, Chapter 4 examines how these investmentsmight fit into the portfolio of the small investor as a substitute forthe venture capital asset class due to their similar return profile.This chapter looks at the portfolio contribution and volatility of atheoretical  investment  portfolio  as  micro  cap  stocks  are  addedand concludes that micro caps have a positive impact on the typ-ical  diversified  portfolio,  suggesting  that  an  allocation  of  5  per-cent  to  20  percent  in  micro  caps  could  be  considered  prudentover long-term time horizons.
As an individual investor making micro cap selections for anexisting portfolio, an allocation of 5 percent is likely a good placeto  start.  There  should  be  a  minimum  target  of  20  to  25  stockswithin the portfolio, and they should be diversified across differ-ent industries to help spread the risk in the portfolio. As an indi-vidual  investor,  you  don’t  need  to  make  all  the  investments  atonce,  but  you  could  begin  by  selecting  one  or  two  new  nameseach month until your portfolio is completely constructed. Thisstrategy allows the investor to dollar-cost-average into the microcap arena and further control the risk.
The  next  question  is  what  to  look  for  when  selecting  microcaps. If the principal agent relationship holds true, there are twogroups  of  investors  whose  actions  should  be  closely  monitoredwhen  screening  for  micro  cap  opportunities.  Company  insiderswho  are  the  principals  of  the  transaction  are  the  first  group  towatch,  and  knowledgeable  institutional  investors  who  are  theagents  in  venture  capital  theory  are  the  other  group  to  watch.
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Observing  the  actions  of  these  groups  is  relatively  simple  in the public capital markets because they are much more transpar-ent,  and  therein  exists  the  opportunity  to  gain  an  informationadvantage.
The buying and selling patterns of the key management teamcan be a stunning leading indicator of a company’s future pros-pects.  Who  is  in  a  better  position  to  make  a  critical  evaluationabout the future business prospects of a company? The key man-agement  team  will  have  firsthand  knowledge  of  the  day-to-dayoperations of the company and how it is progressing. In addition,the insiders have a keen awareness of the current valuation of thecompany. Who better to make an informed principal agent deci-sion about the current value and future prospects of the companythan the existing key management personnel? The pattern of theirbuying  and  selling  can  be  a  very  powerful  indicator  of  futurestock  performance.  These  material  insiders  are  required  to  dis-close their purchase and sale decisions to the public at large in atimely manner through filings with the SEC. The review of thesefilings  can  be  a  powerful  tool  for  screening  the  micro  cap  uni-verse for investment opportunities.
These insider trades can be monitored by reviewing the dailyonline filings made at the SEC through the agency’s web site atedgar.gov, or an individual can subscribe to a service that com-piles insider trading data such as insidertrader.com or the Thom-son Financial Network at thomsoninvest.net. These are just twoof the many sites that provide recent compilations of insider trad-ing data.
A careful review of the company’s recent public filings withthe SEC will then help the investor to develop a theory on whatcatalyst has created buying interest on the part of management.Chapter 6 presents a suggested due diligence list of the data thatan investor should review prior to making an investment. The top10 items are:
1. Federal regulatory filings made by the company2. Competitors of the company3. Customers of the company4. Suppliers to the company5. Industry trade associations
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6. Sell-side research analysts7. Buy-side research analysts8. Newspapers, magazines, and other publications9. Internet searches10. Briefs and related legal documents filed in public lawsuits
These easily available documents will help formulate a picture ofthe company, the industry, and the competitive landscape of thebusiness.
After doing some homework, the list of potential companiesshould begin to take shape. Chapter 7 discusses how micro capvaluations  differ  from  those  of  large  capitalization  stocks.  Thekey thing to understand is that micro caps will normally look verycheap or very expensive when comparing them with the valuationof similar companies that are larger in market capitalization. Thisis driven primarily by the industry in which the micro cap existsand where the economy is within the economic cycle.
Academic research as well as studies done by Uniplan Con-sulting, LLC, our financial research affiliate, have indicated thatsome  screening  variables  are  generally  more  useful  than  othersfor  the  purposes  of  finding  micro  cap  opportunities.  There  arethree relevant financial analysis techniques that will help poten-tial  micro  cap  investors  screen  out  potential  investment  candi-dates  for  consideration  for  their  portfolios.  As  mentioned,  thevaluation  criteria  most  suitable  for  a  given  micro  cap  companywill depend largely on the type of business the company engagesin and the value of the company relative to its industry peers. Thethree financial items to examine are:
1. Price to book value2. Price to free cash flow3. Price to earnings
We call them the “holy trinity” and use them as our basic screen-ing tools to begin our searches. Again, this is not meant to be anexhaustive  list  of  valuation  methods,  but  rather  some  generalscreening criteria that can help narrow the universe of micro capcompanies into smaller groups for more rigorous analysis.
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Chapters 8 through 12 examine, through the use of case stud-ies, how all these various factors can be reviewed in the contextof  real  micro  cap  companies,  including  a  discussion  about  thenewly emerging strategy of private investments in public equities(PIPEs).  These  case  studies  often  have  all  the  aforementionedelements  in  various  dimensions.  They  are  useful  in  reviewing  amethodology for approaching micro cap analysis; however, theyare by no means definitive. Different investors will arrive at vary-ing  conclusions  about  the  same  company.  The  companies  thatyou  select  for  your  portfolio  might  be  entirely  different  fromthose that another investor using similar techniques might select.This, in many ways, is the most interesting and unique aspect ofmicro cap investing.
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CHAPTER 14
Micro Cap FundInvesting
This chapter will attempt to answer the following questions:
• How can you use mutual funds to get micro cap exposure in
your portfolio?
• What should you consider when selecting a micro cap fund?
Not  everyone  wants  to  select  stocks  for  their  portfolio.  This  isparticularly true of micro caps, where there is a much higher levelof primary research required to make investments. These inves-tors should consider a micro cap mutual fund as an alternative fortheir micro cap investment allocation. There is a proliferation offund information available on the Internet. The following is a sim-ple  summary  of  information  that  should  be  considered  wheninvesting in a micro cap mutual fund.
The first question most investors normally ask is: How is theperformance? That is a good question but should not be the lastquestion asked when reviewing micro cap funds. To really knowhow well a fund is doing, compare the fund’s returns to appropri-ate benchmarks. In this case, the Wilshire Micro Cap Index wouldbe  the  easiest  and  most  useful  benchmark.  Then,  compare  thefund’s performance to that of other funds that invest in the microcap securities. Over longer periods of time, a fund should add per-formance over the benchmark. In this category, the time period
173
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considered  should  be  no  less  than  three  years,  and  five  yearswould  be  a  better  minimum  because  of  the  longer  time  horizonassociated  with  micro  cap  investing.  For  a  similar  period,  youshould  also  consider  how  the  fund’s  performance  stacks  upagainst that of other, similar funds. It is important to note that thefunds should be similar because not all funds within a category arealways  comparable.  A  micro  cap  value  style  fund  might  look  asthough its performance is not good relative to a micro cap fundthat invests in emerging technology stocks, but this should be con-sidered when investing in a given fund. This goes to the issue ofvolatility—some funds are more volatile than others. As discussedearlier, the riskier the investment, the greater the expected return.In micro cap stocks, the risk is large, but the return expectationsare  large,  too.  But  also  remember  that  the  greater  the  risk,  thegreater  the  potential  for  loss.  Some  micro  cap  managers  have  apenchant for more risk than others. Those who take on a lot of riskexpect  a  greater  return  from  their  investments,  but  they  don’talways get it. Conversely, some managers are willing to give up thepotential for large gains in return for a less bumpy ride. Consider afund’s volatility in light of the return it produces. Two funds withequal  returns  might  not  be  equally  attractive  investments;  onecould be far more volatile than the other.
Nevertheless, it is important to be certain that no matter whata fund’s return, the manager of the fund is the manager that pro-duced the return. Keep in mind that funds are only as good as thepeople behind them. It is the fund managers who make the invest-ments. Because the fund manager is the person responsible for afund’s  performance,  knowing  who’s  calling  the  shots  and  howlong he or she has been doing it is essential to selecting a microcap fund. Make sure that the manager who built the majority ofthe fund’s record is still the one in charge. Managers change withsome frequency—particularly good managers—so it is importantto do your homework on them.
As with researching a micro cap stock, there are some easilyobtained documents you will need to research a fund. There arethree valuable fund documents:
1. The prospectus2. The statement of additional information (SAI)3. The annual report
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When you request an information kit from a mutual fund, younormally are sent a prospectus and the most recent shareholderreport. These are also available online through the EDGAR site.Read them, because they are a wealth of information. Here’s whatyou  need  from  the  prospectus  and  the  statement  of  additionalinformation.
The prospectus tells you how to open an account (includingminimum-investment requirements), how to purchase or redeemshares,  and  how  to  contact  shareholder  services.  There  are  sixthings  you  absolutely  need  to  know  about  a  fund  before  youdecide to buy shares in the first place.
1. Investment  objective. The  investment  objective  is  themutual  fund’s  investment  mandate.  Make  sure  it  is  a  microcap fund. Funds that can invest up to $1 billion in market cap-italization often call themselves micro cap or mini cap funds.For  our  purposes,  funds  that  focus  on  companies  that  aresmaller than $500 million in market cap are preferred. Invest-ment objectives can be notoriously vague, so a careful readingof the strategy section is important.
2. Strategy. The prospectus also describes the types of stocksand/or  bonds  and  other  securities  in  which  the  fund  mayinvest, but it does not list the exact investments that the fundowns.  The  strategy  section  should  spell  out  what  kinds  ofcompanies the manager looks for, such as small, fast-growingfirms or low P/E firms. If the fund can invest in foreign secu-rities, the prospectus says so. Most restrictions on what thefund can invest in are also usually listed.
3. Risks. This section may be the most important one in theprospectus. Every investment has risks associated with it, and aprospectus must explain these risks. Because micro cap invest-ing is of higher risk than most other investing, you can expectthis section to be fairly long. It is important to not take any risksthat may be associated with the manager’s particular style. Forexample, some managers invest in very illiquid stocks that maynot trade every day. This is a form of liquidity risk that couldhave an impact on the fund’s daily price or net asset value (NAV).
4. Expenses. Everyone needs to get paid, and it costs money toinvest  in  a  mutual  fund.  Different  funds  have  different  fees.
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There is a table at the front of every prospectus that makes iteasy  to  compare  the  cost  of  one  fund  with  that  of  another.You’ll find the sales commission the fund charges, if any, forbuying or selling shares. The prospectus also tells you, in per-centage  terms,  the  amount  deducted  from  the  fund’s  returneach year to pay for management fees and operational costs.Micro  cap  investing  is  relatively  labor  intensive,  so  the  ex-pense ratio of micro cap funds tends to be higher than that ofother types of stock funds. Keep this in mind, because microcap fund expenses can often exceed 2 percent per year.
5. Past performance. As the saying goes, past performance isnot indicative of future results. It can, however, give you anidea  of  how  consistent  a  fund’s  returns  have  been.  A  chartheaded “Financial Highlights” or “Per Share Data Table” pro-vides  the  fund’s  total  return  for  each  of  the  past  10  years,along with other useful information about fund performance.It  also  breaks  out  the  fund’s  income  distributions  and  pro-vides the year-end NAV. Some prospectuses include additionalreturn information in the form of a bar chart that illustratesthe fund’s calendar returns for the past 10 years. This chart isa good way to get a handle on the magnitude of a fund’s upsand downs over time. The prospectus may also use a growthof $10,000 mountain graph, a table comparing the fund’s per-formance to indexes, or other benchmarks to present returninformation.
6. Management. The management section explains the peoplewho will be investing the money in the fund. The fund shouldtell you the name and experience of the fund manager or man-agers.  However,  some  funds  simply  list  “management  team”or some other less-than-helpful description. If that’s the case,consult the fund’s statement of additional information or theannual  report  to  see  if  more  specific  information  is  giventhere.  It  is  also  possible  to  call  the  fund  itself  or  check  out the fund family’s web site. If this still does not yield the namesand tenure of the team, then it is a likely bet that you shouldavoid  the  fund.  If  the  prospectus  does  name  names,  checkhow long the current manager has been running the fund to be  sure  that  the  fund’s  past  record  was  not  achieved  undersomeone else. Also, it is worthwhile to find out whether the
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manager  has  run  other  funds  or  is  currently  running  otherfunds. A look at those funds could give you some clues aboutthe manager’s investment style and past success.
There are three ways in which funds can be managed:
1. The single-manager approach. With this model, there is oneperson who takes primary responsibility for making the fund’sinvestment decisions. The manager normally does not do allthe research, trading, and decision making without help fromothers. So it is important to remember that the single managermay be the sole decision maker but is not likely the sole ideagenerator.
2. The  management  team. This  concept  was  popularized  byfamilies like American Century, Scudder, and Putnam. With thismodel,  two  or  more  people  work  together  to  choose  invest-ments. The level of one team member’s involvement or respon-sibilities  can  be  difficult  to  gauge.  Sometimes  there’s  a  leadmanager who is the final investment arbiter, while other timesit is more of a democracy with regard to portfolio selections.3. The multiple-manager system. The fund’s assets are dividedamong  a  number  of  managers  who  work  independently  ofeach other. This model is not seen very often in the micro caparena.  American  Funds  is  one  of  the  biggest  fund  familiesusing this approach, but they do not have a micro cap product.Multiple managers are more common with subadvised funds,such as Forward Funds, the CDC Nvest funds, and the Ameri-can Advantage Group, in which the fund company hires man-agers from other companies to run the fund.
Funds  run  by  teams  are  often  less  affected  by  managerchanges than funds run by only one person. But that’s true only ifthe fund really was run in a team fashion, whereby decisions aretruly  democratic.  Conversely,  then,  manager  changes  can  be  aproblem for
• Single-manager funds• Funds run by very active managers who’ve proved to be adept
stock pickers or traders
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• Good funds from families that aren’t strong overall, or fromfund  families  that  lack  other  strong  funds  with  a  similarinvestment style
• Funds  in  categories  such  as  micro  caps  where  the  range  of
possible returns is very wide
This  is  why  it  is  important  to  know  managers  and  managertenures in the instances of micro cap funds.
Although the prospectus is packed with great information, itshouldn’t  be  your  sole  source  of  data  on  a  fund.  A  fund’s  state-ment of additional information contains very detailed informationabout the fund’s inner workings. Be sure to ask for this documentspecifically—funds  routinely  send  out  prospectuses  and  annualreports,  but  SAIs  are  often  not  distributed  unless  specificallyasked  for.  The  SAI  often  provides  far  more  detail  than  theprospectus about what the fund can and cannot invest in. The SAIalso is usually the place where you can find out who representsyour interests on the fund’s board of directors and how much theyare  paid.  Finally,  you  can  find  more  details  about  your  fund’sexpenses here, including brokerage fees paid by the fund and abreakdown of where 12b-1 fees go, if the fund charges them.
Once you invest in a micro cap fund, it is important to moni-tor the fund. Mutual funds can also lose their edge. A good fundmay  not  always  be  a  good  fund.  Funds  do  change.  Sometimestheir  performance  slips  or  their  managers  leave  or  their  strate-gies evolve away from their mission. That is why funds need tobe monitored. Here are some of the red flags to watch out for asyou monitor your fund. These items may signal that a change ison the way.
As funds attract new investors and grow larger, their returnsoften become sluggish, weighed down by too many assets. Theylose their potency and their returns revert to the average for theirgroup. This is particularly the case in the micro cap sector. Goodperformance attracts money that makes it harder for the fund tomaintain performance—an ugly paradox. The best funds will stopaccepting money from new investors when their assets grow toolarge, but greed overcomes most funds and they don’t stop. Thatexplains why so many once-hot funds become mediocre.
The mutual fund industry is littered with the bodies of small-growth  funds  or  funds  whose  strategies  involved  a  lot  of  trading
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that put up terrific numbers by buying fast-growing small-companystocks and quickly selling them when their growth stalled. The per-formance of these funds drew lots of attention from investors, andtheir asset base swelled. Returns slowed because the managers justcouldn’t  execute  their  fast-trading,  supergrowth  strategy  with  somany assets under management.
The second side effect of asset growth is that fund managersoften alter their strategies to accommodate asset growth. Somesimply buy more stocks, buy larger companies, or trade less. Nomatter  what  they  do,  though,  they  make  some  kind  of  change.And  as  a  shareholder,  you  need  to  be  aware  of  the  change  andconsider whether this alteration impacts the fund’s ability to trulybe a micro cap fund.
Finally  you  should  be  sure  to  rebalance  your  portfolio.  Sayyou originally constructed a portfolio of 50 percent stocks, 40 per-cent bonds, and 10 percent micro caps. If left alone over a 10-yearperiod, that portfolio could easily grow into a blend of 64 percentstocks, 14 percent bonds, and 22 percent micro caps. Presumably,you set up your original allocation to match your needs and risktolerance.  If  neither  has  changed,  your  allocation  shouldn’t,either. For example, if stocks take over your portfolio, as they doin the example, your returns may rise but so will your risk. Thebest way to return the portfolio to the original risk level is by buy-ing  and  selling  funds  until  you  reach  your  original  allocation.That’s what rebalancing is all about. It forces you to take profitswhen  certain  assets  are  outperforming  and  to  reinvest  in  thosesame assets when they are underperforming. Here are some sim-ple guidelines for rebalancing.
• Don’t  rebalance  too  often. You  needn’t  worry  about  rebal-ancing every quarter, or even every year. Studies have foundthat investors who rebalanced their investments at 18-monthintervals  reaped  many  of  the  same  benefits  as  those  whorebalanced  more  often.  Investors  who  rebalance  less  fre-quently save themselves unnecessary labor and, in the case oftaxable investments, there can be some tax savings, too. Asmentioned, rebalancing requires reducing the winners, whichmeans  realizing  capital  gains  and,  for  the  taxable  investor,paying taxes. Although you should monitor your mutual fundportfolio on a monthly basis at a minimum, resist the urge to
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rebalance too often unless one of your funds has significantlychanged its strategy.
• When  you  rebalance  pay  attention  to  the  stock/bond  split.Your  bond  investments  are  vital  to  keeping  your  portfolio’srisk in line. Because bonds don’t generally move in sync withyour  stock  investments,  a  simple  strategy  of  restoring  yourbond fund allocation to its original weightings every 18 monthswill help to lower your portfolio’s overall risk.
• Rebalance micro cap and other focused styles by the num-bers, not the calendar. Like any good concept, rebalancingcan be taken to extremes. Some investors follow very detailedasset allocations that involve very specific targets, such as a20  percent  micro  cap  target.  They  then  rebalance  when  thestyle-specific  allocations  get  out  of  whack,  as  well  as  whentheir  overall  stock/bond  split  goes  awry.  When  it  comes  tosubasset classes or investment styles, studies by MorningstarMutual Fund Advisory have found that a policy of readjustingwhenever  one  style  takes  up  one-fourth  more  or  one-fourthless than its original portfolio position is most effective. Forexample, you’d want to rebalance when the micro cap fund towhich you devoted 20 percent of your portfolio rises to 25 per-cent  or  sinks  to  15  percent.  This  allows  for  the  longer  timehorizon required by some asset classes to be realized.
• Use new money to rebalance. A longtime strategy of finan-cial advisors is to counsel taxable investors that when addingfresh dollars to their portfolios, they should add to their lag-gards to avoid the tax consequences of selling their winners.Absent  new  money  to  put  to  work,  consider  having  yourfunds’  income  and  capital  gains  distributions  paid  into  amoney market account and using that cash for rebalancing.
Whether you invest in micro cap mutual funds, in separatelymanaged micro cap accounts, or directly in micro cap stocks, thestrategies in this book should help the micro cap investor managethe risks and derive the benefits of making big returns by invest-ing in small companies.
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Index
AAllocation of cash flow, 23–24Alpha (excess return), 169Alvarez, Fernando, 90Amazon.com, 8–10, 168American Advantage Group,
177
American Airlines, 10–11American Century, 177American Funds, 177American Research and Devel-
opment Corporation, 41American Stock Exchange, 5,
80
Anheuser-Busch, 7Annual report form 10–K,
73–76, 108
Annual reports, 174–175Apple Computer, 41APT (arbitrage pricing theory),
29–30
Arbitrage funds, 158Arbitrage pricing theory(APT), 29–30
Asset allocation
micro caps and, 34–39, 46–50modern portfolio theory
and, 33–34
rebalancing portfolios, 179
Asset classes, 47Average P/E, 83–89
BBalanced portfolios, 48–49, 180Banc of America Bridge Capi-
tal LLC, 128
Banc of America Securities,
123, 128
Banking relationships, 66–67Banz, Rolf, 31Barnes & Noble, 9Berkshire Hathaway, 98–99,
102–105
Bernstein, Richard, 3Beshears, Cletese, 110Beta, 29Biotechnology companies
at development-stage, 148PIPEs and, 157–158
Board of directors
annual report form 10–K, 76determining material infor-
mation, 72
of Gehl Company, 137, 141,
143–144
of Michael Foods, 117–118SAI and, 178scrutiny of, 65–66
181
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182
Index
Bobbie Brooks trademark, 96Bobcat steer loaders, 139Bonds
balanced portfolio, 48–49,
180junk, 136returns on, 35
Book value
of Garan, 96–97of Gehl Company, 134, 145price-to-book ratio and,
91–92
of Ptek Holdings, 162Boston Stock Exchange, 80Bottom-tier stocks, 19–20Briggs, Thomas, 113Buffett, Warren, 96, 98,
102–103
Business communication ser-
vices, 161–162
Buy-and-hold index approach,
17
Buyout opportunities, venture
capital and, 39–40
CCapital asset pricing model
(CAPM)ICAPM, 30overview, 26–33, 169on returns, 46
Capital gains, 179–180Capitalization stocks, 2CAPM (capital asset pricing
model)ICAPM, 30overview, 26–33, 169on returns, 46
Cascadian Farms, 113Case Corporation, 140
Case studies
Garan, 95–105Gehl Company, 133–146Michael Foods, 116–131Pozen Company, 147–154Ptek Holdings, 161–165purpose of, 172Suiza Foods, 107–115
Cash flow
allocation of, 23–24micro caps and, 89–90price-to-free cash flow ratio,
92–93, 171
Ptek Holdings and, 162