EVERY WEEK WE

look at dozens of mutual-fund portfolios and usually the same group of companies

Microsoft

Google

General Electric

Wal-Mart Stores

Bronco Drilling

Olympic Steel

TTM Technologies

That changed this week when we took a look at Royce Micro-Cap. For the last 16 years this fund has been investing in the stock market's tiniest companies, including the three we mentioned above, and doing a pretty good job of it. Royce is a shop that has long been known for small-company investing and this fund is a testament to that expertise. It's in the top 10% of its Morningstar peer group over the trailing three-, five- and 10-year time periods. And it charges a relatively inexpensive $143 for every $10,000 invested.

This week we take our first look at microcap funds like this Royce offering. We have written about small-cap funds in the past, but microcaps are even further down the food chain. These products tend to invest in companies with market capitalizations below $500 million. Using that figure as a starting point, we found a universe of just 106 funds one of our smallest groups ever. We trimmed that list to 21 after knocking out load funds. Eventually, we wound up with just two finalists once we also added in our usual performance and expense criteria.

We present microcaps with one caveat: You probably will never invest in one of these funds. There are both pros and cons to this investing niche. We realize that a well-run microcap fund could help diversify a large portfolio. However, we also think your money could be better spent on other parts of the stock market that will provide similar returns and maybe cut back on some of the risk, too.

Microcap fans will disagree with that statement. They argue these tiny firms could well be the stock market's future darlings. After all, Microsoft and Wal-mart, just to name two examples, were technically microcap firms before they shot to fame. "All large caps would have been microcaps when they started," says Shashin Shah, founder of SGS Wealth Management in Dallas.

Microcaps also tend to lie in obscurity since they don't have Wall Street analysts following their every move. That means a savvy manager who does his homework can easily find cheap, well-run companies the rest of the market has overlooked. And just because these are small firms doesn't mean they can't have decent balance sheets and top-notch management teams. Indeed, one of the intriguing aspects of microcap investing is that the best of the bunch will be swallowed up by large competitors. When surprises like that happen to thinly covered stocks the price will pop instantly, leading to big rewards for those who got in early.

Of course, some of the details that make microcaps so interesting can also play against them. Since there is a lack of research tracking these firms, microcap managers need to put in a lot of work evaluating balance sheets, SEC filings, customer relations and future prospects. All that can be tough to gauge because microcap companies can be one-hit wonders whose stock prices hinge on a single product. If, for some reason, that product loses popularity or is bettered by a competitor, then the microcap company could find itself in serious jeopardy. Trading in these stocks can be a roller-coaster ride, too, especially the lower down the market-cap spectrum you go where liquidity can be a problem. (Most good microcap funds won't delve into the smallest of the small fry that trade on unregulated exchanges since they're open to manipulation.) Finally, an acquisition can be a great way for a manager to exit a position. But then he has to find another good stock to replace it.

"They just aren't right for us," says Vincent Barbera, director of financial planning at TGS Financial Advisors in Radnor, Pa.

In the end, the decision to invest in one of these funds will probably come down to the age and risk tolerance of the investor. Older investors would do well to avoid this sector altogether in favor of safer bets. If you invest in an index fund like Vanguard Total Stock Market you will have all the small and microcap exposure you'll need since that fund has just over 8% of its portfolio in that space. Younger investors who can stomach some wild rides and have plenty of time to make up for mistakes should feel more comfortable with a small position in microcaps, say 5% of their portfolios.

"If you have 10 or 20 or 30 years, [microcaps] may produce dividends over the long run," says Shah.

If you jump into this space you can't do much better than investing with Royce Micro-Cap. The managers of this fund help dampen volatility by investing in 184 companies, one of the largest portfolios in this category. And they rarely make big bets on a single company. Indeed, the fund's top holdings usually hover around a 1% weighting each. The managers favor solid balance sheets and a stock price that is trading at a discount. They also tend to take a long-term view, so turnover is a decent 49%, according to Morningstar. Top holdings include Olympic Steel,

Bruker

Exponent

Patriot Transportation

Perritt MicroCap Opportunities, our other finalist, is another example of a fund that has been investing in this space for a long time (since 1988). This fund starts with a universe of 3,000 companies that have market capitalizations between $30 million and $750 million. The stocks also have twice the growth rate of the U.S. economy. It, too, holds a wide array of companies 175 at last count and it's cheap at $127 in annual fees for every $10,000 invested. Shareholders have been rewarded: The fund has returned an average annual 10.3% over the previous 10 years, according to Morningstar. Top holdings include Universal Electronics, the company that makes wireless remote controls for home entertainment centers, Apogee Enterprises, a manufacturer of architectural glass, and software firm Aladdin Knowledge Systems.

The Criteria

We started with funds whose portfolios had median market capitalizations less than $500 million. The funds had to be open to new money, charge less than 1.5% in annual expenses and require a minimum investment under $5,000. The funds also had to have performance track records during the trailing three- and five-year time periods that put them in the top 40% of their Lipper peer group. That left us with just two candidates.

Source: Lipper

Note: Data as of April 18, 2008.

Microcaps Screen Recipe