Anatomy of the Small-Cap Anomaly

Anatomy of the Small-Cap Anomaly

Mapping valuation differences potentially responsible for the

small cap anomaly in developed European and Asian stock

markets.

Marcel Houtzager CFA, Peter Zaldivar CFA, Aditya Eachempati,

Vipul Badjatya, and Nikhil Rastogi

May 2010

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Special Thanks to Rodrigo Garcia-Uribe

ANATOMY OF THE SMALL-CAP ANOMALY Copyright 2010 by Kabouter Management LLC. All rights reserved. Printed in

the United States of America. No part of this document may be used or reproduced in any manner whatsoever

without written permission except in the case of brief quotations embodied in critical articles and reviews. For

information address Kabouter Management LLC, 1 East Wacker Drive, Suite 2505, Chicago, IL 60601

Table of Contents

Executive Summary ......................................................................................................................... 2

Introduction .................................................................................................................................... 2

Summary of Prior Research ............................................................................................................ 3

Methodology ................................................................................................................................... 5

Results ............................................................................................................................................. 6

Possible causes of observed valuation anomalies ........................................................................ 10

Further Research ........................................................................................................................... 11

Executive Summary

A large body of research exists on the question of market efficiency and the Capital Asset

Pricing Model ("CAPM"). Numerous apparent exceptions to the CAPM have been observed,

with the risk adjusted outperformance of small-cap stocks over large-cap stocks being the most

commonly cited anomaly. The bulk of the research to date on this topic has found excess

returns for stocks below a certain size threshold. In this paper, the authors analyze valuations

in a number of developed markets in Europe and Asia across the market cap spectrum. While

CAPM would lead one to expect a gradual decline in valuations as one looks at smaller and

smaller stocks, the research in this paper shows that valuations do not correlate with company

size in a smooth fashion and that there is a kink point below which companies become

cheaper faster than the CAPM would predict. The authors posit that the valuation anomaly

described by these kink points could help explain the existence of the small-cap performance

anomaly, and that the institutional behavior that probably creates these kink points is difficult

to change, which could help explain why the small cap anomaly has persisted, despite ample

information on the topic.

Introduction

During our 19 years as active managers investing in developed international stock markets

(world ex-US), we have observed, along with many of our competitors, that smaller companies

often appear to be undervalued relative to their larger brethren, even on a risk-adjusted basis.

We have also observed that as such smaller companies grow, either organically, or by

acquisition, the undervaluation often disappears. This often results in strong investment

performance, as the companies share prices appreciate at the combined rate of their earnings

per share growth and the growth in their earnings multiples.

Based on these observations, our hypotheses are 1) that institutional investors ignore stocks

below a certain size and liquidity threshold, thereby creating a systematic valuation anomaly

(and opportunities for patient managers willing to invest the time and energy required to invest

in smaller companies), and 2) that this valuation anomaly, and its eventual correction as

companies grow out of it, may help explain the well documented small-cap performance

anomaly to the CAPM. By investigating and describing key aspects of the valuation anomaly,

we therefore hope to contribute to an improved understanding of the small-cap performance

anomaly, and to lay the groundwork for further efforts to understand the linkage between the

two.

Anatomy of the Small-cap Anomaly

Page | 3

Summary of Prior Research

Prior research on topics relating to the small-cap effect show a number of interesting findings,

specifically:

1. The smallest stocks outperformed the largest stocks in developed markets;

2. Less liquid stocks outperformed more liquid stocks, and this effect is likely separate from the size effect;

3. Stocks with less analyst coverage reacted more slowly to news, particularly bad news, than stocks with more coverage, indicating a less efficient market for those stocks; and

4. Institutional investors have shown a preference for larger, more liquid stocks -- possibly to maximize exposure to their best ideas, as well as to realize the benefits of scale. This preference is acknowledged by a staunch defender of the efficient market theory.

Therefore, there is evidence not only that smaller, less liquid, less followed stocks outperform

larger, more liquid, more followed stocks, but that this might be caused by institutional investor

behavior.

Bauman, Conover and Mitchell showed in their 1998 study of stocks in Europe, Australia and

Far East ("EAFE") developed markets that stocks in their lowest market capitalization quartile,

averaging $46.6 million, far outperformed stocks in the highest market capitalization quartile,

averaging $2.5 billion by 22.0% to 10.8% between 1986 and 1996.1 The difference was most

pronounced for the quartile of smallest stocks, with the quartile of the second smallest stocks

returned 13.6% and the quartile of second largest stocks returned 11.1%. Fama and French

found similar results in their study of US stocks between 1963 and 2005, with the smallest

stocks again experiencing the most anomalous higher returns.2 Earlier studies in the 1980s and

1990s had similar findings.

Keene and Peterson found evidence that liquidity has had an impact on portfolio returns,

separate from company size and valuation.3 They analyzed 54 US stock portfolios between July

1963 and December 2002, and found that both size and liquidity had an impact on returns.

They also concluded that the two factors likely had independent impacts.

1 W. Scott Bauman, C. Mitchell Conover and Robert E. Miller, "Growth versus Value and Large-Cap versus Small-

Cap stocks in International Markets", Financial Analysts Journal, Vol. 54, No. 2 (Mar - Apr., 1998), pp. 75-89

2 Eugene F. Fama and Kenneth R. French, "Dissecting Anomalies", The Journal of Finance, Vol. LXIII, No. 4 (August

2008), pp. 1653-1678

3 Marvin A. Keene and David R. Peterson, "The Importance of Liquidity as a Factor in Asset Pricing", The Journal of

Financial Research, Vol. XXX, No. 1 (Spring 2007), pp. 91-109


Page | 4

Hong, Lim and Stein also found a relationship between analyst coverage and market efficiency,

particularly for smaller-cap stocks.4 They found a 60% greater benefit to momentum investing

from smaller stocks in the tertile with the least coverage compared to stocks of basically the

same size in the tertile with the most coverage, using a universe of US stocks between 1976 and

1996. Specifically they found that prices for stocks with lesser coverage did not react as quickly

to bad news as did those with more coverage, while the reaction times for good news was

more similar. They hypothesized that companies with little analyst following, and investment

managers who owned their shares, made efforts to publicize good news, while they had little

incentive to spread bad news for those companies.

Barberis and Thaler hypothesize that anomalous pricing of smaller cap stocks may be the result

of the paucity of arbitrage opportunities in this universe caused by larger trading costs and

lower liquidity.5

Pollet and Wilson found evidence that as mutual funds grow, their managers tend to add to

existing positions, and only seek new investment ideas in order to address liquidity constraints.6

They hypothesize that there may be two reasons for this behavior:

1. Managers prefer to maximize exposure to their best ideas; and

2. Managers enjoy greater returns to scale with fewer positions.

Malkiel questioned the validity of the small-cap effect, positing that the results were skewed by

survivorship bias.7 But, he also pointed out that

"From the mid-1980s through the decade of the 1990s, there has been no gain from

holding smaller stocks. Indeed in most markets, larger capitalization stocks

produced larger rates of return. It may be that the growing institutionalization of

the market led portfolio managers to prefer larger companies with more liquidity to

smaller companies where it would be difficult to liquidate significant blocks of stock."

4 Harrison Hong, Terrence Lim and Jeffrey C. Stein, "Bad News Travels Slowly: Size, Analyst Coverage and the

Profitability of Momentum Strategies", The Journal of Finance, Vol. LV, No. 1 (February 2000), pp. 265-195

5 Nicholas Barberis and Richard Thaler, "A Survey of Behavioral Finance", Handbook of the Economics of Finance,

edited by George Constantinides, Milt Harris and Rene Stulz (2002)

6 Joshua M. Pollet and Mungo Wilson, "How Does Size Affect Mutual Fund Behavior"?, The Journal of Finance, Vol.

LXIII, No. 6 (December 2008), pp. 2941-2968

7 Burton G. Malkiel, "The Efficient Market Hypothesis and its Critics", The Journal of Economic Perspectives, Vol. 17,

No. 1 (Winter 2003), pp. 59-82


Page | 5

Therefore although Malkiel questioned the existence of the small-cap effect, he does seem to

believe in the institutionalized preference for larger-cap stocks. He also seems to believe that

this preference is more relevant than in past years.

Therefore the research seems to indicate some evidence that smaller, less liquid stocks are less

desirable to large institutional fund managers, and that this may have an impact on their

valuations and their returns.

Methodology

In our November 2009 study, we analyzed stock valuations across the market cap spectrum in

seven regions in Europe and Asia where the Kabouter Fund LLC ("the Fund") is active:

Scandinavia -- Sweden, Denmark, Finland, Norway and Iceland

Western Europe -- France, Belgium, Netherlands, Luxembourg and Ireland

Central Europe -- Germany, Austria and Switzerland

Southern Europe -- Portugal, Italy, Greece and Spain

United Kingdom

Japan

Asia Ex-Japan -- Hong Kong, Singapore, Australia and New Zealand

We first graphed valuations against market capitalization. The CAPM would predict that this

relationship should be relatively smooth. Smaller and smaller companies are on average, more

and more risky (at the extreme small end of the spectrum, the majority of startups fail and at

the extreme large end of the spectrum the majority of mega caps do not), and the CAPM

therefore predicts that, ceteris paribus, the relationship between size and valuation should be

smooth and upward sloping as companies get larger. Any kinks in this relationship would

therefore have to be considered anomalous.

Secondly, we tried to further analyze the valuation differences between companies of different

sizes by adjusting for the quality of those companies and the volatility of their stock prices, and

in this manner attempted to isolate the portion of the valuation anomaly that is more likely

created by institutional bias alone. To remove quality and volatility differences between

companies from the equation as much as possible, we therefore took the following four steps:

1. We compared valuation metrics (price/book, price/earnings and EV/EBITDA) across a

number of ranges of market capitalizations in each market -- Under $100 million, $100

million to $250 million, $250 million to $500 million, $500 million to $1 billion, $1 billion

to $5 billion, $5 billion to $10 billion, and above $10 billion;


Page | 6

2. We examined the differences in quality of the companies across these ranges of market

capitalizations using fundamental metrics -- return on equity, return on capital -- and

proprietary metrics: "K1", which incorporates factors including earnings per share

growth, capital structure, earnings stability and return on capital and "K2", which

considers the price volatility of stocks;

3. We examined the sensitivity of valuation metrics to differences in the quality of the

stocks using the above metrics;

4. We used the findings in the first three steps to arrive at a quality-adjusted comparison

of valuations across the ranges of market capitalizations listed above.

During our research we considered over 12,000 companies in developed markets in Europe and

Asia. For each market, the Kink Point was defined was deemed to occur where we observed a

sudden decline in the pricing level between market cap ranges.

Risk-adjusted price to book = price to book ratio K2,

where K2 a Kabouter proprietary measure of total risk in the stock, i.e. Fundamental Risk

plus Stock Price Volatility. It is calculated as:

K2, = K1/360 day standard deviation of stock price

where K1 a Kabouter proprietary measure of fundamental risk in the stock, i.e.

Fundamental Risk plus Stock Price Volatility. It is calculated as:

K1 = 20%* Correlation of basic EPS + 25%*ROC + 25%*Last 5 year EPS growth before

extraordinary income + 30%* Altman Z Score

Results

Our research consistently showed the presence of Kink Points below which valuations, as

measured by Price to Book Ratio dropped off steeply. This is illustrated in Exhibit 1 using data

from November 2009 for Kabouter's "Asia Ex-Japan Region", which includes Hong Kong,

Singapore, Australia and New Zealand.


Page | 7

Exhibit 1

Kink Points -- Asia Ex-Japan Includes Hong Kong, Singapore, Australia and New Zealand As of November 2009 (in US Dollars)

Source: Bloomberg; Kabouter Management LLC

0.39

1.04

1.23

1.55

2.43

Kink Points

Price

to

Book

0

1.0

1.5

2.5

2.0

3.0

Less than

$250 million

More than

$10 billion

$5 billion to

$10 billion

$3 billion to

$5 billion

$250 million to

$500 million

$500 million

to $1 billion

$1 billion to

$3 billion

Market Capitalization


Page | 8

We also found the valuation anomaly exists even after adjusting for company quality (see

Exhibit 2 where the quality and risk-adjusted Price-to-Book Ratio is also kinked).

Exhibit 2

Kink Points -- Asia Ex-Japan Includes Hong Kong, Singapore, Australia and New Zealand As of November 2009 (in US Dollars)


0.39

1.04

1.23

1.55

2.43

0.48

1.19 1.30

1.58

2.06

2.23 2.30

Kink Point

Price

to

Book

0

1.0

1.5

2.5

2.0

3.0

Less than

$250 million

More than

$10 billion

$5 billion to

$10 billion

$3 billion to

$5 billion

$250 million to

$500 million

$500 million

to $1 billion

$1 billion to

$3 billion


Actual Price to Book

Predicted Price to Book (Using Kabouter risk estimator)


Page | 9

We found Kink Points in most developed European and Asian stock markets in the $250 million

to $5 billion range. This may indicate that smaller-cap stocks remain systematically

underfollowed by institutional investors across markets, which we think could be an important

aspect this aspect of the anatomy of the small cap anomaly (see Exhibit 3).

Exhibit 3

Kink Points by Region As of November 2009 (in US Dollars)

Region Countries Number of Companies

Kink Point

Price to Book below this point drops more steeply:

Scandinavia Sweden, Denmark, Finland, Norway, Iceland

1,050 $500 million

Western Europe France, Belgium, Netherlands, Luxembourg, Ireland

1,195 $250 million

Central Europe Germany, Austria, Switzerland

1,488 $250 million and $1 billion

Southern Europe Portugal, Italy, Greece, Spain

743 $500 million

United Kingdom UK 1,727 $1 billion

Japan Japan 2,327 $250 million

Asia Ex-Japan Hong Kong, Singapore, Australia, New Zealand

3,528 $500 million

12,058



Page | 10

The kink points for other regions are illustrated in Exhibits 4 through 9. It is interesting to note

that in certain markets, such as Scandinavia, Central Europe and the UK, there is a Kink Point at

the larger end of the spectrum, whereby Mega-cap stocks over $10 billion are actually

undervalued relative to Large-cap stocks in the $5 billion to $10 billion range.

Possible causes of observed valuation anomalies

In our regular discussions with portfolio managers, buy side analysts, sell side analysts, brokers,

and clients we have often found the following phenomena:

1. Managers wish their funds to be scalable to at least $2 billion - $5 billion, in order to

meet their personal earnings objectives, given the typically high opportunity cost of

their time;

2. They wish their funds to be relatively concentrated so that each stock has a meaningful

impact on fund returns. This means that they typically wish to have no more than 50-

100 stocks in their portfolios. In a 100 stock portfolio, each stock accounts for an

average of 1% of the fund's returns;

3. Therefore, many managers limit themselves to investing in stocks in which they can

potentially invest at least $30 million - $50 million;

4. Most managers do not wish to take more than a 5%-7% stake in companies in which

they invest, since larger positions would be difficult to trade in and out of and hence

illiquid. As a result, they are limited to considering stocks with a minimum market cap

of $250 million to $1 billion -- the range in which Kink Points are frequently found;

5. Brokers and sell-side analysts, correctly gauging their large clients' lesser interest in

smaller stocks, give them far less coverage. Our research shows that non-US small-cap

stocks in developed markets are covered by an average of two analysts, compared to 11

analysts for Mid-Cap stocks and 25 analysts for Large-cap stocks in these same markets;

6. Smaller companies, responding to the lack of interest from large fund managers and

brokers, invest less in investor relations efforts, and furthermore tailor these efforts to

local investors and those personally familiar with their company;

7. Of the more than 20,000 stocks in developed non-US markets, only a small minority are

large-cap stocks. Consequently, an intrepid investor wishing to analyze non-US smaller-

cap stocks must navigate an enormous, foggy sea of tens of thousands of stocks, little


Page | 11

sell-side coverage, and companies unaccustomed to dealing with overseas investors, or

even to speaking any language other than their own.

While the specific numbers described here vary somewhat from market to market, we have

observed this dynamic across all developed world markets.

Further Research

It would be interesting to see how the data changes over time. Also, it might be productive to

find ways to document how smaller companies are "re-rated" as they move up to mid-cap and

large-cap status such that re-rating theory can be shown to be responsible for a meaningful

portion of the small-cap performance anomaly. One way to examine this might be to follow

those mid-cap and large-cap stocks that were publicly traded when their size was below the

Kink Point in their region, and examine whether they were re-rated as they grew.

Another possible topic for further research might be to examine the causes for the Kink Point at

the larger end of the scale, whereby mega-cap stocks are undervalued relative to large-cap

stocks in certain markets. We believe these Kink Points may also be caused by institutional

behavior, specifically by the behavior of hedge fund and other active managers who find that

their clients are somewhat reluctant to pay more than index fund fees for strategies that use

mega caps. Tracking the correlation between the emergence of the mega-cap discount in these

markets and the hedge fund boom might be interesting.

Finally, this paper dealt with specific developed markets in Europe and Asia. It might be

interesting to repeat the study in the USA, Canada and even in emerging and frontier markets.


Page | 12

Exhibit 4

Kink Points -- Scandinavia Includes Sweden, Denmark, Finland, Norway and Iceland As of November 2009 (in US Dollars)


0.85

1.35 1.391.30

2.24

1.73

1.61

0.74

1.23 1.16

1.33

1.92

1.39

1.61

$250 million to

$500 million

Less than

$250 million

$500 million

to $1 billion

$1 billion to

$3 billion

$3 billion to

$5 billion

$5 billion to

$10 billion

More than

$10 billion


Price

to

Book

2.5

2.0

1.5

1.0

0.5

0

Kink Points




Page | 13

Exhibit 6

Kink Points -- Western Europe Includes France, Belgium, Netherlands, Ireland and Luxembourg As of November 2009 (in US Dollars)


0.61

0.93

1.401.34 1.32

1.36

1.09

0.51

0.95

1.29

1.08 1.06

1.34

1.09

$250 million to

$500 million

Less than

$250 million

$500 million

to $1 billion

$1 billion to

$3 billion

$3 billion to

$5 billion

$5 billion to

$10 billion

More than

$10 billion Market Capitalization

Price

to

Book

2.0

1.5

1.0

0.5

0

Kink Point




Page | 14

Exhibit 7

Kink Points -- Central Europe Includes Germany, Austria and Switzerland As of November 2009 (in US Dollars)


0.35

1.26 1.23

1.45

1.92

0.41

1.27

0.28

0.91

1.111.20

1.67

0.30

1.27

$250 million to

$500 million

Less than

$250 million

$500 million

to $1 billion

$1 billion to

$3 billion

$3 billion to

$5 billion

$5 billion to

$10 billion

More than

$10 billion


Price

to

Book

2.2

1.7

1.2

0.7

0.2

0

Kink Point




Page | 15

Exhibit 8

Kink Points -- Southern Europe Includes Portugal, Italy, Spain and Greece As of November 2009 (in US Dollars)


0.28

0.52

0.88

0.74

1.40

1.22

1.41

0.22

0.44

0.76

0.57

1.14

1.01

1.41

$250 million to

$500 million

Less than

$250 million

$500 million

to $1 billion

$1 billion to

$3 billion

$3 billion to

$5 billion

$5 billion to

$10 billion

More than

$10 billion Market Capitalization

Price

to

Book

1.5

1.2

0.9

0.6

0.3

0

Kink Points




Page | 16

Exhibit 9

Kink Points -- United Kingdom As of November 2009 (in US Dollars)


0.38

0.94

1.36

1.88

2.08

2.21

2.04

0.49

0.90

1.07

1.50

1.76

1.56

2.04

0.0

0.5

1.0

1.5

2.0

2.5

$250 million to

$500 million

Less than

$250 million

$500 million

to $1 billion

$1 billion to

$3 billion

$3 billion to

$5 billion

$5 billion to

$10 billion

More than

$10 billion

Price

to

Book

2.5

2.0

1.5

1.0

0.5

0

Kink Point




Page | 17

Exhibit 10

Kink Points -- Japan As of November 2009 (in US Dollars)


0.15

0.30

0.49

0.28

0.32

0.23

0.41

0.27

0.38

0.48

0.29

0.28

0.20

0.41

$250 million to

$500 million

Less than

$250 million

$500 million

to $1 billion

$1 billion to

$3 billion

$3 billion to

$5 billion

$5 billion to

$10 billion

More than

$10 billion


Price

to

Book

0.6

0.5

0.4

0.3

0.2

0

Kink Points




Page | 18

About Kabouter Management LLC

Kabouter Management LLC was founded in 2003 by Marcel Houtzager and Peter Zaldivar.

Kabouter invests in a portfolio of under-researched non-US micro to mid-cap equities with a

prospect for growth and eventual institutional discovery. Kabouter companies are

characterized by low leverage, a successful operating history, a recession-resistant business

model, and a high degree of management ownership. The focus is on micro-cap companies --

which are among the least researched by major investment firms -- thereby enabling

professional investors to add value through creative and diligent research, and in some cases,

friendly advice. Messrs. Houtzager and Zaldivar previously managed non-US smaller cap

portfolios for seven years while at Wanger Asset Management. These portfolios reached over

$1 billion in assets. Kabouter's supportive and sophisticated investor base includes professional

money managers, entrepreneurs, family offices and foundations. In addition to the Kabouter

Fund LLC, the firm manages a separate account which also focuses on under-researched non-US

equities. As of 2009 year-end, Kabouter had approximately $180 million in assets under

management.

Contact:

Linda Choi

Chief Operating Officer

Kabouter Management LLC

1 East Wacker Drive, Suite 2505

Chicago, IL 60606

Tel: (1-312) 546-3091

Fax: (1-312) 546-4260

E-mail: [email protected]


Page | 19

Certain Risk Factors:

Before considering an investment in the Kabouter Fund, please read the Risk Factors of this

presentation and please review the Confidential Private Offering Memorandum of the Kabouter

Fund available from Kabouter Management, LLC, upon request.

Before investing in the Kabouter Fund, you should carefully review the Confidential Private Offering Memorandum and, to the extent you consider it appropriate, consult with your independent professional advisor in evaluating the merits and risks of acquiring an interest in the fund. Although the risks are described in further detail in the funds Confidential Private Offering Memorandum, in reviewing this presentation, you should consider the following risks:

An investment in a hedge fund is considered speculative and entails substantial risks. There can be no assurance that the investment objectives of the Kabouter Fund, including its risk management and diversification goals, will be achieved and results may vary substantially over time.

While the Kabouter Fund may be considered similar to an investment company, the fund is not required to register nor is it registered as such under the Investment Company Act of 1940 in reliance upon an exclusion available to privately offered investment companies. Accordingly, the provisions of the Investment Company Act and other securities laws, which provide certain regulatory safeguards to investors, are not applicable to the fund or to the Manager of the fund.

The Kabouter Fund is chiefly dependent on the efforts of Mr. Zaldivar and Mr. Houtzager. If Mr. Zaldivar or Mr. Houtzager become unavailable to the Manager, the Manager may lose its ability to sustain the funds operations.

Interests in the Kabouter Fund are subject to restrictions on transferability and resale and may not be transferred or resold to another person except under limited circumstances. Also, unlike a mutual fund, an interest in the fund cannot be redeemed on a daily basis but is subject to lock-up periods and substantial illiquidity. Access to capital is prohibited for one year after each investment and subject to a 4% redemption fee until the second anniversary of each investment, and thereafter capital may be withdrawn only upon 60 days written notice at the end of each quarter. Investors should be aware that they will be required to bear the financial risks of an investment in the fund for an indefinite period of time.

The Kabouter Fund may employ investment techniques such as margin transactions, short sales, option transactions and forward and futures contracts, which practices can, in certain circumstances, maximize an adverse impact to the funds portfolio.


Page | 20

The Kabouter Funds portfolio is sensitive to global market, economic, social and political conditions that could result in dramatic decreases in value.

The Kabouter Fund invests in companies that are smaller and less well-known than larger, more widely held companies. Small companies tend to be more vulnerable to adverse developments than larger companies. Small companies may have limited product lines, markets, or financial resources, or they may depend on less seasoned management. Their securities may trade infrequently and in limited volumes. As a result, the prices of these securities may fluctuate more than the prices of securities of larger, more widely traded companies. Also, there may be less publicly available information about small companies or less market interest in their securities as compared with larger companies, and it may take longer for the prices of these securities to reflect the full value of their issuers earnings potential or assets.

The Kabouter Fund invests in non-U.S. companies that involve special risks not usually associated with investing in U.S. securities. Some of these risks include expropriation and nationalization, confiscatory taxation, difficulty of repatriating funds, social, political and economic instability and adverse diplomatic developments. In addition, there may be lower quality information available about non-U.S. companies, and foreign markets may not provide the same protections available in the U.S.

The Kabouter Fund may invest in securities of companies in emerging markets that are subject to risks due to inexperience of financial intermediaries, lack of modern technology, lack of a sufficient capital base to expand operations and social and political instability.

The Kabouter Fund may invest in restricted securities as an alternative investment strategy if there exist opportunities to enhance the funds position. Restricted securities are subject to legal or other restrictions on transfer. No liquid market exists for restricted securities. The market prices, if any, for such securities tend to be more volatile, and the fund may not be able to sell them when it desires to do so or to realize what it perceives to be their fair value in the event of a sale. As a result, calculating the fair market value of the funds holdings may be difficult.

The Kabouter Fund will incur substantial brokerage and transactional costs typically greater than the costs of transacting in U.S. securities that must be overcome for the fund to generate profits.

Past performance does not guarantee future returns. The possibility for gains is accompanied by the possibility of loss.

Anatomy of the Small-Cap Anomaly

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