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Small cap managers under pressure Investor pull out increases redemption-induced selling

NEW YORK (CBS.MW) -- Investors have been pulling out of underperforming small cap stocks in big numbers over the past two months, adding to the pressure on small cap fund managers who are going to be forced to sell to meet redemptions.

The result of that kind of pressure on the fund managers could in turn knock share prices of companies with market capitalizations under $1 billion lower still.

Trading at a 21 percent discount to the S&P 500 stocks, small cap stocks are now cheaper than they have been in 40 years, according to Salomon Smith Barney research.

Redemptions - when investors sell their fund shares - have been bigger-than-usual for about two months, a trend that Keith Mullins, Salomon Smith Barney's emerging growth stock strategist, on Thursday called "unprecedented and quite concerning."

An estimated net $1.91 billion flowed out of small cap funds in January, with the gap widening to an estimated net $3.49 billion of outflow in February, according to Lipper Inc., a mutual fund industry tracker.

"It's not one week, but a lot of weeks and it's not a little money, but a lot of money," Mullins said. "I'm sure some (portfolio managers) are having to sell stocks to meet (redemptions), but no one has admitted it."

Mullins doesn't think the small cap stocks are down solely because of cornered fund managers, but says the scenario is a threat.

"It's not a zero-sum game. There are other investors who will take advantage of this, and my sense is that this is not going to develop into a full-throttled vicious cycle, but it could," Mullins said. He suspects the small caps are nearing a bottom.

According to AMG Data Services, cash outflows from small cap stock mutual funds, or emerging growth stocks totaled $160 million the week ending March 17. An estimated $2.6 billion cash flowed out of the funds in the week ending Feb. 3. It's the worst showing since at least 1992, Salomon Smith Barney research shows.

Meanwhile, overall flow to the equity mutual funds has been largely positive for most of this year. Charles Biderman, president of Trim Tabs, a mutual fund researcher, thinks the growing amount of money into stock funds in general is also making investments in small caps more difficult.

"As the funds have gotten bigger, they can't buy small caps. That leaves only the small cap funds to buy them," he said.

Emerging growth fund managers like Tom Press wonder if some of the volatility in small caps is due to the growing number of redemptions. Press co-manages the Strong U.S. Emerging Growth Fund with $9 million in assets via his Next Century Growth firm.

"Net outflows are definitely taking place (in the industry). We've seen money go out at a fairly high rate over the last two months, and if that continues, it will definitely be a negative," said Press.

"We're seeing compaies where minor disruptions are causing big impacts on the stocks on the downside," he said.

When Cambridge Technology Partners (CATP) warned of a profits shortfall on March 19, shares of two small-cap technology consulting companies Press watches dropped over 10 percent each.

"We added to both companies. We're trying to take advantage of the volatility," Press said. His fund, which he sub-manages for Strong Funds, has posted 5.5 percent growth since its Jan. 4 launch, boosted by gains in CNet (CNET) and GeoTel (GEOC).

Written By Emily Church, CBS MarketWatch