Making money in small-capitalization stocks – usually defined as stocks with market capitalizations of less than $500 million – has traditionally required a combination of a hot stock market and luck. The co-founder of a $550 million New York-based hedge fund, Laurus Offshore Fund’s portfolio manager David Grin, argued he has developed a better way: Rather than inject capital into small- and micro-caps and hope for the best, he buys convertible bonds from the companies he and his research staff like and holds them for a three-to five-year period.

The kicker is that the stock embedded within the convertible bond is priced at least 10% above the market. Mr. Grin said the benefits from this are two fold: The fund can only profitably convert if the stock rallies, “so we are heavily incentivized to invest only in what we are confident about,” and the company gets cheaper financing than usually available from a bank. Moreover, he said Laurus does not arbitrage the convertible bond by selling thousands of shares short, thus creating pressure on the stock’s price.

The results have been good. This year, the fund is up 18.03% through the end of November, compared to the 15.94% return of the 57 funds in the HedgeFund.net small-cap fund index. Last year, the fund was up 31.73%, and has reported profits every month since launching in January 2001.

Mr. Grin said that in the absence of shorting stock – the preferred risk-management tool for most convertible bond investors – he and his staff manage risk by diversifying their investments across 24 different industries. He said Laurus had invested in 120 different companies.

One of Laurus’s biggest winners has been SpaceDev, a maker of engines for space flight. The company garnered a lot of attention recently when a spaceship using one of its engines was the first privately built ship launched to attain outer space orbit. Mr. Grin said the fund has a $5 million investment in the company where the stock was convertible at $.55 a share; it is now $1.85 a share.

Another winner for the fund was its investment in Implant Sciences, a company in the process of developing a remote-control, mobile bomb-sniffer for the U.S. Navy. The company provided financing two years ago that was convertible at about $1 a share; the stock is now $10.08 a share. Mr. Grin said the company’s product was of particular interest to him as a former captain in the Israeli Army’s bomb-detection unit.