Seeking Alpha with Micro-Cap Funds

Historically, top performing stocks have always been micro-caps. The Russell Microcap Value Index provides historical and current statistical data for the microcap segment of the US equity market. The top performer was Cbre Realty Finance Inc (CBF) with a return of 45.49, with Medical Staffing Netwk (MRN) bringing up the rear for the top 10 performers with a return of 27.35. These kinds of dream returns are naturally what every investor seeking a slice of alpha growth is looking for, and micro-cap mutual funds offer just this opportunity. However, behind the hype lies a significant amount of risk and a need for being flexible enough to get in and out of the market as the economy turns.

Microcap funds invest in companies with a stock market capitalization of $300 million or less. The simple reason for this over performance is that these companies have more potential to expand, capture a bigger market share and increase revenue than established companies with a large capitalization and market presence.

When a microcap company fulfills that potential, its stocks are naturally in high demand, thus fuelling demand and share prices. Micro-cap mutual funds merely take advantage of this potential and the only trick here is to spot companies poised to show explosive growth.

However, investing or trading into micro-cap funds needs some lessons and caution. The risk factor is significantly more than that for a conventional mutual fund. Micro-cap funds are also more vulnerable to changes in the general market and economy. Fluctuations in microcap stocks are highly volatile, and generally trend towards an amplified curve following the indexes.

General rule of thumbs for investing into micro-cap funds include:

• Stick around when the economy is booming and is likely to do so for some time in to the future. Microcaps should be divested just before a downturn in the markets.
• Small companies are excessively reliant on short-term borrowings from banks and their performance is adversely affected by rising interest rates. Invest when interest rates are low or stable and divest when rates are about to rise.
• You are able to accept periodic and cyclic losses based on bad bets or market downturns.

Financials, technology and consumer services and goods have been sectors which regularly throw up star performers in the micro-cap bracket. Every year, there are a few microcaps with buzz and hype just starting to build around their value and prospects. This is the time to get in on the ground floor. Select a fund managed by someone with a historical track record of regularly coming up with small cap winners. Do not pick a fund which has not been through at least one market crash. During every recession, market crash or even a mild cause of worry, such as the current credit crunch triggered by subprime mortgage foreclosures, a lot of micro-cap funds go out of business. Those who survive are astutely managed and are highly likely to be able to survive another crash.