Don’t Give Up on Small-Cap Funds

08/08/2007 12:00 am EST

Focus:

Tim Middleton, contributor to MSN Money, says small-caps may not lag the rest of the market the way some pundits anticipate and recommends three excellent small-cap funds.

The recent panic attack in credit markets will send some investors fleeing risky small-company stocks for the perceived safety of megacaps. But that doesn't mean the small-cap party is over.

Although small-cap stocks have doubled the returns of large caps in those eight years, they're just as likely to continue to rack up gains as to surrender leadership.

The usual rule of thumb, which I think is sound, is that small-company stocks should make up about 15% of your equity holdings. Less and you miss out on the added returns they offer. More and you accept too much risk—they're 40% more volatile than large caps.

Once you've settled on how much to invest, it's time to pick the fund you are most comfortable with. I've found three gems:

Keeley Small Cap Value (KSCVX) has long specialized in corporate restructurings, such as firms emerging from bankruptcy or spun off from larger concerns. This is a surprisingly fertile area for investment. The fund owns more than 170 names and has an average of only 1% of assets in each of the ten largest holdings.

Morningstar analyst Andrew Gogerty notes that manager John Keeley's two decades of experience in this niche has produced consistent above-average returns. Over the last five years they have averaged 22.4%.

[But] "when credit is under stress, as it is now, you oftentimes have more pressure on the smaller companies than you do on the larger companies," Keeley acknowledges.

Perritt Micro Cap Opportunities (PRCGX), a no-load fund, is much smaller [than the $5-billion Keeley Small Cap], with assets of $550 million, and it focuses on much smaller names; the average market cap is $286 million. Assets are spread around more than 170 names.
"Diversify, diversify, diversify," says manager Michael Corbett. "You don't want to get caught up in making too big a bet on individual names."

He's an outstanding stock picker: Five-year average returns have been 24.3%. The fund is heavily invested in industrial materials, a sector that has been red hot for much of this decade. But lately he's discovered bargains in the technology sector.

Bridgeway Small Cap Value (BRSVX), another no-load fund, has about $300 million in assets, rising fast recently due to its market-beating performance. Over the last three [years it] has delivered annualized returns of 24.6%.

The manager, John Montgomery, uses quantitative models to select stocks according to a variety of criteria, which range from balance-sheet fundamentals to relative strength of the stock price. He owns fewer than 100 names, has about one-quarter of assets in the top 10, and owns companies with an average market cap of $1.2 billion. (Middleton says he owns this fund—Editor.)

If you don't have small-cap exposure, one of these funds is a good place to get it.

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