Fishing Small-Caps for Tomorrow's Whales

Winners like DryShips keep Satuit's manager in the small-cap game.
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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)

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."

Dynamic Materials Still Booming, Says Manager

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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%.

The fund has enjoyed strong success in the energy services arena, and Johnson expects the boom to continue even if the U.S. economy slows. "The strong cash flow of energy companies will fuel a continuing strong level of drilling activity."

One name he likes is

Flotek Industries

(FTK) - Get Report

, which supplies specialty chemicals to drillers. The company has grown revenue and earnings more than 40% year over year, yet it is trading at 20 times analysts' 2008 earnings estimate. The stock recently traded at $38, and Johnson believes it could revisit its 2007 high of $55 a share.

Elsewhere on the oil patch, Johnson has large expectations for

Particle Drilling Technologies

(PDRT)

, a development-stage company nearing commercialization. Its technology is designed to increase the rate of penetration in the drilling process, primarily in hard-rock drilling environments.

"The management comes from

Baker Hughes

and each successive test has yielded significant improvements," says Johnson. "We expect big things from this company in 2008."

Aside from the energy services arena, Johnson expects the China boom to continue as well.

One of the fund's most successful holdings has been

DryShips

(DRYS) - Get Report

, says Johnson. The company is a play on commodities being shipped to China. "Shipping rates doubled in the past year and we don't see many new ships coming on line to drive down rates until 2010," he says.

The fund originally bought the stock when the company was valued in the market at less than $500 million. It now boasts a $3.1 billion market cap, having risen in price to $86 from $15 over the past year, even breaking $130 not too long ago. In fact, the stock grew so big that the managers had to move it up a weight class into their

(SATSX)

Satuit Capital Management Small-Cap fund.

Talk about landing a big one.

Before joining TheStreet.com, Gregg Greenberg was a writer and segment producer for CNBC's Closing Bell. He previously worked at FleetBoston and Lehman Brothers in their Private Client Services divisions, covering high net-worth individuals and midsize hedge funds. Greenberg attended New York University's School of Business and Economic Reporting. He also has an M.B.A. from Cornell University's Johnson School of Business, and a B.A. in history from Amherst College.