- The Washington Times - Tuesday, February 17, 2004

The nation’s tiniest and most troubled companies led last year’s rally with spectacular gains, and now many market players are betting that bigger, more stable concerns will preside over the next stage of the recovery. But that doesn’t mean you should sell off your small-cap mutual funds.

If anything, financial experts say, the astonishing pace of 2003’s advance is the best case yet for giving small-caps a permanent place in your portfolio. And even if you missed out on last year’s gains, there’s still plenty of reason to put money in this asset class.

The smaller firms that survived the downturn have emerged leaner than before, and in some cases with stronger management, benefiting from an influx of senior staff laid off by larger organizations. Now, with a robust economy predicted for this year and many smaller companies consistently reporting earnings above expectations, small-caps are poised for continued success, said Mary Lisanti, president of New York-based investment adviser AH Lisanti Capital Growth.

“A lot of intellectual property resides with small companies,” Ms. Lisanti said. “There’s usually some theme that gives them a nice wind at their back. You add that to an economic expansion and it becomes a nice, stiff breeze.”

Any number of factors can help a small company rise above larger competitors or give an upstart firm an edge. Some small companies are focused on the nation’s swelling Asian and Hispanic populations. Others are targeting fashion to women over the age of 35. Still others are peddling new computer technologies, alternative sources of fuel or potentially lifesaving medical devices.

There are 5,500 public companies with market caps below $2 billion, and chances are there’s a future Nike Inc. or Microsoft Corp. hidden somewhere among them. Investing in individual small-caps can be risky, though, so for most people, mutual funds remain the best choice.

“It really is not a do-it-yourself area,” said Ms. Lisanti. “This is a stock-picker’s market.”

Even in well-managed funds with limited volatility, however, small-caps pose a certain amount of risk. For most people, it would be appropriate to put between 5 percent and 10 percent of their total portfolio in a small-cap fund, said Scott Bordelon, a fee-based financial planner in Covington, La. More aggressive investors might consider placing up to 15 percent in small-caps, with the rest held in more stable equities and bonds.

“It’s certainly not an area you should load up on because there’s more risk,” Mr. Bordelon said. “But I don’t think you should ever say I’m not going to be invested in small-caps, because it’s part of a diversified portfolio. No one knows with exact certainty what’s going to happen in the future, and diversification in styles is one of the best protections an investor can have.”

If you were among the investors who raised their small-cap exposure to more aggressive levels last year, it may be time to count your winnings and trim back, said Laura Pavlenko Lutton, a mutual fund analyst at Morningstar Inc.

Broadly speaking, she said, small-caps have had a strong run and are probably due for a breather.

“But you don’t want to abandon this group,” Ms. Lutton said. “That was a great lesson of the bear market. Small-caps were chugging along when many of the diversified funds were crashing and burning. You always want to have a small portion of your portfolio dedicated to small-caps, so you won’t miss it when they go up again.”

Some of last year’s best-performing funds were focused on small-cap value stocks — undervalued companies with strong fundamentals. But with the market moving so high, some experts say it’s getting harder for fund managers to find financially healthy companies that are reasonably priced. If you are looking for small-cap exposure through a single fund, Ms. Lutton suggests finding one that blends both value and growth investing styles.

Most blended small-cap funds will have a U.S. focus, she said, which is fine, because foreign small-caps would probably add more volatility than the average investor would want. Blended small-cap funds that top a picks list compiled by Morningstar analysts include FPA Paramount Fund, Royce Premier and Third Avenue Small-Cap Value. All have low expenses relative to other funds in the group, solid long-term records and strong management.

The Royce family, which specializes in small-caps, also has two funds on Morningstar’s value list — Royce Total Return and Royce Special Equity.


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