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[The recent merger and reorganization of two microcap funds provide an interesting window into the mechanics of a unique portfolio management process and a deeper understanding of the microcap market. While the two funds seem like a natural fit based on a decades-long history of both managers employing a similar value-based approach to investing in the same universe of stocks, their shared investment philosophy was only the beginning of an intricate process to combine the two portfolios.
To better understand this investment merger process and get an update on the microcap marketplace, we reached out to Eric Kuby, Chief Investment Officer & co-Portfolio Manager, North Star Micro Cap Fund and Michael Corbett, formerly Chief Investment Officer of the Perritt MicroCap Opportunities Fund. They explained their process of combining the two portfolios as an intensely collaborative effort that used a quantitative factor model to score all holdings, followed by qualitative discussions to understand the investment thesis behind each company.
They both strongly believe small and microcap stocks are entering a new cycle of outperformance, citing historical patterns of “serial correlation” where periods of good performance tend to continue for an extended timeframe. We also discussed several timely microcap sub-topics that we explored together, including the impact of AI on smaller companies, the potential for increased M&A activity, and macroeconomic tailwinds like interest rates and tariff pressures.]
Hortz: What are the regulatory processes involved in merging two separate mutual funds?
Kuby: We saw a great opportunity to merge two long-standing microcap mutual funds with a shared philosophy. We made the necessary regulatory filings and received the approval of the Perritt shareholders through proxy solicitation. The entire process took approximately 3 months.
Hortz: Since the merger of the two funds entailed the merger of two different shareholder bases, how does that influence or direct your investment decisions?
Corbett: The good news is that the two shareholder bases share a common objective in holding the Funds, namely an allocation to an actively managed portfolio of microcap companies that meet the classic definition of value stocks.
Hortz: How did you both practically approach this merger? What were your first few steps in the merger process?
Kuby: The process started with months of going through the portfolios and getting everything into shape. The portfolio managers and research analysts from both firms met regularly to review the holdings, one by one. Whereas there were common holdings the North Star team was already very familiar with, there were many Perritt names we were excited to learn about.
Hortz: Can you explain your quantitative factor model and how you used it?
Kuby: The small cap universe includes thousands of companies, so having a systematic way to narrow the field is extremely important. The factor model helps us do exactly that and it is a great way of focusing our attention on a smaller group of companies that warrant the research.
The model ranks companies using several metrics, with each factor assigned a weighting in the overall score. The purpose is two-fold: it helps us quickly identify undervalued companies that are demonstrating improving fundamentals, while also allowing us to monitor how the current portfolio holdings compare to the broader opportunity set.
Importantly, the model is designed to surface opportunities, not make decisions. Companies that rank highly in the quantitative analysis move into our fundamental research process, where we evaluate them through the lens of our proprietary North Star Six Characteristics investment mosaic.
Corbett: That is really the secret sauce of this business. The model helps narrow the field, but the real work is seeing beyond the numbers – What’s the story of the business, and who are the people running it?
Hortz: Can you walk us through a specific example of a stock that scored highly on your quantitative model and one that scored poorly, and detail the subsequent qualitative conversation that determined its place in the new portfolio?
Kuby: A good example is Legacy Housing (LEGH). The stock scored well in our model because the shares are inexpensive and the balance sheet is strong. The story also made sense given our thesis on the housing market. The U.S. continues to face a housing shortage, and Legacy operates in manufactured housing, which provides a more affordable solution. As mortgage rates have ticked down and housing becomes a policy focus, we believe some tailwinds could emerge for that business.
On the other hand, Motorcar Parts of America (MPAA) is a company we have owned in the past and that has screened attractively at times. But more recently, news around the business has highlighted a more challenging operating environment. It is still an interesting company, but when we stepped back and compared it to other opportunities in the portfolio, it was simply less compelling at the time. So, it moved out of the portfolio and into what we call our “Bullpen”, which is essentially our watchlist of companies we continue to follow closely and could revisit.
Hortz: What are the possible effects of interest rates and tariffs on microcap companies?
Kuby: Much of the initial “tariff tsunami” appears to be behind us. That created a period of uncertainty as companies evaluated supply chain exposure and potential cost pressures. But smaller companies often have an advantage in that they tend to be more nimble. Many smaller companies have already adjusted their supply chains, diversified sourcing, or passed through price increases where possible.
Corbett: Interest rates tend to have a more direct influence on the microcap universe. Smaller companies are often more sensitive to financing conditions because they rely more heavily on bank lending. As interest rates stabilize or begin to decline, access to capital improves, borrowing costs fall, and banks become more willing to extend credit. That can be particularly helpful for smaller businesses looking to invest in growth, manage working capital, or pursue acquisitions. When financing conditions improve and economic visibility increases, investor interest often returns to the space. We are beginning to see signs that capital is flowing back toward smaller companies.
Hortz: What do you see as the potential impact of AI on smaller microcap companies?
Corbett: While the big technology companies get most of the attention for innovations in AI, the impact of the technology reaches far and wide. Smaller microcap companies can use AI to achieve greater efficiency in logistics, marketing, and transactions. The implantation of AI will ultimately enhance margins for these companies.
Kuby: If you think back to the DotCom era, many of the long-term winners were companies that simply became better businesses because they embraced the internet. We believe AI can follow a similar path. It is also very difficult today to predict which of the hyperscalers will be the long-term winners and losers, so our focus is less on picking those outcomes and more on identifying companies that will benefit from adopting the technology.
Hortz: From an investment perspective, can you share a few examples of how you are playing AI in your combined portfolio?
Kuby: Across our combined portfolio, we have meaningful exposure to Industrials, Consumer Discretionary, and Financials. For example, in Consumer Discretionary, investments in data analytics, inventory optimization, and supply-chain efficiencies can improve margins and operating discipline. In Industrials, AI-enabled automation and predictive maintenance can drive better asset utilization and cost control, while in Financials, AI tools are increasingly improving underwriting, fraud detection, and customer analytics. Many smaller companies are nimble and can implement these tools quickly, which may allow them to compete more effectively against larger competitors.
Corbett: We have invested in companies such as Bel Fuse (BELFB) that supply products to the AI innovators, but we have recently turned our attention to more companies that will use AI in their businesses, such as EZCorp (EZPW). EZCorp is a chain of pawn shops that uses AI to implement more sophisticated pricing.
Hortz: Any other microcap companies in your portfolio that you would like to discuss which provide further examples and insights into your stock selection process?
Kuby: Acme United (ACU) is really the poster child for our investment strategy. It checks every box in our Six Characteristics framework. It is a simple business selling safety, first-aid, and cutting tools – products used every day. The company has strong brands, recurring revenue through first-aid refill kits, and extensive distribution with the major retailers.
What stands out most is the exceptional management team, led by CEO Walter Johnsen, who has a long track record of disciplined, shareholder-focused capital allocation. The company has grown steadily across multiple economic cycles while maintaining a strong balance sheet, compounding value through several successful bolt-on acquisitions, operational improvements, and consistent free cash flow. Despite this, the stock has historically traded at valuations that do not fully reflect the quality and durability of the business.
Hortz: With the potential for a small cap and microcap outperformance cycle and renewed M&A activity, what one or two key characteristics make a microcap company an attractive buyout target in the current environment?
Corbett: I have usually answered this kind of question with: “We never purchased companies with the intention of them being bought out. But high-quality companies with a niche business may ultimately be bought out.”
I would also say that today’s environment is attractive for M&A, driven by reduced regulation, favorable interest rates, and lower valuations in the microcap universe. Dr. Gerald W. Perritt used to talk about how stocks often perform in streaks of overperformance and underperformance. Small cap stocks in particular tend to exhibit serial correlation: once they begin performing well, they often continue performing well for a period of time and get the attention of potential acquirers.
Kuby: We really have not seen that kind of sustained period for small caps in quite a while. But when you look at the combination of current valuations and improving earnings growth, the space may be setting up for a very constructive period ahead.
Valuations across the small cap and microcap universe remain relatively attractive, which creates opportunities for larger companies looking to acquire growth or niche capabilities at reasonable prices. So, while we do not buy companies because we think they will be acquired, we do believe that many of the businesses we own possess characteristics that make them logical acquisition candidates over time, particularly in a market environment that is becoming more conducive to deal activity.
Hortz: How would you characterize to shareholders and financial advisors the new composition of the fund resulting from the merger? What specific portfolio statistics or risk metrics improved most significantly through this combination?
Kuby: Several portfolio metrics improved meaningfully through the combination. The portfolio’s long-term EPS growth estimate increased to 15.0% from 13.2%, while valuation measures became more attractive: price-to-sales declined substantially from 1.5x to 1.1x, EV/EBITDA improved from 11.7x to 10.0x, and forward P/E decreased from 18.8x to 14.6x. In other words, the combined portfolio reflects better value characteristics while also offering higher expected growth.
Corbett: The North Star Micro Cap Fund (NSMVX) represents the best ideas from two investment teams that have each spent decades dedicated to the small cap universe. From a structural standpoint, the combination improved diversification and lowered the expense ratio, which are both meaningful benefits for shareholders.
This article was originally published here and is republished on Wealthtender with permission.
About the Author
Bill Hortz
Founder Institute for Innovation Development
Wealthtender is a trusted, independent financial directory and educational resource governed by our strict Editorial Policy, Integrity Standards, and Terms of Use. While we receive compensation from featured professionals (a natural conflict of interest), we always operate with integrity and transparency to earn your trust. Wealthtender is not a client of these providers. ➡️ Find a Local Advisor | 🎯 Find a Specialist Advisor