NEW YORK (TheStreet) -- Microcap stocks have lagged recently. During the past five years, iShares Russell Microcap Index ETF (IWC) has lost 1% of its value annually, trailing the S&P 500 Index by 3.6 percentage points.Most of the poor performance can be traced to big losses that microcaps suffered during the recession. As the financial crisis began unfolding in the second half of 2007, tiny stocks were among the first to sink, and they dropped sharply throughout the market downturn of 2008. While the definition of microcaps varies, many portfolio managers say that the group includes companies with market capitalizations of less than $500 million. In contrast, the average market value of stocks in the S&P 500 is $48 billion. It is not unusual for microcaps to underperform in downturns. The tiny companies tend to be more volatile and less well-run than the blue chips. Microcaps often face big debt burdens. As a result, the group records more than its share of bankruptcies. When investors began fleeing risk during the recent market downturn, they dumped microcaps. Hedge funds that had to raise cash were among the big sellers. Should you avoid microcap funds? Not necessarily. While microcaps are prone to big downturns and long periods of subpar performance, the stocks tend to compensate by excelling in bull markets and outperforming over the long term. During the past 85 years, microcaps have returned 12.3% annually, compared to 9.4% for large stocks, according to the University of Chicago's Center for Research in Security Prices. The data suggest that investors who want to use a microcap fund should be prepared to wait patiently through downturns and what could be prolonged periods of underperformance. To own a fund that can knock the cover off the ball in a bull market, consider Wasatch Micro Cap Value ( WAMVX), which has returned 5.3% annually during the past five years. After crashing in the downturn, the fund gained 70% in 2009, outpacing the S&P 500 by 43 percentage points for the year. Portfolio manager Brian Bythrow is an opportunist, holding a mix of growth and value names. He classifies some of his holdings as fallen angels, growth stocks that have slipped because of temporary problems. Other favorites are value-priced stocks that are beginning to enter a growth phase. Bythrow prefers companies that move under the radar. Many holdings have little or no coverage by analysts.
A favorite holding is Virtus Investment Partners ( VRTS), a mutual fund company with a market value of $362 million. In 2008, the company was spun off from Phoenix Cos. ( PNX), a life insurer. Virtus is little-known partly because it has only been an independent public company for a short while, says Bythrow. At the time of the spinoff, the business had a narrow profit margin. But earnings have been increasing as the company expands its distribution. Another holding is First Cash Financial ( FCFS), which operates a chain of pawn shops in the U.S. and Mexico. "Mexico is an underserved market, and there is room for growth," says Bythrow. Another opportunistic fund that holds growth and value names is Artio U.S. Microcap ( JMCIX), which returned 64% in 2009. Portfolio manager Samuel Dedio likes to find companies that have compelling products and can gain market share. Some of his stocks have suffered setbacks and seem poised to execute turnarounds. A holding is Morton's Restaurant Group ( MRT), an upscale steakhouse chain with a market value of $119 million. The company languished during the recession, but sales and earnings are bouncing back. Dedio says that the company can increase its number of outlets by 50%, with much of the growth coming in Asia. "People are underestimating their ability to grow in China," he says. "The Chinese love beef." Another holding is Cenveo ( CVO), a commercial printer with a market cap of $407 million. The company produces envelopes used for advertising and billing. Sales slumped during the recession as the volume of direct-mail promotions weakened. But these days the number of credit-card solicitations is increasing, says Dedio. He says that the stock remains cheap because investors worry that the company has high debt levels. Dedio says that the balance sheet will improve as earnings recover and the company pays down debt. "Two or three years from now, the leverage will come down, and people will feel more comfortable with the stock," he says.