Investors think small in hopes of big profits

A growing number of investors and money managers Russell tracks are thinking small. Really small.

The reason: They see potentially rewarding investment opportunities in micro-caps, which historically have shown average annual growth rates greater than those of small-cap and large-cap stocks.

These smallest-of-the-small stocks are attractive to these investors because they are less widely followed by analysts than large stocks and even what are generally considered small stocks. As a result, with some research, these investors believe they can obtain information that might not be available in the broad market, enabling them to find bargains before other investors do.

The micro-cap stocks – generally defined as those that range from a market capitalization of $50 million to $500 million – include many smaller regional companies that seldom gain attention in the national spotlight. As a result, few analysts have paid attention to them historically. Coverage has been restricted largely to those who followed the stocks because of their interest in them as local companies.

As the number of managers who follow the stocks grows, investor awareness also has increased. In December 2005, Prudential Investments estimates, about $14.7 billion was invested in micro-cap products, more than double the $6.7 billion invested in December 2002.

Investors who wish to gain a sense of the performance of micro-cap stocks before investing in them – and to track their performance once they are invested – can, of course, follow the individual stocks. But a way to track their performance overall is through an index, such as the Russell Microcap Index, which consists of the smallest 1,000 stocks in the small-cap Russell 2000 Index, as well as an additional 1,000 smaller companies.

Russell developed the Microcap Index after its research showed that the smallest stocks were performing significantly differently than other stocks generally grouped under the category of small-cap stocks.

The Russell Microcap Index grew 10.7 percent in the five years to Aug. 14, 2006. This return compares with the broad-market Russell 3000’s 4 percent gain over that time and the small-cap Russell 2000’s 8.6 percent. Performance recently has been less dramatic, with the Russell Microcap Index adding 2.4 percent in the last year to Aug. 14, compared with the Russell 2000’s 4.5 percent – but historically micro-cap stocks have moved in cycles.

Another reason for increased interest in the micro-cap stocks is that the index has shown relatively low correlation with the indexes for small-cap stocks and large caps. Historically, stocks in the micro-cap index have moved in different cycles than the other stocks, making them potentially good diversifiers in a well-balanced portfolio.

Investors who want the opportunity to invest in micro-cap stocks can do so in several ways. One is to seek out stocks through research and invest in them individually. Another way is to invest in one of several mutual funds that are now available. A third method is to invest in exchange traded funds based on a micro-cap index.

As usually is the case with investments, the potentially higher reward that might be offered by micro-cap stocks is accompanied by potentially higher risk and volatility. Historically, micro-caps have tended to follow strong surges of out-performance with a flattening-out period.

But with stock returns forecast to revert closer to the 75-year average of 7 percent a year (as measured by the Dow Jones industrial average) in future years, investors are looking for new investment opportunities.

Micro-cap stocks are seen as one of those potential new avenues.