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April 1, 2013

Big Trades on Small Firms

By Tom Steinert-Threlkeld

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George Metrou was only an intern. But he found himself in the right place, at the right time.

The firm he had joined was growing. The portfolio manager, one Michael Corbett, was looking to hire. So, after graduating from DePaul University in 2005, Metrou joined Perritt Capital as an analyst.

He was the third analyst. And all three-Metrou, Matthew Brackmann and Brian Gillespie-remain in their posts today.

Perritt focuses on companies it finds that are being ignored by almost any other asset manager or research house. Its MicroCap Opportunities Strategy Fund takes stakes in companies with a market worth of no more than $500 million. Its Ultra Microcap Strategy Fund looks for companies with market worth of no more than $150 million.

Metrou and his fellow analysts are largely generalists in the hunt for little-known companies they believe can deliver the "small firm effect": where investors, over time, get higher returns from small-cap stocks than their higher-cap brethren, statistically speaking.

"We're playing at the very small end of the small cap," said Metrou. "What we're looking for, generally, are underfollowed, under-researched companies, finding things before the Street does."

Once a potential investment is identified, Metrou or one of the other analysts will meet with management teams. Quality of management is a top priority-and once it's found, maintaining a relationship with them is paramount. Initial interviews are followed up with additional calls, particularly after earnings results come in. If the teams don't respond, that becomes "a red flag and something we won't tolerate too long."

But most management teams are responsive and provide their direct lines for follow-up conversations.

Then there's the financial analysis. Each firm is put through a nine-factor test, which examines fundamental income statement and balance sheet metrics-gross margin, return on assets, profit and cash flow that exceeds profit, for starters.

With so little trading in these small firms, Metrou does not rely on algorithmic trading at all, because he is interested in block trades-trades of more than 10,000 shares and typically around 25,000 shares.

He networks with 40 or 45 brokers on a regular basis, to overcome the lack of liquidity. And a fair amount of "appointment" trades.

The brokers also act as a source of alpha, because often, Perritt is the only place where a broker can work a big trade for a small company.

Assets of the two firms' funds sat at $100 million at the start of the century, hit $700 million in 2007 and now are around $475 million.

Block trades account for 35 percent of all Perritt trading. And the firm does not rely on electronic markets that specialize in large blocks, such as the Liquidnet dark pool.

Metrou and his fellow analysts trust their network of 40 to 45 brokers across the country and rely on to send it indications of interest every day in stocks it holds positions in. And then it responds, with "voice negotiations."