The Hidden Bargains in Micro Caps

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There are a lot of good reasons to invest in small-cap stocks, especially when it comes time to count your money. An investor who stashed $10,000 in the small-cap Russell 2000 Index 15 years ago would have seen his investment grow to $30,349 while someone who bought the S&P 500 Index would only have $19,805, according to Morningstar data. That relationship of outperformance holds true even over longer time periods. But how abundant are small-cap opportunities in today's somewhat pricey market environment?

A bargain's a bargain, no matter how small
While small-cap investors are probably grateful for the beefy returns this sector has generated in recent years, significant price appreciation brings its own downside -- elevated valuations. And since current valuations have a meaningful inverse relationship to future returns, today's higher prices may be signaling subdued returns in the days ahead. Given that the most recent trailing 12-month price-to-earnings ratio for the Russell 2000 Index is 19.3 versus 17.2 for the S&P 500, it would appear small caps have a higher return hurdle to clear. But not all small caps are created equal. In fact, micro-cap stocks are trading at significantly cheaper multiples than larger small caps. At last glance, the MSCI US Micro Cap Index was sporting a mere 12.6 P/E.

Micro-cap stocks are the smallest of the small-cap universe -- generally, companies with a market capitalization between $50 million and $300 million. And while these pint-sized businesses frequently offer outsized growth prospects, they also come with a hefty helping of risk and volatility. As such, investors need to approach this market with their eyes wide open.

And while there are a few worthwhile exchange-traded funds that focus on the micro-cap market, such as iShares Russell Microcap Index and Wilshire Micro-Cap ETF , investors may want to consider getting their exposure elsewhere. That's because micro-cap investing may be another area where active management has an advantage over indexing. According to Barron's, two-thirds of active micro-cap funds have beaten comparable ETFs over the past three years. That's because the most illiquid stocks, which exchange-traded funds routinely avoid, tend to have the highest performance in this peer group. For example, a recent study from Yale University found that the most liquid quartile of micro-cap stocks returned an annualized 1.3% from 1972 through 2011 while the least liquid group earned a 15.4% return in that same time period. So if you want to make the most of the micro-cap market, consider some of the following first-rate actively managed funds.

Small stocks, big bite
Over at Perritt MicroCap Opportunities (PRCGX), manager Michael Corbett isn't afraid to delve into less liquid small-fry companies, since he believes those stocks tend to be the primary driver of the fund's returns. The focus here is on finding attractive emerging businesses that the broader market is ignoring. The current portfolio is heavily concentrated in tech and industrial and currently includes roughly 120 names.

Corbett has made several timely investments recently, including nursing service provider Addus Home Care , which had been racked by operating inefficiencies and was swiftly punished by the market. However, Corbett believed management would turn things around and increase profitability, and they did. Likewise, asset-management firm Virtus Investment Partners was severely undervalued and misunderstood in the market since its beginnings as a product of a reverse merger. Corbett believed the company was vastly undervalued based on its assets under management compared to industry norms, and the market eventually rewarded his patience. The portfolio's investment in both Addus and Virtus has increased more than 500% since the time of purchase, helping to fuel the fund's 11.6% annualized 15-year gain, which lands it ahead of 89% of its peers in that time frame.

Bumps in the road
The road has been more difficult as of late for the team at Royce Micro-Cap (RYOTX), but the longer-term case for owning the fund is still solid. Management seeks out high-quality emerging companies with stable earnings and high returns on capital. For example, the second largest holding in the fund is professional training and coaching service provider GP Strategies , which is a favorite because of its successful performance in a challenging environment as well as recent acquisitions that have helped boost the company's bottom line.

While the fund boasts a solid investment process and long-term track record, Royce Micro-Cap has run into difficulties in recent years, with performance falling into the bottom 3% of its peer group over the most recent three-year period. The fund has been stung by its heavy exposure to materials stocks and its large foreign stock allocation, as these two areas of the market have been under pressure in recent years. However, the investment approach that has led to great success in the past remains intact and should help steer the portfolio back on track. This fund isn't for the volatility-shy, but over time it should prove to be a market-beating source of return for micro-cap investors.

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Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. She and The Motley Fool have no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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