. Perritt also manage a sub-micro-cap fund, the $78 million Perritt Emerging Opportunities Fund, (PREOX), which invests in companies with up to $100 million in market cap.

Standard & Poor's gives Perritt MicroCap Opportunities Fund a five-star ranking overall, as well as in each of the three-, five-, and ten-year time periods. The fund has earned a 10-year average annual total return of 16.16% versus 8.63% for its peers in the Small Cap Growth category; a 24.86% annual average for five years versus 7.97% for its peer group; and a 35.47% annual average for three years versus 25.72% for its peers.

How do you define micro cap versus small cap and the emerging opportunities fund?

About twice a year, we rank the publicly traded companies by market capitalization. We break it down by 10 different deciles, look at what separates the bottom half, and that gives us about where the mid-market cap is. For us, micro caps are companies in the eighth decile and below. That number [cap in dollar terms] changes. Our most recent numbers show that a micro-cap company is about $500 million market cap, or less. That is how we define it; we changed that number in our last prospectus, because the number was around $400 million a year ago. That's how we separate it; that's where we start [for] companies going into the MicroCap Opportunities Fund.

The Emerging Opportunities Fund was something that we started because we wanted to focus on the ninth and 10th decile market-cap companies. We define that loosely as companies below about $250 million in market cap, but ultimately, we're really trying to have companies that fall below $100 million in market cap, or that 10th decile, and focusing on keeping our median market cap and average market cap below $100 million. Today, we have average and median [market caps] that are around $80 million and $70 million, respectively, for that fund, as opposed to our MicroCap Opportunities Fund, which is around $260 million and $280 million in median and average market caps.

What's the investment process for the funds?

They're the same in terms of our process--the basic difference has to do with the market cap, so when we look for companies that fall under that $100 million market cap, they end up in the Emerging [Opportunities] Fund; if they're above that level, $100 million to $500 million, they end up in the MicroCap Fund. We can buy companies down to about the $50 million market cap [level] for the MicroCap Fund, but we prefer to have companies above $100 million.

We tend to be value-based in our approach. We screen through databases but also network through regional brokerage firms and research firms to generate new ideas. I have three analysts in-house who are scanning those sources as well as earnings releases that come out, SEC [and other] Web sites to find new ideas.

Once we find an idea that falls in [our] market-cap level, we put it through our quant model. It's a nine-factor model, and it's proprietary to the firm, but I can tell you that it's nine items that you can get right off the income statement, balance sheet, and cash-flow statement. If a company gets at least six out of those nine, it passes the first screen, and then we can do more analysis on it. We sometimes let "fives" get in if we know they're going to get a six soon after, given what's going on with the fundamentals of the business. After a company reports their quarterly numbers, we redo that test to see how they're progressing on that score. None of those factors have to do with valuation. Just think of it from the standpoint of items on those three statements going in the right direction. We like to think of it as, if they're going in the right direction, then they have the shareholders' interest at heart--they're doing what they can to enhance shareholder value, so that's why we use that tool.

From there, we say, "Okay, what's the business, what's the business model, what are they trying to achieve?" Then we get to know management. We tend to average between three and five companies in our office a week, whether it's companies that we own, or companies that we're looking at, and we attend about four to six conferences a year to try and meet the companies. We're not the type of firm that actually goes and visits the company at their offices or their facilities, although we do that at times. From there it is really [asking] what are we paying for the business, how does it relate to the industry or their peers or the overall market?

Do you look at sectors as well to get ideas or is it strictly on a company-by-company basis?

We build our portfolios from the bottom up, so stock selection is first, but once we start adding names to the portfolio we're always looking over our shoulders to see how the industries are breaking down, and then say, "are we too heavy or too light in one industry or another--and why is that?" So we don't necessarily make a decision to say we should go into one industry or another.

Do you have a top limit on the amount you'd invest in a certain industry or sector?

I don't as a simple rule; when we get to a 30% number that usually tends to be a sign that we need to cut back or stop adding to that industry.

I understand that the MicroCap Fund is currently in a "soft close." Does that mean that you will be moving to a harder close soon?

It's something that I'm discussing with my board right now. This is the friendly season--when funds get flows--and you tend to lose that friendliness as the year progresses, so that's part of the reason why my board and I have been a little hesitant to do the hard close now, because we know it's going to soften up, so we don't want to close it, and then open up again. Hopefully we'll have a firmer answer on that sometime in later April/early May.

Would you talk about some winners?

One of the top holdings that I've had for a long time is Flanders, [which is] in the filter or filtration business. We've held this stock for around four or five years now, so we've made a lot of money. They've been taking market share in a big way for the last several years, particularly from companies like 3M. Flanders has an interesting strategy in that it uses its own name but also [licenses the] Arm & Hammer and Lysol [names]. If you go to any Lowes or Home Depot, you'll see their furnace filters right next to 3M, and their prices tend to be half, or even less than half, of the price of 3M even though the quality is the same, if not better.

Are there other top holdings you might talk about?

One of the largest right now is Newpark Resources [which is] in the energy services industry. I wouldn't say we have a huge exposure there but it's certainly an overweight, an area that we have a lot of confidence in. They do most of their work in the Gulf [of Mexico]. Demand for energy is rising around the world and we're much more interested in buying the energy services companies as opposed to the companies that own the oil and gas.

Any companies that disappointed?

There's always a surprise here and there but there haven't been that many disappointments because the market's been so strong. We owned SpatiaLight, (HDTV) which disappointed us in a big way. It provides chips that go into big-screen TVs. It promised that shipments of the product would occur, and they're being put off. That's been a disappointment and we've gone ahead and taken the loss on that investment.

Where would the MicroCap or the Emerging Opportunities Fund fit in an investment portfolio?

We think that all investors should have some exposure in this space, and obviously the younger the investor, and the longer their time horizon, the greater the percentage that they should have in these type of vehicles. We've [said] that they should mix part of the MicroCap and the Emerging to get that exposure in the micro-cap and sub-micro-cap space because that's really what we're doing; if you do a split of something like 70%/30%, 80%/20%, for MicroCap and Emerging [respectively], and [for] someone's overall portfolio, if they're really conservative, 10% of their portfolio; for someone that's more aggressive, usually 20% or 25% of their portfolio--more if they can tolerate the volatility. There certainly would be volatility and risk to invest in this space, but over the long run, small- and micro-cap stocks have always provided the best results relative to the rest of the market.

You said earlier that yours is a value orientation in terms of pricing, but the fund is classified as a growth fund, right?

It depends on who is categorizing us. Morningstar usually categorizes us as a blend, S&P has us under growth, (they used to have us under blend), and I'm pretty sure that Lipper has got us as a small blend. If you're going to put me in a box, calling me a small- or micro-cap blend is appropriate. We tend to be value-oriented, sort of a GARP approach. If a company is growing at 20% or 30% a year, I'm not going to pay 30 times [earnings] for that company, I'm going to pay 15 or 20 times [earnings]. That's what I mean when I say we're value-based in our approach.

What else do advisors need to know about these funds?

We're trying to be true to our style, investing in the micro-cap space, [so] closing the fund is certainly a possibility. We can keep taking in more money, let our fund run to $1 billion or $2 billion, but then I'd be changing my stripes. We're committed to being in micro-cap funds and [we're] a micro-cap shop, so we'll continue to invest in that space.

Staff Editor Kate McBride can be reached at kmcbride@investmentadvisor.com.

Has Value Run Its Course?

Seventy percent of investment managers are bullish about large-cap growth

Investment managers remain bullish on large-cap growth funds despite a market performance that has favored value over the last five years or so, according to a quarterly poll conducted by Russell Investment Group.

The poll, Russell's Investment Manager Outlook, recorded the opinions of 101 senior-level investment decision-makers at U.S. large- and small-cap equity managers, and found that 70% of those investment managers are optimistic that large-cap growth stocks will perform well over the next year.

According to the report, the two Russell indexes most reflecting large-cap growth--the Russell 1000 Growth and the Russell Top 2000 Growth--were the two lowest-performing indexes in the Russell family over the first two months of 2006.

Additionally, the 10-year annualized total returns for the Russell value and growth indexes at each market capitalization level showed a 4% differential favoring value at each level.

Only 8% of managers surveyed felt the market was overvalued. Twenty-four percent felt it was undervalued.

"Managers feel that the growth segment of the market is not fairly valued," said Randy Lert, Russell's chief portfolio strategist. "On average, the belief is that we've had this very long value run, and sort of a mid-cap/small-cap value run on top of it all. [The belief is] that the large-cap growth sector has lagged and it's undervalued compared to the rest of the market. I think managers think that the value run has sort of had its day."

According to Lert, many observers have been perplexed by "a number of aspects in the market over the last year, one of which is why value has continued to do so well. In general, the manager community has not been completely aligned with what's been going on in the market."--Ryan G. Murphy

For a longer and more detailed version of this interview, as well as, "In The Running," a list of the other funds we considered for this month's profile and that you may find of interest, go to "Web Extras" at www.investmentadvisor.com.

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