Is small beautiful? It might be if you are chasing growth. Micro-cap funds, holding investments in companies with market capitalizations of $500 million to $1 billion, require a steady hand and clear exit strategy to reap returns.

With relatively few companies going public this year, and an energetic mergers and acquisitions market, micro-cap funds are one way to cash in on the innovation, imagination and energy of successful small companies.

The world of microcaps is rife with assumptions.

People often assume they’re investing in American companies, which is usually true. Analysts say that almost by definition, the market for microcaps is all-American. Small companies might branch out to the rest of North America, but usually are not engaged in global trade.

But microcaps are usually not startups, says Eric Kuby, chief investment officer of North Star Investment Management Corp., based in Chicago, but stable companies that have been around for decades. Stable, established companies with steady but unsexy growth comprise the backbone of micro-cap funds.

People assume that micro-cap funds are where initial public offerings land, but that’s not usually the case. Part of the opportunity for micro-cap funds is determined by the cost of new regulations for publicly held companies, says Michael Corbett, president of Perritt Capital Management in Chicago. “The cost of being public has increased significantly in the past five years due to Sarbanes-Oxley,” he says.

Consequently, many fast-growing, small companies are deliberately delaying their IPOs until they can justify the expense, which Corbett says can be in the millions of dollars. “It’s a big percentage of your cash flow,” he says. “That’s why companies are staying private longer.” When they do go public, he says, they’ve grown out of the micro-cap category.

And, don’t confuse microcaps with penny stocks, says Christopher D. Tessin , managing partner of Acuitas Investments in Seattle. Such bargain-basement stocks are almost always excluded from indexes and funds.

Predictably unpredictable. The only thing you can count on with microcaps is that they’re unpredictable, fund managers say. Unlike big companies, which have diversified product lines and a wide array of customers, microcaps are specialty companies that don’t have much in common except for their size.

That means micro-cap fund performance is largely unrelated to overall market trends and usually does not track with indexes of larger companies, managers say.

Instead, managers of micro-cap funds track industry trends and are on the lookout for big hits that can propel a small company into the limelight — and into the sights of a potential acquirer. “The illiquidity gives you an upside,” Corbett says. “If something really good happens, the upside is enormous.” One company that’s in the right place at the right time can drive results for a micro-cap fund.

Hand-holding equals fees. Managing a basket of puppies takes time and patience, which is why the fees for micro-cap funds are usually around 1.2 percent to 1.7 percent. Kuby looks for an expense ratio of less than 1.5 percent. “Fees are going to be higher, but the performance is generally net of fees so you can compare performance for funds,” he says.

The world of microcaps involves one-on-one relationships, analysis and management. Indexing and automation don’t work well with so many specialized holdings.

“There’s no automatic pilot,” Kuby says. “There’s a gigantic universe of companies that are very, very different — every industry group, every type of company, some that are fast growing, some that aren’t.”

Lots of analysts cover each major publicly held company, but few, or none, cover each micro-cap company. Getting enough information to make intelligent decisions is a big part of the cost, Tessin says.

One way to incorporate microcaps, Tessin says: “Go passive in large cap, and actively managed with small cap.”

Micro-cap fund managers look for values in companies suffering growth pains such as:

— “Broken IPOs,” Corbett says. “There are bargains there.” He looks for companies whose IPOs “stalled at the gate, usually related to the valuation being too high when they went public. There’s excitement, euphoria and the newness of it all, and then they go public and poof.”

— Restaurant chains, which are especially vulnerable to post-IPO deflation. Corbett cites Noodles & Co. (ticker: NDLS) and Potbelly Corp. (PBPB) as concept restaurants that sparked a big appetite at first. “Then, after they reported their numbers, the market said, ‘that’s not exciting. It’s just lunch.'”

Corbett also recommends investing in a relatively small micro-cap fund because large funds “become unwieldy, eroding returns.” “The maximum capacity for a microcap would be about $500 million in a single fund,” he says. “How much capacity does the manager have to run the product?”

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Why Microcaps Are an Alternative to Investing in an IPO originally appeared on usnews.com