From the June 2012 issue of Investment Advisor • Subscribe!

Managing Through the Micro-Cap Mania

Small-cap volatility doesn’t faze Michael Corbett and his team at Perritt Capital Management. The deeper they can go in the sector, the better

Photography by <a href="http://tjmckenzie.com/">Tom McKenzie</a>. Photography by Tom McKenzie.

If you think the small-cap space has had a wild ride recently, try micro caps, and then get your head around the following boast Michael Corbett makes about one of the funds he manages:

“The Ultra MicroCap Fund has the lowest average market cap [for the companies which it invests] of any mutual fund out there,” Corbett, chief investment officer and portfolio manager with Chicago-Based Perritt Capital Management, proudly states.

Call him crazy (we certainly did at the beginning of our interview), but there’s a method to what at first appears to be madness, one that’s serving the firm—and its investors—well.

It’s a method that’s been around for almost three decades, one founded by Dr. Gerald Perritt and that is deeply rooted in academic research on the merits of small capital or micro-cap investing. It involves the so-called Fama-French Small Firm Effect, which came out of the University of Chicago in the early 1980s. For those who don’t know, the effect holds that the smaller the firm’s market cap, the better the performance over the long term when compared with larger firms, due to more opportunities for growth. Corbett’s method also involves a quality screen the firm uses (again from University of Chicago) developed by Joseph Piotroski in his landmark paper, “Value Investing: The Use of Historical Financial Statement Information to Separate Winners From Losers,” in which he employed a nine-factor evaluation of financial statements (we told you it was academic).

Corbett, who’s been with the firm since 1990 and took over portfolio management duties in 1996, stresses the importance of these two philosophies when looking for quality micro-cap companies, which is good, because he then doubles down.

“Our flagship fund is the MicroCap Opportunities,” he says. “The way we define the term micro-cap is investing in the bottom 20% of micro-cap companies. We link all the companies by market cap and separate the bottom 80% from the bottom 20%.”

What’s more, he says, with the Ultra MicroCap Fund (PREOX), the firm goes even further and invests in the bottom 10% of market cap companies.

“Both funds have the same process of quality screens,” he adds. “The difference between the two is the average market cap of both funds. With MicroCap Opportunities, we’ve invested in the $125 to $200 million market cap range over its life. The Ultra MicroCap Fund [which recently changed its name from the Emerging Opportunities Fund] has invested in companies between $40 million and $80 million in market cap over its life.”

Sounds interesting enough, but what about that aforementioned wild ride?

“The larger the market cap, the better the performance last year, or maybe I should say the less bad,” he concedes before shrugging it off. “But so far this year, it’s the reverse; the smaller the name, the better the performance. We’re off to a decent start. And it doesn’t bother us anyway. We’re really more about full market cycle performance and interested in how when we make an investment, which has us looking at a three-to-five or even a five-to-10-year time horizon. What happened recently was short-term noise.”

The extreme volatility in the micro-cap space was caused by a rush to liquidity by investors of all kinds, according to Corbett. Fearful investors shunned the stocks that were less likely to be able to provide them with short-term cash, and they placed a premium valuation on more liquid, defensive names.

Technology is one area in which Corbett is currently finding alpha. Evaluations are “very attractive,” and even though the firm doesn’t build its portfolios based on what the indexes might look like, in a sense, he says, it’s overweight to technology, having more technology companies than ever before.

“The possibility of shareholder value is significant because of how strong the balance sheets are,” he says.

Perritt Capital Management's Ultra MicroCap FundAnd, of course, he’s finding alpha in what he refers to as “the energy stuff.” But one area that’s not so obvious is what he calls “cash attitudes.”

“In 2008 and 2009, we found a lot of companies with an attitude of ‘we have enough cash and a strong enough balance sheet to survive in a downturn,’” Corbett explains. “That’s changed; they’ve proven they can survive. The attitude is now moving toward, ‘I need to use this cash to find a way to thrive.’ What do you do with cash or excess cash? Should they even start to borrow more from banks or other entities? You might not think of it within micro-cap companies, but we’re starting to see a lot of them pay out, or at least initiate, dividends.”

He claims that 30% of the companies in the Ultra MicroCap Fund portfolio either increased their dividend or initiated a dividend in just the last year. And he’s had a fair amount of companies that have bought stock in open markets.

“In some cases, it’s pretty excessive,” he says. “I mean, where it’s 15% or 20% of the shares outstanding that they bought back. And there are also companies that are looking to buy other companies.”

When asked about global macro events and news headlines, and how the fund positions itself defensively, Corbett is blunt.

“Generally speaking, we don’t [think about global macro events]. We’re about building portfolios from the bottom up and much more interested in finding great companies that can do well regardless of the environment.”

But as we said, there’s a method, and he hedges somewhat.

“With that said, you can certainly have pretty severe macroeconomic storms that can cause continued problems. There continue to be concerns about the issues within Europe and other debt problems that surround even this country. But it’s an interesting time, and it makes it exciting because I think a lot of that is already priced in. In a sense, I think everyone’s overdoing it in terms of their nervousness. We continue to be cautiously optimistic in terms of what’s going on. We’re always aware of it, but our general thought is to find great companies that can continue to survive and thrive through any type of environment.”

As for the all-important performance track record, “I can tell you that the three-year number is phenomenal,” Corbett says. “[March] was the three-year anniversary of the 2009 market low. Any general equity manager should, therefore, have a solid three-year number. We did do much better than the benchmarks (by the way, we use the Russell 2000 and the Russell Microcap). We’re up 120% and 130% from the lows.”

Because of the 2008 hit, he adds, the five-year return is not strong, but the longer cycles, the 10-, 15-, and 20-year performance numbers “are pretty far ahead of the benchmarks in real world performance. We’re pretty proud of that record because that really is our time frame; making sure we’re taking long-term investments in the right direction”

“We’re off to a really great start this year. Both funds are up double digits for the year. I think that, as I said before, it will continue. We’re starting to see signs of improvement, even in the overall economy, which should bode well for the types of stocks we have in our portfolio.”

 

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