When is bigger better? Not very often, microcap managers would tell you. The designation microcap usually refers to companies whose market capitalization is less than $500 million. Investors in the category, which are growing in number, argue that historically the shares of small companies have outperformed their larger competitors for one simple reason: They grow faster.

That’s the good news. The bad news is that small-cap stocks are thinly traded and volatile. Think of it as the very end of the stock market teeter-totter – definitely not a comfortable seat for the faint of heart. Whitney George, who manages the $640 million Royce Micro-Cap Fund, describes stocks in the sector as roach motels: Investors can get in, but when things get tough they can’t get out.

Still, the sector appears to be gaining in popularity. Investors have been attracted because of above-average performance and an ongoing desire to diversify portfolios. In response to multiyear above-average performance, the Russell Investment Group last year launched a microcap index. It is composed of the smallest 1,000 stocks in the Russell 2000 plus the next 1,000 smallest companies below those. Russell noted that between June 2000 and the first quarter of 2005, the sector increased 9.03% annually, compared with 5.07% for the Russell 2000.The market cap of the stocks in the new index ranged from $55 million to $500 million; the weighted average was $290 million.

In the wake of the launch of the Russell index, as well as a similar index from Zacks Investment Research, a number of ETFs sprang up to benchmark the index. Industry participants expect these vehicles to attract funds to the sector, as well as visibility, which may prove both positive and negative. Because market caps are small, managers are constantly driven to discover new, undervalued stocks; funds raised through the index products will only exacerbate the problem.

Although it is difficult to precisely measure the money flowing into the sector, Morningstar has isolated 26 funds that carry the word microcap in their title; after seeing a withdrawal of assets during 2004 and 2005, the funds are estimated to have raked in $340 million in the first five months of this year. That figure does not include the index products. Because of the funds inflow and consequent bidding up of many small issues, Mr. George closed the Royce Micro-Cap to new investors. He cites a “mismatch between money flows and the availability of attractive stocks.”

The stocks tend to rise and fall in concert with general optimism or pessimism about the economy. The decision to launch the Russell index last June was looking pretty good in July, when it was up 7.1% (vs.3.89% for the Russell 1000). By the end of the year, concerns about hurricane losses, rising oil prices, and Fed tightening had taken their toll, and the group had fallen behind. The largecap 1000 index was up 6.27% for the year, compared to 2.57% for microcaps. Some of the gain in the larger-cap group was because of the inclusion of Google into that rare air. Also helping the larger companies’ performance was the view that economic growth was slowing, and that the best time to own smaller companies was in the early stages of a recovery.

The manager of the Satuit Microcap Fund, Robert Sullivan, would disagree. During a presentation made at the end of last year, Mr. Sullivan made the case that microcap stocks over “non-recessionary periods” dating back to 1945 have, on the whole, outperformed the broad averages. He looked at 10 such periods, and found that micro stocks rose on average 16% in the periods studied, compared to 14.3% for small caps and 12.1% for large-cap issues. What Mr. Sullivan’s charts also show, however, is that the smallest stocks did better in only five of the periods shown. At other times, different sectors outran them.

Other attributes of the microcap sector, according to Mr. Sullivan, are that valuations compared to growth rates tend to be lower for smaller companies. It is true that micro companies tend to fly below Wall Street radar, and thus may be “undiscovered” and offer attractive value. It is also the case that smaller companies are legitimately viewed as more risky. They are often newer and can suffer growth pains as start-up management systems are stressed by revenue expansion.

Mr. Sullivan’s $62 million fund, rated five stars by Morningstar, has handily outperformed both the Russell microcap index and the Russell 2000 index since inception in 2000. So far this year, the fund is ahead 8.21%; over five years it has earned on average 22.8% annually after fees. But, it has not been smooth sailing.

Satuit was up nearly 63% in 2003 after a decline of 14.3% in 2002. As we said: Not for the faint of heart. The five-year standard deviation is 19.1%.

To make life even more exciting, Mr. Sullivan has made some sizeable sector bets, by overweighting energy and telecommunications services while underweighting financial services and consumer discretionary stocks. On the whole, these judgments have been excellent, though over the past couple of months the fund has not kept pace. The top holdings are an eclectic bunch, and include Smith Micro Software (SMSI), Comtech (COGO), Sterling Construction (STRL), and Core Labs (CORE), an oilfield company. At the end of March, the median market cap in the fund was $328 million.

The Royce Micro-Cap fund has also made some significant bets on energy, which has pumped up its performance as well. The fund is ahead 5.5% so far this year, and has compounded at 16.1% since its inception at the end of 1991. Several of the top 10 holdings of the firm are energy-related, focused especially on the oilfield services sector. Mr. George had been reducing some energy holdings earlier, but now sees the group as becoming attractive again. Similarly, he thinks there are bargains to be had in precious metals, as slumping commodities markets are causing investors to throw mining stocks overboard.

The managers of the Royce fund caution that the volatility of microcap stocks means that the sector should only be undertaken by those willing to invest for at least three years, preferably five. He describes the sector as driven by “fear and greed on steroids.” Then again, his fund is closed.

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