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The MicroCap Moment
MicroCap Milestone
Fremont U.S. Micro-cap Fund turns five
Manager beats out the S&P 500 since inception
By Richard Hefter, CBS MarketWatch
Last Update: 8:21 PM ET Jul 7, 1999 Courtesy of MicroCap1000.com
BOCA RATON, Fla. (CBS.MW) -- Bob Kern is nationally recognized as a pioneer and leading practitioner of microcap investing. Prior to co-founding New York-based Kern Capital Management, he headed the smaller-cap equities team at Morgan Grenfell Capital Management. In 1969, he founded the Smaller Capitalization Equities Group at Chase Investment Management, and in 1982 he was one of the first investment professionals to focus on microcap investing when he began managing the Bechtel Post-Venture Capital Account – providing U.S. microcap exposure for Bechtel Group's profit-sharing plan.
In 1994, he began managing the Fremont U.S. Micro-Cap Fund, which last week celebrated its fifth anniversary. One of the top microcap performers for the first half of 1999, the $250 million fund has also outperformed the S&P 500 over the last five years (through June 30), up 28.55 percent on a compounded annual basis versus 27.86 percent for the S&P 500.
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How do you account for your fund's outperformance?
Microcap investing is definitely all about stock selection. The value-added comes primarily through fundamental research of these companies that aren't well followed or widely owned. And there's really two things that relate to research. One is to set out to find winners, which everybody does, but what is less focused on and what has been a key element of our performance is doing fundamental research to minimize the investment mistakes. Mistakes are extremely costly, but they're more costly in the microcap area than in any other asset class, just because of the liquidity consideration.
What do you do to minimize mistakes?
We go for depth of knowledge versus breadth. Each of our senior investment managers is a specialist within a specific economic sector, so when they get down to the individual company investment decision within the microcap universe they're making the decision with that background knowledge. We strongly believe that the best opportunities for microcap companies to grow and prosper is to be an innovator. We're focused on those economic sectors where the level of innovation is the greatest, and those are four key areas: technology, health, consumer, and the whole broad area of service companies.
How do you screen companies?
We do initial screening for revenue growth and then look for companies that have improving profitability, because you get a double leverage of growing revenues and improving profitability. We look at three primary questions: First, how good is the business? Not only financial analysis but who are the competitors, what's the competitive environment. Second, how strong is the management? That gets into spending time visiting companies, talking with managements, discussing business strategies. Third is how much is the business worth? That's the valuation side of the equation. I think when all is said and done, if you can answer the question, "Would you buy this entire company at the market value of the equity?" -- if you can answer yes to that question, you've gone a long way to making a sound fundamental investment decision.
What are some companies that meet your criteria?
One of the areas that's experiencing very rapid growth is flat panel displays. The market there is being driven by portable computers. But you're going to see more and more flat panel displays used in desktop applications. You're already seeing that in the trading rooms of many brokerage firms because they take up less space. So there's very strong growth.
If you look at who's producing flat panel displays it's really non-U.S. companies. It's Japan, Korea and now Taiwan. There's not really the opportunity to invest directly in manufacturers of flat panel displays, but one of the companies we have an investment in, Photon Dynamics (PHTN: news, msgs), is one of two companies in the world that produces test equipment for flat panel displays, the other being a Japanese company. So Photon Dynamics is very well positioned to participate in the strong growth that we envision for flat panel displays. And we tend to think their approach to testing is somewhat better than the approach taken by the Japanese company.
Can it penetrate these markets?
Photon Dynamics has had a lot of success in the Korean market. The new market that is gearing up to produce flat panel displays is Taiwan, and the company is having a great deal of success there as well. They haven't been able to crack the Japanese market in any meaningful way, but I think that may well happen, especially if the technology that they've had is perceived to be better, which I think it is, than that of the Japanese company.
So that's one clear example of a company taking advantage of a trend in an industry where it's a market leader and one of the few players.
I think that surprises many people -- that you can find microcap companies that are leaders in their particular niche markets.
How about another example?
One of the areas that we have invested in and we think again is going to be very dynamic growth market for years to come is providing secure communications over the Internet -- something called virtual private networks or VPM's as they're known. The problem with the Internet today is there isn't any security in terms of most of the communications that are going on. With E-commerce becoming more important and sensitive information being transferred either intra-company or inter-company it would obviously be desirable to have a means of making sure the transfer of that information was secure. That can be done essentially through encryption technology, and combined with encryption in some cases is compression so the speed of the transmission can be greater.
There are two companies that we have investments in that are leaders in this particular area. One is Hi/fn (HIFN: news, msgs), and the other one is Information Resource Engineering Group (IREG: news, msgs). Both of these companies have been quite successful in terms of working with companies like Cisco, Nortel Networks which is the old Bay Networks, Lucent and the others in terms of providing this technology.
You've just celebrated your five-year anniversary. How important is a five-year track record for a MicroCap fund?
The industry has certain milestones of three, five, and 10 years for measuring fund performance, so in that respect it's important. A longer term track record gives people a degree of conviction and confidence about the characteristics of the fund and hopefully something about the rate of return potential in that asset plan. And in the microcap sector there are only about nine or 10 funds that have five-year track records.
Why so few?
It's really only within the past five years that microcap investing has come into its own. When I started in this area back in 1982 there were relatively few investors that focused on this sector of the market. You had Chuck Royce [of Royce Funds]; Bill Naskovitz at Heartland Advisors; and Preston Athey down at T. Rowe Price. It was a relative handful of investment professionals associated with mutual funds that focused down at this very small company sector of the market.
And the interesting thing is that most of the early funds were value funds.
But you focused instead on growth companies. Why?
While there may be fewer growth companies, there are microcap companies with very exciting growth potential. And those are the ones we seek out of this full universe of 5000 companies. So we narrow the universe down quite a bit in terms of where we focus our research efforts.
You said earlier that the microcap arena is where stock selection is most effective. Can you explain?
It has to do with the inefficiency of the microcap market, which is a result of several things. One is the research coverage. I don't know how many people follow Microsoft or GE -- there must be 50 or 100 -- but as you go down the market cap scale you can see the average coverage of a company go down. When you get down to microcap, we come up with about two analysts per company. And one of those or maybe both are the investment banker of the company. So you're not getting the coverage in terms of investment research in the microcap area.
The other thing you have to keep in mind is that what drives brokerage firms to allocate their research resources to a company is the investment banking potential. Larger companies obviously have the opportunity to do bigger deals, raise more money, and generate bigger investment banking fees. With microcap companies, especially those ones that don't need financing, brokerage firms say, "There's no opportunity for us here to make money. There's no money being made on trading these stocks."
But your returns are higher than the S&P 500…so obviously somebody's paying attention.
Our whole philosophy and focus on innovators is geared very strongly to attract money from outside the microcap universe. I don't think any of us would do very well in microcap if we had to depend upon the cash flows to the asset class and then the buying and selling that the managers might do. We've got to have the ability to attract money from other asset classes, primarily small cap, maybe even some mid cap, and especially some aggressive growth into the sector.
So you focus on companies you expect will have high visibility.
Right. One of the things I've found is that when some of the microcap companies have done secondary offerings -- you usually tend to think additional supply from the secondary offering would depress the price of the stock – but just the reverse happens. The stock goes up. Many times it's through the road show and through the underwriters for the secondary offerings that these companies gain exposure. It brings in research coverage which didn't exist before -- because going back to what I said about investment banking, there's some money in it.
Is more money starting to flow in this sector?
The institutional market is taking more of an interest in small caps and looking at microcaps along with it. So I sense that yes there's some reallocation of assets. I think we're in the period now -- and we're seeing it in the Fremont funds -- where the performance is attracting additional assets and our cash flows are strongly positive at this point.
Richard Hefter is editor of MicroCap1000.com, an online resource on small and microcap U.S. stocks. Small-cap stocks are generally considered to be those of companies whose market cap is $1 billion or less. MicroCap1000.com is owned and operated by Microcap Financial Services Inc. of Boca Raton, Fla.
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