When Smaller Equals Better

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?