FUND Q+A: Dedio says micro caps are worth the ride

NEW YORK, April 8 (Reuters) - As the U.S. economy recovers, calls for a shift into larger-capitalization stocks have grown louder, but Sam Dedio of the Artio U.S. Microcap Fund sees great rewards with tiny companies.

Microcap stocks are more volatile, but they've also outperformed their larger brethren over a long period. The Center for Research in Security Prices in Chicago shows micro caps have managed a 12.3 percent annualized return from 1926 through February 2011, Dedio notes.

By comparison, small caps have produced an annualized return of 11.5 percent, mid caps 11.1 percent, and large caps 9.4 percent over the same period.

Dedio says investing in solid companies will still lead to outperformance as the economy gains strength. As of Feb. 28, the Artio U.S. Microcap fund is up 4.7 percent after a 34.5 percent gain in 2010. Q: The historical performance shows micro caps have outperformed larger names over the past 80 years or so -- does that make them better investments? A: The rub is there is more volatility with the smaller caps -- so you get about 200 basis points more of annualized outperformance -- but can you handle the bumpy ride? That's what it comes down to. When you look at micro cap, if you go one step further and take the tiniest subset of companies you get an extra 70-80 basis points a year for going out on the risk plank. So, for people that are long-only investors, when the market is more positive, there is more interest and more money flow coming into the space, micro caps and small caps are more sensitive to that. After what has happened in the last couple of years, with the big move to bonds and asset allocation being so skewed toward fixed income, when you have a situation like this where the equity market comes back, it doesn't take a lot to move these smaller, illiquid companies, especially some of them that are micro cap. Q: With some of these smaller names, a lot of their businesses lack the broad spectrum of larger ones. With micro caps, don't most have binary business models -- one product and that's it? A: In some cases, that's for sure. We try to find companies that have products or services that change the behavior of the spender -- consumer spender or the business spender. For a lot of these micro cap companies, they are really just inputs into finished goods that a bigger company makes. So they might just be a part that is overall a larger piece of machinery, or a niche market. When you look at some of our tech companies, they are inputs into other systems. We talk about a company like Advanced Energy Industries Inc (AEIS.O). The legacy of that company is really providing power supply management to bigger companies' products -- like Applied Materials Inc (AMAT.O). Q: Advanced Energy is your heaviest position -- has that been your best over the past year? A: Advanced Energy has done well since we bought it. For micro cap year-to-date New York and Co (NWY.N) has done well for us. That is a specialty retailer that is kind of reformatting their stores and refreshing their offerings. Management focus has been a little bit more intense and it's starting to pay off there. Some energy stocks have done well, that is no surprise. Energy services companies like Union Drilling (UDRL.O) and Gulfport Energy (GPOR.O). Q: What was your worst investment? A: We bought this company called Zagg Inc (ZAGG.O), they make the smart phone and (computer) accessories. They are a big play in growth on Apple iPads. We think that it's still misunderstood. It's a controversial micro cap, very volatile stock. In this product set you have to take some risk on for stories that are misunderstood -- that is why they are so volatile. Either they are misunderstood and people are surprised at the upside or they are misunderstood and they flame out or fizzle out. That is micro cap investing. Q:Do you use the Russell Microcap Index .RUMIC as a benchmark? Do you have a target for it? A:My target is that if you are willing to tolerate the risk, it should outperform the large-cap indices. There is no reason why they can't. The proposition we offer is that we are stock pickers and hopefully we can outperform our benchmark and deliver some alpha. That way, even if the asset class underperforms relative to other asset classes, you get a little pickup from stock selection over a market cycle. You decide if you want the asset allocation, everybody should have a little bit, and be willing to hold it when it goes down a lot. Then when you have the downturn like we had, it's probably time to add more to it. But it takes courage to hang on when you are down 35, 40 percent and step up to buy more. That is how stock markets work and as a student of the market I can't tell you it's been any different this time than it has been other times. (Reporting by Chuck Mikolajczak; Editing by Leslie Adler)