Fund in Focus: Touchstone Micro-Cap Growth Fund

In conjunction with the bottom-up stock selection process, the managers use a macroeconomic overlay to identify certain industries to avoid. For example, Shipman cited, when New York Attorney General Eliott Spitzer uncovered problems at Marsh & McLennan (MMC) and went after the insurance industry, the fund unloaded its small-cap insurance holdings. "Changes in the regulatory, legal or political climates can often hurt smaller-cap stocks," Shipman said.

Bjurman, Barry is quick to sell a stock that it sours on; the fund had a 101% turnover rate in its first year of operation. A stock will be unloaded when its market-cap reaches $1.5 billion, no matter how good it is doing. (The fund currently has an average market cap of $272 million). Shipman said the firm will dispose a company if it posts a disappointing earnings report, if its price falls 15% from its recent peak, or if it becomes overvalued relative to future growth prospects.

The fund recently sold off CryptoLogic Inc. (CRYP), which is involved in software security for Internet gaming. "It's a 30%-35% annual earnings grower, but in August the company announced that it would miss its profit targets by a substantial margin," Shipman said. "We sold it at prices ranging from $20 – $17. It has since dropped to about $16." Shipman explained that when a micro-cap company posts an earnings warning, "it's usually time to get out."

While the introduction of Russell Investment's new Microcap Index is a welcome development, the fund will likely not use it as its benchmark until it has a longer history. Ironically, as investors become more aware of micro-caps, the sector may lose some of the inefficiency that makes it appealing.

However, Shipman, whose fund currently uses the Russell 2000 Growth Index as a benchmark, noted that the new Russell Microcap Index is not a close match to the stocks in his portfolio. "The Microcap Index took the 1,000 smallest companies of the Russell 2000 Index, and next smallest 1000 stocks by market cap," he said. "Consequently, about 46% of companies in that index are between $300 million and $500 million in market-cap. So, there's still a lot of opportunity for the companies we are mandated to buy, that is those with market caps below $300 million."

For comparison, the Russell 2000 Growth Index rose 18.0% for the one-year period ended September 30, versus a 17.0% gain for the Russell Microcap Index.

"Micro-caps are a barometer for risk-taking among U.S. investors," he said. "The smaller entrepreneurial companies tend to flourish when tax rates are low, thereby encouraging risk-taking. We have seen historic low taxes on capital gains, and if we get an extension on these low rates, that would be even better for small- and mid-cap stocks."

However, Shipman cautioned that the Fed's policy on credit tightening may hurt smaller companies. Shipman added that the most favorable environment for micro-caps lies with the "stability of purchasing power, as represented by stable commodity prices, which we don't have now. If we get signs of inflation, or even deflation, that will result in a bad environment for micro-caps."

Contact Bob Keane with questions or comments at: [email protected].