Q:  What is the history of the company? A : Established in 1987, Perritt Capital Management, Inc. is an independent registered investment adviser specializing in small company investing for individual and institutional investors. The firm is based in Chicago and manages about $500 million of assets, including two no-load mutual funds and separately managed accounts. Q:  Do you prefer to invest in companies of a certain size? A : In the Micro Cap Opportunities Fund, we look at companies that have less than $500 million as capital at the time of purchase. In the Emerging Opportunities Fund, we only consider companies with market cap of $300 million and below at the time of purchase. Q:  What is the investment objective of these two funds? A : Both funds seek to capture the benefits of the ‘small company effect’ through a bottom-up, fundamental stock selection. Q:  What do you mean by the term ‘small company effect’? A : There was a research paper presented at the University of Chicago, which conducted tests using the Capital Asset Pricing Model. This test revealed that a portfolio consisting of the bottom fifth of all stocks on the NYSE in terms of market value outperformed a portfolio composed of the largest cap stocks even after adjusting for risk. These results were taken as evidence that small cap stocks yield higher returns than large cap stocks. During his academic days, our founder, Dr. Gerald Perritt, liked this strategy and these two funds have been built around the same tenets. Q:  What kind of knowledge have you gained after more than 20 years of experience in the micro cap field? A : We have found that smaller companies have historically provided higher absolute risk-adjusted returns. Additionally, we have determined that if one does his research and invests in financially strong companies that have sound fundamentals at reasonable valuations, one can enhance investment return potential over the long-term. Diversification of the portfolio also reduces company-specific downside risk. Q:  How do you translate your philosophy into an investment strategy? A : Our belief is that companies with a sustainable competitive advantage generate both superior returns and command premium multiples, which could be true with all market caps. In this fund we invest in a diversified portfolio of value and growth equity stocks that at the time of purchase have a market cap of $500 million or less. We seek such micro-cap companies that we believe have the potential for long-term capital appreciation based on superior or niche products. If the company has a superior management and/or other exceptional factors that can act as catalysts, that will serve us even better. Q:  What is your research process? A : We follow a three-step process in our research. The first step is to identify stocks that look attractive and are worth additional investigation. This is what we call the idea generation step. The second step is to conduct preliminary analysis on these companies with a thorough nine-factor process, based on balance sheet, income and cash flow statements. At that stage, for a stock to be taken up for further evaluation, it must meet at least six of the nine factors. Third, we conduct fundamental and technical analysis on these companies to determine if they meet our valuation and investment criteria. After the stocks are selected we determine the intrinsic value of each one of them and only add those to our portfolio that are priced by the market at a favorable discount. If a stock is found not attractive on the price front, we will keep the name in our file list to be tracked on an ongoing basis. Q:  Could you elaborate on each of the steps? A : When we look at the overall market we define micro-cap as the bottom 20% of the companies by market capitalization. Of this 20%, the bottom 10% generally goes to the Emerging Opportunities Fund. There could be a few overlapping names, and if a name in the Emerging Opportunities Fund does well and grows it could be selected in the MicroCap Opportunities Fund. Research is a very important part of the process in the micro-cap space. It is true that liquidity can be limited and that there are very few research firms following these companies, and that is why we do a fair amount of research internally. In addition, over the last twenty years we have developed a network of regional brokerage firms and paid-for research firms that assist us out with further ideas. Our research process starts with screening the various databases, comprising earnings releases, newswires and regulatory filings, where we like to see if any new ideas may pop up. Our interaction with about two dozen regional brokerage firms and research firms helps us generate better ideas because many micro-cap names do not usually appear in traditional databases. Even if they end up there, the data may not be reliable, so we like to do our own research and dig through the numbers ourselves. Once we get an idea, the company is put through our proprietary nine-factor evaluation process that combines a quantitative model with fundamental analysis. The nine-factor model is entirely based on items that you can obtain from the balance sheet, income statement, and the cash flow statement. For instance, some of these nine factors include gross margin expansion, positive cash flow, positive return on assets, repayment of debts through internal accruals as opposed to financed from the equity or the bond markets, market share stability and shares outstanding. All of these items indicate to us that shareholder value is enhancing. In addition to employing this process when researching prospective investment ideas, we also use it to monitor companies that are already held in the portfolio. If a company scores well on six out of the nine factors, we will continue research on this company by starting with questions to management, channel checks, as well as assessment of the valuation and the growth rate before we buy any of those names into the portfolio. As a whole, we look for companies that have a niche business or characteristics that set them apart from others and gives them a competitive advantage, such as building a franchise that will give them sustainability in the sector and will also help them move forward. Q:  How do you construct your portfolio? A : In this space one does not know how a company will perform because we do not have any past and comparable data. We feel through experience that diversification is a very good way of covering downside risk. We believe that the 80:20 ratio works quite well in this space, wherein 20% of the stocks give 80% of the returns. For us, diversification means going up to 100 -200 names in the portfolio, staying diversified by sectors, and limiting initial position sizes to 0.5% - 1.0% of portfolio assets. If you take a look at the entire spectrum of the market, you can see that growth does not reside exclusively in certain sectors. Thus, diversification by sectors and by names substantially increases the chances of the 80:20 theory most of the time. In terms of internal operations, we have a team of three analysts apart from me. They are generalists, even though they specialize in some sectors. Additionally, we also have a research analyst who helps us primarily with the 9-step process. Generally, we do not have any name with weighting above 3%, which is the threshold for cutting back the weighting in any position. The average weighting would be between 1% and 2%. Q:  Would you share some examples of portfolio holdings? A : At the time of this interview, Health Grades Inc was the largest position in our portfolios. The stock was recommended to us by an analyst from Portland, Oregon, who had been associated with that name from the beginning. The California-based company is a grading agency of hospitals and doctors. They also have an association with both Google and Yahoo to make any search for grading of hospitals and doctors easily researched on these two portals. When we did the 9-point evaluation, they passed in seven areas, so we decided to conduct additional research. When we met the CEO we learned that he was one of the founders of the company and was also a shareholder, which told us that he had the company’s interest at heart. Yet, while we were scrutinizing the company, the stock was over-priced with a P/E ratio of 40 and six to seven times revenues. The stock was trading at $6, so we put the name in our file list. Then, in 2008, the stock price dipped to as low as $2 before we acquired a substantial portion. The stock recently received a buy-out offer at $8. One of the catalysts that we were able to identify was that the impact of the ageing baby boomer population would generate the need for such a grading agency. Q:  How would you describe your sell discipline? A : There are several aspects to our sell strategy. Since we pay attention to market-cap, we have to move on when the market cap becomes too big. With that in mind, sometimes we have to give up some of our favorite companies, but we have to stick to the basics of investing in the micro-cap companies. The other aspect has to do with valuation. We sell when a company gets too expensive based on our outlook for that company for the next 2 to 3 years. If a company is trading at 1.5 or 2 times its growth rate, we need to start selling that stock or to sell it altogether. The last aspect is when companies are bought out. We have a lot of companies being acquired in this space and we wouldn’t be surprised if that rate continues based on some of the conversations we’ve had with the management teams. On the negative side, when we have the wrong interpretation or assessment of the business, we’ll have to admit our mistake. We wouldn’t sell a company if it just misses the numbers in a quarter; we tend to give them a lot of time, so there are no stop losses set. Q:  What are the specific risk characteristic of the micro-cap space and how do you control risks? A : There is, certainly, a lot of risk investing in this space, but there is a lot of compensation too. The risks are typically tied down to few general things, such as companies that have very few product lines and only a few customers and sometimes these companies do not have any marketing strategies. We try to investigate the companies and ask all the questions to make sure that they have a broad-based customer list, product line and a cogent marketing program. Sometimes they do not and we will still invest in them, but we’ll ask a great deal of questions of management to assess the risk. Despite these risks, a well-diversified portfolio allows us to be exposed to risks of only between 1% and 2% for an individual name, as opposed to the upside. We tell our clients that we invest in a space that certainly has its share of risk, but if we can get 20% to 30% of the stock selection right, then all that risk is absolutely worth taking. The one thing that we try to avoid is investing in stocks that could go to zero if something goes wrong. In order to do that, our team is constantly assessing balance sheet items to make sure that the company has assets, cash, and some intrinsic value, which will prevent it from going bankrupt. That would be a very rare event for us because we make sure that we assess the company as fairly as we can.