3 terrific small-cap funds

By Tim Middleton

Last week's panic attack in credit markets will send some investors fleeing risky small-company stocks for the perceived safety of megacaps. But that doesn't mean the small-cap party is over.

"Eight years ago, on a price-to-sales ratio, small caps were trading at a 60% discount to large caps," says Satya D. Pradhuman, director of research for Cirrus Research. "They're currently selling at about a 30% discount. That's about average. But markets rarely go back to averages; they usually overshoot."

Translation: Although small-cap stocks have doubled the returns of large caps in those eight years, they're just as likely to continue to rack up gains as to surrender leadership. If your small-cap holdings have grown uncomfortably large, this is a grand time to take some profits. But if you don't own enough, it's also not a bad time to buy.

3 great funds

For mutual fund investors, picking good small-cap funds is complicated by the fact so many of the best are closed to new investors. But I've found three gems.

Keeley Small Cap Value (KSCVX) is up 7.8% this year, as of July 26, ahead of the S&P 500 Index ($INX) by more than 2 percentage points. Perritt Micro Cap Opportunities (PRCGX) is ahead 10.5%. Bridgeway Small Cap Value (BRSVX) has spurted 12%. In all three instances, these gains extend what were already some of the best in the industry.

The usual rule of thumb, which I think is sound, is that small-company stocks should make up about 15% of your equity holdings. Less and you miss out on the added returns they offer. More and you accept too much risk -- they're 40% more volatile than large caps.

Once you've settled on how much to invest, it's time to pick the fund you are most comfortable with. Here are outstanding prospects:

Picking up the pieces, profitably

Keeley Small Cap Value has long specialized in corporate restructurings, such as firms emerging from bankruptcy or spun off from larger concerns. Manager John Keeley likens spinoffs to "underwritings with no underwriter. Nobody is getting paid to price the company accurately, so typically they are priced inaccurately."

This is a surprisingly fertile area for investment. The fund owns more than 170 names and has an average of only 1% of assets in each of the 10 largest holdings. Morningstar analyst Andrew Gogerty notes that Keeley's two decades of experience in this niche has produced consistent above-average returns. Over the last five years they have averaged 22.4%.

This arena is also ground zero for credit deals, however; when the Dow Jones Industrial Average ($INDU) plunged 2.3% last Thursday, this fund sank 3.2%. "When credit is under stress, as it is now, you oftentimes have more pressure on the smaller companies than you do on the larger companies," Keeley acknowledges.

But he adds the stress "provides an opportunity here as valuations become more attractive."

Keeley Small Cap is a broker-sold fund, and a very popular one: Assets have ballooned to more than $5 billion. Keeley has responded by buying into more deals rather than concentrating larger bets on individual positions. The average market capitalization of stocks in the fund is $1.4 billion, comfortably within the small-cap range despite its size.

Spreading your bets

Perritt Micro Cap Opportunities, a no-load fund, is much smaller, with assets of $550 million, and it focuses on much smaller names; the average market cap is $286 million. Assets are spread around more than 170 names.

Continued: Technology bargains

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