'Small Caps' Now a More Comfortable Fit

Small-company stocks, the laggards of 1997, appear ready to rumble.

Mutual funds that invest in small companies surged more than 4 percent last week.

These funds, on average, are still down for the year. But some analysts see the winds shifting.

"Small caps" are the hot potatoes of the stock market. They can either sizzle or burn. The right one at the right time can significantly outperform the broader market, and it looks like they are ready to cook.

Small-cap stocks may have "hit bottom" says Robert Dickey, an analyst at Dain Bosworth, an investment house in Minneapolis.

Small-cap funds buy stocks of small companies, those in the emerging stage of their corporate existence. Their market capitalization - the number of shares times their stock price - is $1 billion or less, often under $500 million.

Few experts, so far, predict that small caps will outperform the blue chips that have led the current bull market.

But since April 24 the Russell 2000 index, which tracks small caps, has gained 7 percent.

And even before that surge, many investment houses saw better times for the sector.

Launch time

Case in point: The Transamerica family of funds will roll out a new small-cap fund June 30.

Manager Phil Treick, sounds upbeat about the prospects. He sees many "good smaller companies with distressed prices" and plans a portfolio of 40 to 50 stocks.

Because the small caps are so volatile, they represent an aggressive investment strategy.

Many analysts suggest combining a small-cap fund with more conservative funds, such as a balanced fund (with a stock/bond mix) or a growth-and-income fund (investing in large caps).

So far this year, that volatility falls mostly on the down side.

As of May 1, small-cap funds lost 4.12 percent, according to Morningstar Inc., the Chicago fund-rating service, which tracks 449 of them.

Go for value

Ed Trumpbour, who oversees small-cap products at Brandywine Asset Management in Wilmington, Del., recommends "small-cap value" funds.

These look for companies whose shares sell at a discount to their true value. This contrasts with "small-cap growth" funds that look for above-average growth in profits.

The categories are two distinct components of the Russell 2000 index.

The divergence has widened this year, Mr. Trumpbour says, with small-cap growth stocks down sharply, and small-cap value stocks essentially flat.

The 194 small-cap growth funds tracked by Morningstar fell 9.89 percent through May 1. But the 150 value funds it tracks gained 1.83 percent.

If interest rates rise further, some smaller growth companies could run into problems raising the money necessary to expand.

Value-oriented companies are typically steadier than growth-oriented companies. Thus, in the market downturn of 1987, small-cap value stocks were down only 16 percent, compared with 28 percent for small growth stocks.

The top-performing small-company funds for this year are shown in the chart above.

Many analysts, however, advise against picking funds based on short-term performance. So here are some top small-cap funds that have high three-year average returns (shown in parentheses).

In Morningstar's value category the top performers include Kemper Dreman Small Cap A (24 percent), Fidelity Low-Priced Stock (19.3 percent), and Pioneer Capital Growth A (18.2 percent).

Among the top performers in the growth category are Franklin Small Cap Growth I (24.7 percent), Kaufmann (20.7 percent), Managers Special Equity (18.9 percent), and Putnam OTC Emerging Growth A (17.7 percent).

To pick one of these funds, the Morningstar and Value Line mutual fund surveys, available in most libraries, provide one-page fund profiles that cover risk levels, fees, sales commissions, and minimum investments.

Still in the shadow

One factor hurting small-cap funds is their own performance.

"When 70 percent to 80 percent of all fund managers are underperforming" the market indexes, "that sends investors flocking to index funds, which pushes up the price of large-company stocks," says Tim Ebright, one of the three managers of Manager's Special Equity Fund.

Investors are also skittish about higher interest rates. "Investors want safety and liquidity," Mr. Ebright says. That flight to safety boosts the blue chips.

Adventurers Only, Please

NEW YORK

EIKO THIEME, who manages the American Heritage small-cap fund, admits that it takes some courage to invest in his fund.

In 1991, 1992, and 1993, the fund was up a total 232 percent. In 1994 it was down 35 percent; in '95 it dipped 30 percent; in '96 it drooped 5 percent.

And this year? Talk about comebacks! The fund is up 41 percent, leading the pack of small-cap funds. It ranked first among all mutual funds in the first quarter.

"I keep telling people, 'We are a high-risk' fund.... But we're also for superior performance over time," says Mr. Thieme. "If you had come aboard in early 1996, you'd be up over 30 percent now.

"We are probably the closest thing to a venture capital fund," often investing in fledgling companies.

He is an active trader who easily mixes different investment styles.

On Tuesday morning, April 29, for example, he came to work and immediately bought shares in Bank of New York, which he calls a solid, small-cap firm with undervalued share price.

But he's far from conservative, with half his holdings in just one company. Senetek, a British firm, makes a beautification cream and a medical treatment.

Shares now trade around $3. Thieme predicts $10 in a few years.

Two other key holdings are also related to the health-care business: PDTI, now at $27, should hit $200 by 2000, he predicts; ADM Tronics, at 30 cents a share, Thieme also expects to soar.

His total portfolio is focused - around 30 stocks. "If you want to get rich, you must concentrate," he says. "Once you make your money, then you can diversify."

"Look at Bill Gates," co-founder of Microsoft. "He didn't get rich by diversifying. He focused."