Fishing Small-Caps for Tomorrow's Whales

The hard part about fishing for a few good micro-cap stocks is knowing where to drop a line.

Investors avoided the minnows of the market this year, opting instead to go whaling for less economically sensitive mega-caps. The Russell Microcap Index is down close to 9% year to date compared with the S&P 500 which, despite a lot of bellyaching, is still up 5% for the year.

Bob Johnson, co-portfolio manager of the $150 million (SATMX - Cramer's Take - Stockpickr)Satuit Capital Micro Cap fund, says it is easy to get lost in the vast ocean of micro-cap stocks, but the massive quantity of names provides some great opportunities as well. Johnson and co-manager Bob Sullivan screen 4,000 stocks based on sales growth, earnings growth and other quantitative factors. Then they reduce that number to a more manageable 600 names before undertaking a bottom-up stock selection process.

"We've found that this is the best way to approach such a large universe of stocks," says Johnson. "Once we get our arms around it, we carefully scout for companies with above-average earnings growth at below-average multiples."

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Because micro-cap companies are generally undercovered on Wall Street, Johnson and Sullivan often rely on regional brokerages for analyst reports. They also visit with management when possible.

So far, their legwork has paid off. The fund is up a year-to-date 8.4% and has returned an average of 21% annually over the past five years, good enough to earn it five stars from Morningstar. The fund's managers are also quick to throw back a catch if it grows too big for their boat, or if it does not work out. The 65 stock fund -- very low for micro-cap standards -- has an annual turnover of 137%.