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Posted 8/7/2001
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Mutual Funds
How to outsmart the investing herd Success begets success, or so the thinking goes. But among mutual funds, it's far more likely that today's hot tip will be tomorrow's dud. Here's why you should avoid the 'closed fund' stampede. By Timothy Middleton Through mid-year, Perritt Micro Cap Opportunities Fund (PRCGX) has been the 10th-best-performing mutual fund in the entire industry. Lipper reports that its total return, as of July 19, was 31.8%.
The fund’s marketplace, small-capitalization value stocks, is the hottest segment of the market this year. Lipper’s average such fund is ahead 13.5% this year, compared with a 9.4% decline for small growth funds, and a 19.2% plunge for big growth stocks. But investing in small-cap funds is tricky. Many of the best funds, notably Schroder Ultra (SMCFX) and Wasatch Small Cap Value (WMCVX), are closed to new investors. Bridgeway Ultra-Small Company (BRUSX), which has been closed for three years, has said it will close even to existing shareholders if assets (currently $52 million) hit $55 million. Gerald Perritt, in turn, vows to close his fund when assets reach $100 million. The fund’s median market cap is a mere $141 million. Typically management and private investors own the majority of shares, which therefore don’t trade. With such a small float, “You don’t want to be 5% owners of these businesses,” he says, “because of liquidity issues -- you can’t get out.” The fact that the fund is a top performer, albeit for a short period, and that it will be closed if its success continues are enough to make novice investors drool. The mere announcement that a top-performing fund will close usually produces a flood of last-minute investments. Before you stampede in this way, take a closer look. Perritt, one of the industry’s most candid and insightful analysts, actually has a lackluster performance record, both in his fund and in his investment newsletter, Mutual Fund Letter. Recognizing his limitations, Perritt lately has taken on a co-manager, who is much more responsible for the fund’s recent performance than its founder is. But to the degree the fund has new management, its prospects become even more difficult to judge. Life at the top After laboring in obscurity for most of his fund’s 12 years of existence, Perritt is relishing the attention he’s getting from Lipper, whose top-funds lists are the most widely followed in the financial press. He’s particularly relishing the perverse fact that his fund only appears in the Lipper tables: It doesn’t appear in newspaper fund listings. “To be listed in the Wall Street Journal, you’ve got to have $50 million in assets,” Perritt grouses. “Heck, if we got to $100 million we’d close the fund. So about the time that -- if our performance continues -- we start appearing in the newspapers, you won’t be able to invest in it anymore.” Lipper's ranking of the year's hottest funds
Source: Lipper Small value goes in and out of favor regularly. When it’s in, Perritt gets flooded with assets. “Three years ago, for one month we were the best-performing fund in America,” he recalls. “In 45 days assets went from $8 million to $38 million. Shortly thereafter the Asian crisis hit, and we went from $38 million to $8 million.” To avoid a recurrence he has, like many small-company managers, imposed a 2% redemption fee on shares held less than 90 days. Perritt’s fund was launched in the spring of 1988, and since then, as of June 30, it has delivered average annual returns of 8.3%. Partly that mediocre return is due to the fact that small-cap stocks have been the market’s stepchild most of that time. Mark Hulbert, who has followed Perritt’s Mutual Fund Letter since 1986, says its recommendations have paralleled the fund’s performance. “This has not been a good time for small value,” he says. Two years ago, when the fund was languishing in the bottom quartile of its category, Perritt named his research analyst, Michael Corbett, as lead manager. “My role is in the area of strategy,” Perritt says. “I direct the areas to focus on, and what kind of diversification we should have, and Michael and his staff pick the stocks.” Corbett says he builds a broadly diversified portfolio of about 75 names. “We typically start positions with 1% to 2% of assets,” he says. Currently, the fund’s top holdings include the names in this table:
Source: Company, MSN Money Corbett cites Suprema Specialties as the kind of investment the Perritt fund likes. It took its stake nearly two years ago, when Nasdaq was red-hot and Suprema was trading at $6.50. (It’s currently about $15.) “This is the whole small and micro-cap stock thing. Which average guy out there would have bought a cheese company when you could buy Cisco Systems (CSCO, news, msgs)?” Corbett says. “The big guys couldn’t even buy a company like this. They had a market cap of like $40 million. There are 5.6 million shares outstanding, but the float is probably about 1.5 million.” Even after its recent run-up, Suprema still has a price-to-earnings multiple on trailing earnings of only 11. “These companies are so cheap and there’s no reason for it, except ignorance and denial.” Eventually, Perritt’s managers believe, these undervalued companies will gain recognition. When that happens, the fund sells into this strength, Corbett says. Five years ago it acquired a stake in U.S.Physical Therapy (USPH, news, msgs), which operates outpatient clinics. The stock did nothing until the middle of last year, when a major Wall Street firm picked up coverage with a "buy" rating. The shares have since soared from less than $4 on a split-adjusted basis to more than $17, where it has plateaued since May. “We bought it for $3, split-adjusted, and scaled out at around $17 three months ago,” Corbett says. “The valuation now is really out of control. It’s trading around 40 times earnings now. We’re value-oriented. I’d rather buy companies growing around 20% and trading at multiples of 10 or 15.” When to invest Since Corbett took over picking stocks at Perritt Micro-Cap Opportunity, the fund has gone from trailing the market to trouncing it; it outpaced the S&P 500 ($INX) last year by 15 percentage points, and this year is ahead by around 40. This year it is also soundly beating the Russell 2000 Value Index ($RUJ.X), after lagging it badly in 2000. This recently improved performance could be attributed to the manager’s learning curve -- or it could be a fluke, or the result of decisions made long before Corbett got the job; turnover is a scant 25%. There’s simply no way to know. The Wall Street Journal famously throws darts at stock tables every so often, and every so often those picks beat the experts. Indeed, a longstanding member of our Start Investing Community calls himself "Monkey With Darts," to remind everybody that success over a short period says nothing about long-term performance. So while I regard Gerry Perritt highly -- and have interviewed him regularly for his shrewd views -- and think he was wise to surrender the helm of his fund to Corbett, I would be very skeptical about buying into the fund. As I’ve written here before, it’s far more certain that hot funds will turn cold than the prospect that cold ones will heat up. In general, the worst possible time to buy a fund is when it threatens to close. After running up 40.8% in 1998, Vanguard Health Care (VGHCX) closed to new investors and trailed the market by 12 percentage points in 1999. It then reopened and soared more than 60% last year. The herd tends to run the wrong way. If Perritt’s dreams are fulfilled and his fund grows to $100 million, watch out. What managers are buying now Hoping for point-of-sale profits: Corbett recently added TransAct Technologies (TACT, news, msgs) to his portfolio. “I’ve been watching this company for several years, as they were developing new products,” he says. “In the last several months they’ve started rolling them out, and we’re pretty excited about what they have to offer.” The company makes printers for gaming and point-of-sale transactions. Waiting for the right price: The Perritt fund is studying -- but hasn’t yet bought -- Medtox Scientific (TOX, news, msgs), a supplier of laboratory services. On July 19, it reported sales up 15% and diluted earnings ahead 63%. That’s exactly what Corbett, who relies on regional brokerage firms for many of his ideas, was expecting. “If they had been significantly ahead of what we were thinking, we probably would have jumped right in,” he says, “but since they were right in line with our expectations, we’re going to do some more research.” He calls the stock’s multiple of nearly 19 times this year’s expected earnings “a bit pricey.” At the time of publication, Timothy Middleton owned the following securities mentioned in this article: Cisco Systems.
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