Big returns in the smallest packages: micro-cap funds can produce an oversized payoff for investors.

Over the years, stocks have been great investments. Ibbotson Associates in Chicago calculates that $1 invested in large company stocks at the end of 1925 would have grown to $2,284.79 by the end of 2003, assuming that no taxes were levied and dividends were reinvested. Not bad.

The numbers for small company stocks are better--much better. According to Ibbotson, over that same time period your $1 would have grown to a staggering $10,953.94.

In Wall Street-speak, a company's market capitalization is the total value of its shares. The small company stocks Ibbotson tracks are in the bottom 20% in terms of market cap. While a corporate giant, such as General Electric, has a market cap of more than $300 billion, an example of a micro-cap would be PetMed Express, a company that provides medical care for pets and has a market cap of around $139 million.

Historically, the top performers have been micro-caps. "They've been spectacular performers in the past three or four years," says Laura Lutton, an analyst at mutual fund research company Morningstar. "When the economy was struggling, smaller and more nimble companies were more likely to keep growing, and their stocks did nicely."

THE LITTLEST LEADERS

Indeed, of all the diversified U.S. stock funds tracked by Morningstar, the best three-year return through the first quarter of 2004 was posted by Bridgeway Ultra-Small Company Market (BRSIX), which gained more than 40% per year. Others in the top 10 included Oberweis Micro Cap (OBMCX), Perritt Micro Cap Opportunities (PRCGX), and Fifth Third Micro Cap Value (MXSAX), all of which had annual returns between 25% and 30%. Says Lutton, "Funds in this category have done so well that we question how long they can continue to be leaders. Investing in such small companies can be extremely risky with the potential for painful losses, so I wouldn't make them a core holding. Nevertheless, they can deliver large gains, too. For many micro-cap funds, the past performance has been so strong that they could play a small role in a diversified portfolio."

Similarly, Ron Pearson, president and CEO of Beach Financial Advisory Service in Virginia Beach, Virginia, says that investors should limit micro-cap fund holdings to less than 5% of their portfolio: "[With that percentage], you reduce the risks of investing in micro-caps. At the same time, outstanding performance there could make a positive difference lot your overall returns."

According to Pearson, the good news is that good micro-cap managers generally do well year after year: "They know how to find good companies in an area of the market where not many people are looking." The bad news? Most micro-cap funds try to avoid growing too large so they frequently close to new investors after they've successfully attracted substantial capital.

WHERE TO INVEST

Those looking to invest in microcaps now must find a fund that's open to new investors. As of this writing, such funds included Gartmore Micro Cap Equity (GMEAX), which was up 93% in 2003, and Satuit Capital Micro Cap (SATMX), which rose 63%.

"We suggest that our clients invest in small cap funds rather than micro caps," says Robert Pagliarini, a certified financial planner and executive vice president with Allied Consulting Group in Los Angeles. "The companies in small-cap funds aren't quite as risky as micro-caps because small-caps can own companies with market caps of up to $1 billion." Micro-cap funds generally restrict holdings to companies with a market cap of $350 million or less.

Small-cap funds also offer the possibility of outstanding returns. Says Pagliarini, "Our current favorite, Third Avenue Small Cap Value (TASCX), usually keeps 10% to 20% of its assets in micro-caps so investors have some exposure to those stocks." Lutton, too, says that while there are no micro-cap funds on her "pick" list, she favors Royce Total Return (RYTRX), a small-cap fund that may hold around 15% of its assets in micro-caps.

Whether you prefer to buy small or extra small, mutual funds that hold little companies can deliver sizable returns. If you can stand the risk of a steep slide now and then, putting a pinch of micro-caps in your portfolio can pump up your long-term profits.

TOP RETAIL MICRO-CAP FUNDS BY 3-YEAR RETURNS

                                                         1-Year
Fund Name                   Ticker        Category       Return (*)

Perritt Micro Cap Opport    PRCGX         Small Blend    60.83%
Satuit Capital Micro Cap    SATMX         Small Blend    61.23
Tamarack Enterprise A       TETAX         Small Blend    41.82
Aegis Value                 AVALX         Small Value    37.66
Perkins Discovery           PDFDX         Small Blend    61.45
Tamarack Micro Cap Val A    TMVAX         Small Value    56.51
Munder Micro-Cap Eqty A     MMEAX         Small Growth   66.78
Corbin Small-Cap Value      CORBX         Small Value    32.15
TA IDEX TA Sm/Md Cp Val A   IIVAX         Small Value    56.55
Gabelli Westwood Mighty A   F009PB        Small Value    28.48

                                                         Geometric
                            3-Year        5-Year         Market Cap
Fund Name                   Return (*)    Return (*)     Average in $MM

Perritt Micro Cap Opport    23.92%        20.22%         158
Satuit Capital Micro Cap    20.51         NA             289
Tamarack Enterprise A       18.87         15.44          317
Aegis Value                 18.64         19.62          236
Perkins Discovery           16.57         17.53          69
Tamarack Micro Cap Val A    16.21         14.80          329
Munder Micro-Cap Eqty A     14.98         17.26          343
Corbin Small-Cap Value      11.81         6.07           118
TA IDEX TA Sm/Md Cp Val A   11.76         NA             282
Gabelli Westwood Mighty A   10.75         12.48          157

                            Min-Initial
Fund Name                   Purchase      Phone

Perritt Micro Cap Opport    $1,000        800-332-3133
Satuit Capital Micro Cap    $1,000        800-567-4030
Tamarack Enterprise A       $1,000        800-422-2766
Aegis Value                 $10,000       800-528-3780
Perkins Discovery           $2,500        800-998-3190
Tamarack Micro Cap Val A    $1,000        800-422-2766
Munder Micro-Cap Eqty A     $2,500        800-468-6337
Corbin Small-Cap Value      $2,000        800-924-6848
TA IDEX TA Sm/Md Cp Val A   $1,000        888-233-4339
Gabelli Westwood Mighty A   $1,000        800-422-3554

SOURCE: MORNINGSTAR INC. MORNINGSTAR MAKES EVERY EFFORT TO ENSURE THE
COMLETENESS AND ACCURACY OF THIS DATA BUT CANNOT GUARANTEE IT.
MICRO-CAPS ARE DEFINED AS FUNDS WITH GEOMETRIC AVERAGE MARKET
CAPS OF $350 MILLION OR LESS. RETURNS THROUGH APRIL 30, 2004.