Small-minded manager produces big returns

They're saying it again: This is the year for small-cap mutual funds.

But the experts have said that at the beginning of each of the last two years, only to find that these funds - which invest in the stocks of small companies - get trounced in the ensuing 12 months.

And 1999 is no different.

The reasoning goes that the blue chips have charted such a spectacular runup and become so expensive, that investors will turn to smaller, lesser-known companies and drive their stock prices higher.

And that looks like a reasonable scenario for this year, but don't watch the clock, fund pros say.

Small-cap mutual funds - those that hold shares for firms valued at around $500 million but up to $1 billion - have yet to join the bull-market euphoria.

Unfortunately, with low-cost goods from Asia flooding US shores, they may continue to trail the herd.

"Small-cap investing is very, very difficult," says one expert, Philip Treick (pronounced Trike). The Russell 2000 index, which measures small-cap stock performance, "is not pretty" these days, he says. The index underperformed the market last year, losing almost 10 percent, compared with double-digit gains for indexes that measure performance among blue-chip stocks.

Mr. Treick himself is no scowling curmudgeon out to discredit small-cap funds. He is portfolio manager for the No. 1 small-cap fund in the United States: Transamerica Premier Small Company Fund (800-892-7587; minimum investment $1,000 or $50 on a monthly investment plan).

Treick's fund blew the competition out of the water in 1998, posting a gain of more than 80 percent (see chart below).

Nonetheless, Treick readily concedes the challenges of managing small-cap funds now.

They require require well-honed focus on specific companies rather then industries. You either hold the hot stocks or you lose money.

Since most small firms lack market share and strong cash flow, they need a strong product, outstanding management, or both for growth.

Morningstar Inc., Chicago found that of the 624 small-cap funds it tracks, most looked lackluster last year.

The 176 small-cap "value" funds averaged a negative 9 percent. (Value funds look for beaten-down companies with intrinsic value.)

The 172 small-cap "blend' funds - with both value and growth characteristics - lost an average 7 percent.

Only "growth" funds, such as Mr. Treick's fund, scored on the up side, but just barely. (Growth funds look for companies that will post strong earnings over time.) The 276 small-cap growth funds tracked by Morningstar gained 1.2 percent.

Treick sees better times for both value and growth funds in 1999, but he stresses deflation poses a significant threat, despite the strong US economy.

Smaller companies face a competitive disadvantage when consumer prices are falling under pressure from cheap imports from Asia.

He also sees the growing popularity of the Internet and computer technology in general as deflationary forces.

Investors should shop carefully among small-cap funds, Treick says.

He suggests avoiding those that own shares in more than 200 companies, a typical portfolio among small-cap funds.

That quantity becomes too cumbersome for managers to monitor, he says, and can hold down the average return.

Treick's portfolio, for example, averages fewer than 25 companies from a wide range of industries.

They include Amazon.com, the online bookstore, and animation studio Pixar, which created the film "A Bug's Life" for Disney. Both posted hefty stock gains in 1998.

Other Treick picks include ENVOY, a business services firm, Speedway Motorsports Inc., which owns race-car tracks, and Hollywood Entertainment, a video chain that owns Reel.com, an Internet sales site.

You can see the rest of his holdings on the Internet: www.morningstar.net (type TPSCX in the "Quicktakes" box. Oddly, the fund's own Web site, funds.transamerica.com, is out of date.)

Treick scours the landscape for innovative companies.

He found Speedway, for example, when he arrived late at a conference and one of the few unoccupied chairs placed him next to a Speedway executive. The subsequent conversation made him realize the company was unique and well positioned for growth.

Treick says small-cap funds work best for investors who are willing to hold stocks for a year or two and can withstand market volatility.