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EX-FINANCE PROFESSOR GETS FAILING GRADE ON HIS SMALL-CAP FUND

For some time, Gerald W. Perritt, 47, has been widely regarded as a font of investment wisdom. Over the past three years, his two newsletters that offer low-risk stock and mutual fund recommendations to subscribers have been better-than-average performers among the 86 entries tracked by the Hulbert Financial Digest. His six well-reasoned books published since 1983 -- on subjects ranging from small-company shares to asset allocation -- have added to his reputation.

"Perritt has a unique talent for explaining difficult investment concepts to the layman," says Bob Edwards, president of the Mutual Fund Education Alliance, a not-for-profit organization in Chicago.

As a result, Perritt's name, face and opinions often appear in the financial press.

So maybe he should have left well enough alone instead of launching a mutual fund in May 1988 devoted to investing in small companies. That idea would surely find support among the 1,000 shareholders who have invested $5.6 million in the fund, Perritt Capital Growth. They have received a paltry 7 percent total return for the 19 months through November -- one-third that of the average small-capitalization stock fund tracked by Lipper Analytical Services.

Worse, for the first 11 months of 1989, Perritt's fund ranked 79th among 81 funds in its category, showing a total return of only 1.3 percent, compared with the small-cap fund average of 21.9 percent.

Such short-term results don't necessarily label the fund a loser. Still, Perritt clearly has some explaining to do, and the ex-professor of finance is eager to do it. Marshaling stacks of academic studies, he argues that the best long-term approach is to stick with very small companies. He favors issues with market capitalizations -- a firm's stock price times the number of shares outstanding -- that rank among the bottom 20 percent of companies listed on the New York Stock Exchange.

Citing generally accepted data compiled by Ibbotson Associates, an investment research firm in Chicago, Perritt notes that such small-cap stocks have posted compound annual returns of 12.3 percent since 1926, vs. only 10 percent for Standard & Poor's 500-stock index. So why has his fund stumbled? He contends he's the victim of his own purism. He buys only small-company shares, while some other so-called small-cap funds tend to "cheat," as he puts it, by loading up on bigger stocks when those issues are outperforming small stocks. He adds that his fund will easily outdistance its less rigorous competitors when small-cap stocks return to favor.

Although Perritt's defense seems to be based on an objective analysis of the facts, not everyone is buying it. "I have tremendous respect for Gerry, but it's hard to account for his performance gap," says Peter Schliemann, manager of Babson Enterprise, a competing small-company stock fund.

Some half-dozen other funds that place similar limits on the market caps of their holdings far outdistanced Perritt Capital Growth from January through November of last year. Among them: GIT Equity Special Growth, up 23.5 percent; Schliemann's Babson Enterprise, up 22.7 percent; and Over The Counter Securities, up 19.8 percent. Even the DFA U.S. 9-10 Small Company Portfolio, an index fund that buys shares of every small-cap company, beat Perritt's fund by more than 10 percentage points.

Perritt's stock picking does not rest solely on factual evidence about the performance of small-cap issues as a group. Like other fund managers, he also makes judgments about which small stocks are apt to do best in the long run -- a controversial subject among market theorists.

The best-performing small-cap stocks, Perritt believes, are those that are held by few institutional investors and that trade at price/earnings ratios below the Standard & Poor's 500 average -- recently 14.5 times earnings for the past 12 months. "It's not clear why small stocks do so well, but some studies suggest it's because of gains from undervalued stocks that are initially neglected by investors," he says. His fund holds mostly the low P/E shares of companies with sales of less than $300 million that are too small to attract much attention from institutions.

Many small-cap stocks, however, fall into the categories Perritt passes over. David N. Dreman, a New York City money manager and author of "The New Contrarian Investment Strategy" (Random House, $19.95), points out that a corporate giant with an institutional following can have a small market capitalization if its shares trade at a very low price. Thus, Dreman concludes that the impressive long-term returns of small-cap stocks are based, in large part, on turnarounds by depressed shares.

It's also possible that Perritt's value-oriented approach rules out the most promising small-company stocks: shares of rapidly expanding emerging growth firms. "Some small-cap companies should be bought for their high growth potential," says Siegel. "A low-P/E approach is going to miss those."

None of this proves that Perritt's strategy won't work in the long run. But why buy his lagging fund now in the hope that it will rebound when you can pick up another that is already reaping bigger rewards from small-cap stocks? "As an investor, you have to go by the available evidence," says Don Phillips, editor of Mutual Fund Values, which rates nearly 1,100 funds. "So far, the evidence on Perritt's fund isn't encouraging."

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