Four small-cap managers talk about opportunities and challenges ahead.

    After seven years of outperformance, small-cap mutual fund returns will almost certainly slow. But the ride is not over, say veteran small-cap managers from around the country.
    "Obviously, there's lots of discussion about whether it's too late in the game for small caps," says Whitney George, managing director and senior portfolio manager of Royce & Associates.
    Small cap "is all we do. We view it as evergreen. It's where there is new products and innovation. It's how big companies get big, as part of the ongoing food chain," says George, who produced 6% to 8% year-to-date returns, as of August 21, in Royce Select III, Royce Value Plus Service and Royce Microcap and one-year returns ranging from 18.2% to 22.5%.
    As for the outperformance that many are predicting for large cap, many are not convinced. "How many large companies can really grow at 15% a year?" asks George, echoing the sentiments of other small-cap managers we spoke to who think earnings challenges will continue to confound large-cap stocks. "You can count them on one or two hands. So your choices are reasonably limited. In the small-cap world, there are hundreds of companies growing very rapidly, but because they're small cap they're considered value," George says.
    The folks at his shop routinely incubate stocks for two to three years, and they are hoping any correction will give them buying opportunities. "If consumers slow down a lot, we'll find opportunities in retail restaurants and banking. If oil prices back off, we'll look for opportunities in energy names. After a great ride with health care and tech, Royce is buying companies that make steel or process scrap metal," he says. "The expectations are really low here. People think they'll go bankrupt. We think consolidation will make them healthy.
    So far, George has been right on the money. He bought Western Silver, a mining and precious metals firm, in the high single digits back in 2004 and it ended up in the high $20s when it was bought earlier this year. "That's a fabulous example of what we love to do and some of the most fun we had," says George. "We're finding interesting risk-reward ratios with great balance sheets that give them staying power."
    Regional banks are on the radar screen at Royce now because of current concerns about the soft housing markets and exotic mortgages. "These things can create the kind of turmoil we like, if the upside prices come down. When economic news causes people to become concerned, it's in that environment where we find the types of stocks we like to plant and harvest," George says.
    Morningstar mutual fund analyst Todd Trubey, who follows the small-cap market, admits that the firm started to predict a slowdown for small caps about three years ago. "You generally don't expect things to go for this long, although this is not the longest streak of outperformance ever recorded," Trubey says.
    But that doesn't mean he is expecting to see carnage, or for that matter even disturbing losses in the small-cap arena. "We don't ever want to call the market, but as far as small-cap managers being able to continue to ply their trade, I think they'll be able to ply their trade," Trubey says. "I also think that some, like Whitney George, will continue to do well in his field and on an absolute basis."
    As for stock selection getting a bit more challenging in the small- and micro-cap arenas (generally defined as companies with market caps of $500 million and under), Trubey says he's heard it both ways from the small-cap managers he covers. "We're hearing from some that it's getting harder and harder. And there are those saying: 'Ah, you can always find good small stocks.'"
    Chris Cordaro, chief investment officer at RegentAtlantic Capital in Chatham, N.J., says that despite cutting his firm's small-cap allocation in February to 8% from about 12%, he still favors value. One fund he likes? Royce Micro-Cap, which he has used for about five years. "We have about $15 million and we'd put new clients in, but it's closed right now," says Cordaro, who directs the firm's $1.2 billion in assets. "We believe that on the value side, there are always opportunities with small cap. And since the value premium is more pronounced in small cap, you're better compensated."
    Bradford G. Evans, a co-manager of the Heartland Value fund, who helped mastermind a turnaround earlier this year, says he is never short on ideas for investing and is buoyed by banks willingness to continue to lend to small-cap companies. "Their access to capital is still very good. I also like the fact that we're close to the end, or at the end, of the Federal Reserve's rate cycle, so we may not see the kind of lending tightening that can hit small companies particularly hard," Evans says.
    Another bright spot? Lots of insider buying. "We look at this very closely and we're seeing a lot of it in our names, so it makes us bullish."
A key fundamental of Heartland Value's turnaround, after two years of dismal performance (just a 2% return in 2005), was a broad-based move into technology, says Evans, who likes software, semiconductors and telecommunications companies. "What we're investing in is good balance sheets and superior technology; maybe there is a short-term issue that has caused the company to fall from favor, but there is a turnaround in the future."
    Right now, he likes companies like Input-Output, a leading seismic equipment provider to the oil and gas industries. With superior technology, market demand increasing for exploration and only two analysts (both small, regional shops) following the company, the stock returned more than 42% year-do-date. "Insiders have been buying this stock consistently and recently," Evans says. "We believe this stock is flying under the radar."
    Another stock he likes is Federal Signal, a manufacturer of fire trucks and safety equipment for police and fire vehicles. "We started buying at $16 a share and we think it will trade as high as $30," Evans says. "What we see is a solid, new management team, a zest for managing raw material costs and the sale of noncore businesses, which is strengthening the company's balance sheet."
    Phyllis G. Thomas, who manages both the ING Smallcap Value Choice A and the Nuveen NWQ Small Cap Value A funds, also is emboldened by seeing that small companies are still able to borrow so readily. "Despite the Fed tightening rates 17 times, credit spreads are still very narrow. If you look at a survey of smaller companies, you'll find that they have a fairly easy time borrowing. We still think we're in a market when small cap will do quite well," says Thomas, who has managed to hand in one-year returns that range from 15.3% to nearly 18% in the ING fund. Her YTD numbers run from just over 9% to 10%.
    "On the large-cap front, I think it's a growth rate issue that will hurt them. They're having trouble growing," says the senior fund manager. "Finding mispriced securities in the $500 million to $600 million market-cap range is getting tougher." But that doesn't mean she doesn't think she's found a number of stocks with significant upside potential.

One of her favorites is Century Aluminum, a stock she began buying at $7 a share, which has traded as high as $55.
"We like the fact that they hedged their aluminum prices out about a year and a half, so we knew they'd have cash flow to service their debts until aluminum prices moved up. That's exactly what happened," she says. "The fact that they bought a competitor and did an equity offering, along with signing a long-term contract to provide hydro power in Iceland, continues to make them an attractive holding."
    Jack LaPorte, a 30-year veteran of T. Rowe Price and longtime manager of the New Horizons Fund, seems torn right now. "If investors demand a higher risk premium and the emphasis shifts to large caps, I'm not saying there will be a decline in small caps, just a tougher time outperforming."
One gets the feeling, however, that LaPorte might enjoy being wrong. New Horizon's year-to-date performance was a negative 2%, with one-year performance at 9.8% at this writing. "I think smaller cap will come in somewhere in the high single digits with large cap a bit higher," LaPorte says.
For his part, he's looking for sectors and companies that can best navigate a slowing economy. "Those that can produce at least 10% earnings will do the best going forward."
    In that vein, LaPorte likes Coventry Health, a health-care services company and managed care provider that has a strong balance sheet and is making acquisitions in new markets. The growing company has rewarded New Horizon with 15% returns.
    Echoing other managers, LaPorte says one thing that might help small caps continue to perform well relative to the overall market, are the obstacles to earnings growth faced by many large-cap companies. "If I'm wrong about investors' desire for greater risk premiums and they continue to seek higher returns, small cap may continue to outperform," he says, almost wistfully. "Again, I think that's pretty low probability, but it could happen."