NEW YORK ( TheStreet) -- Not many mutual funds hold micro-cap stocks -- small companies with market values of less than $500 million. The tiny stocks can be hard to trade and prone to periodic crashes.
But micro-caps can be worthwhile holdings, says Hal Ratner, a chief investment officer of Morningstar Investment Management. The smallest stocks sometimes diversify portfolios and deliver winning returns, Ratner says.
To appreciate the potential rewards and risks, consider Aegis Value (AVALX), a micro-cap specialist. During 2008, the mutual fund lost 51.4%, trailing the S&P 500 by 14 percentage points, according to Morningstar. But the next year, Aegis skyrocketed, gaining 91.4%, topping the S&P 500 by 64 percentage points.
The periods of outperformance often compensate for the occasional disappointing years. During the past 10 years, micro-caps returned 12.1% annually, compared to 8.5% for the S&P 500, according to Morningstar/Ibbotson. "Micro-caps can be volatile, but they can give you the potential for strong returns," says Hal Ratner of Morningstar.To hold micro-caps, try a relatively steady mutual fund. Top managers can earn winning returns by combing through the ranks of obscure companies and finding bargains. A solid choice is Wasatch Micro Cap Value (WAMVX). During the past five years, the fund returned 8.0% annually, topping the S&P 500 by three percentage points. While the average market capitalization of S&P 500 stocks is $54 billion, the Wasatch portfolio has an average capitalization of $496 million. Portfolio manager Brian Bythrow sometimes buys companies with market capitalizations of less than $200 million. "We want to find small companies that will grow to be bigger businesses," he says.
Most of the tiny stocks receive little attention from Wall Street analysts. In contrast, major blue-chips are covered by dozens of analysts. Bythrow aims to spot growth companies before Wall Street discovers them and pushes up the prices. One of his successful holdings was First Cash Financial (FCFS - Get Report), which operates pawnshops in Texas and Mexico. The fund bought the stock a decade ago, when the chain had a market capitalization of $100 million. The company was little-known and operating in an industry that does not normally attract many fund portfolio managers. Catering to growing markets, First Cash prospered. Bythrow recently sold the stock after it reached a market capitalization of $1.5 billion.