9 Reasons to Micro Cap

Categories Author: Jim O'Shaughnessy, Investing, Market Cap

Imagine an undiscovered market where valuations are not systematically picked apart by Wall Street analysts, where huge changes in valuation often go unnoticed, and a stock’s price is very much at odds with its true value. This isn’t a fantasy, because such a market exists today — it is the overlooked stocks with market caps between $50M and $200M, commonly known as microcap stocks. This market offers one of the largest opportunity sets for consistently generating significant excess returns that I have found in all of my research into investment strategies over the course of my career.

What’s more, the 2 opportunities mentioned above (plus 7 more listed at the end of this post) have persisted since I published the First Edition of What Works on Wall Street 20 years ago. Why? Because the small market cap of these stocks makes them impossible for virtually all professionally-managed portfolios to invest in. Many of these stocks have no analyst coverage and are ignored by both Wall Street and also the financial media.

Ask yourself these questions:

When was the last time you heard anyone on CNBC, Fox Business, or Bloomberg talking about a stock with a market cap less than $200 million?

When was the last story you read in The Wall Street Journal or Barron’s focusing on stocks with market caps less than $200 million?

In this regard, ignorance leads not to bliss, but to highly inefficient pricing. In a true microcap portfolio,1 nearly half (45%) have no analyst coverage and 75% are covered by only one or two analysts. What’s more, the lack of analyst coverage often obscures very attractive acquisition candidates. Indeed, 70 of the stocks you would find in that portfolio have since been acquired by other companies (from 2012 to present).

Here are 4 examples of what to expect when you look at some of the
strong-performing stocks that get selected:2016-12-21_01

To be sure, there are also stocks that had no analyst coverage and did poorly, but the point is clear: a lack of coverage can lead to very inefficiently-priced stocks.

Often, these stocks are even overlooked by sophisticated individual investors because they lack access to the tools and data that might help them determine which tiny stocks, out of the thousands available, are the ones that could generate great excess returns. Even with the proper tools, individual investors might lack the ability to put together a portfolio that is diversified enough to tame the higher volatility generated by these tiny stocks.

In today’s market, there are over 1,108 microcap stocks in the U.S. with market capitalizations between $50M and $200M. These stocks, in aggregate, represent less total market capitalization than Pfizer alone! They are never part of generic asset allocations because capacity is so limited. Large asset managers can’t focus on this area of the market for the same reason — it wouldn’t matter to their bottom line.

Only one ETF (iShares Micro-Cap, ticker: IWC) tracks the Russell Microcap® Index, which allows investors easy access to this part of the market. But even IWC acts more like a “small cap” ETF — with a weighted average market cap of $432M! It’s also market cap-weighted, giving the greatest weight to those stocks with the highest market capitalization and the lowest weight to the smallest stocks.

Because of the limited capacity, limited attention, and small size of these companies, the microcap market has historically proven to be the most fertile ground for active stock selection strategies. Our own strategy, live since 2006, has a 214% cumulative return through November 2016 — higher by 129% versus the Microcap benchmark over that period.

The next part of this post explores how a disciplined active stock selection strategy2 can work so well in such a neglected part of the market, and how an allocation to microcap can significantly improve the portfolio’s overall results.

Quality Matters — A Lot — in Microcap

When researching the Microcap Universe, one of the first things you notice is how many tiny stocks have absurdly poor quality. We use a pair of multi-factor composites as the primary measures to ascertain a stock’s quality: Financial Strength (looks at such things as external financing and one-year change in debt) and Earnings Quality (looks at such things as current accruals-to-assets and depreciation-to-CapEx). This chart shows how the average microcap stocks score poorly on various quality metrics:

Quality Characteristics by Universe (Averages through 12/31/15)

Start date: * 12/31/1969   ** 9/30/1971

This data reinforces our intuitive understanding of how microcap stocks (i.e., the smallest companies in the market) tend, on average, to be lower-quality and are therefore more susceptible to value traps.3 A selection process that eliminates the lowest-scoring 1/3 of the universe based on quality allows us to focus on the higher-quality stocks instead.

Valuation & Momentum Work Better in Microcaps

We also eliminate what we believe are the worst companies from the Microcap Universe, using our multi-factor composites for Value4 and Momentum.5

Our research shows that it is better to use several factors rather than just one or two when evaluating the relative attractiveness of a stock — individual factors come in and out of favor but combining them gives what we believe is the best signal.

Now that the bottom 1/3 of the universe has been eliminated, we then select from the remaining stocks by cheapest Value and highest-scoring Momentum. We do this because we have found that, historically, like our quality measures, our Value and Momentum composites work much better in the microcap space. This chart shows how the cheapest microcap stocks have exhibited much higher excess returns than our Large Stocks Universe:6

Factor Alpha — Excess Return* vs. Universe (1970‒2015)


* Universe: Large Stocks (10.5%) … Small Stocks (11.3%) … Microcap Stocks (9.3%)

From 1970 to 2015 (shown below), the inflation-adjusted $10K microcap investment in the cheapest decile of stocks by valuation grew to $6.5M — more than quadruple the real return versus the cheapest large stocks!

Growth of a $10K Investment (Inflation-adjusted, 1970‒2015)

What’s more, the spread between the cheapest and most expensive OSAM Value decile is much more extreme in microcap stocks: $10K invested in the most expensive decile of microcap stocks fell to just $118 after accounting for the effects of inflation. In other words, if you consistently invested in the most expensive microcap stocks, the inflation-adjusted value of your initial $10K portfolio is essentially worthless. In contrast, $10K invested in the most expensive OSAM Value decile of large stocks saw $10K fall to an inflation-adjusted $4,992 — still horrible but not nearly as ghastly as buying the most expensive microcap stocks. The results are not as dramatic when buying the microcap stocks with the highest price momentum — here, your $10K grows to an inflation-adjusted $2.7M versus large stocks’ $609K. Putting the two themes together leads to strong — and consistent — results.

A True Microcap Strategy

Starting with approximately 4,600 stocks, then removing the lowest-scoring stocks (by Financial Strength, Earnings Quality, Value, and Momentum) and selecting the highest-scoring stocks (by Value and Momentum), a “truly microcap” portfolio ends up with approximately 132 stocks.7 This portfolio has a weighted market cap average of $230M and a median market cap of $178M — considerably smaller than either the Russell Microcap® Index and/or many of the other “microcap” strategies available to investors — and it gets you higher-quality, cheap stocks with strong price momentum. In other words, “a Core portfolio comprising the best of Value and Momentum” is the type of microcap I recommend for investors.

Microcap’s 9 Simple Truths

To sum it up, I believe that microcap stocks — invested in a true microcap portfolio — offer one of the best opportunities for consistent, long-term excess returns for these reasons:

They are overlooked.

1. Few or no full-time analyst coverage

2. Few institutional investors

3. Limited commercial opportunities for most asset management firms, thus creating fertile ground for active management

They are undervalued & unappreciated.

4. Highest source of alpha in the U.S. equity markets

5. Significant deviations from true value

6. Ideally suited to a quantitative process

They are uniquely positioned.

7. Can be a good proxy for private equity8

8. Are positioned as excellent takeover candidates9

9. They have daily liquidity — unlike other investments with a similar return profile

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  1. Using the O’Shaughnessy Micro Cap portfolio of undervalued microcap companies with solid growth metrics as an example (see osam-microcap.com).
  2. See osam-microcap.com for more info.
  3. For example, although it makes sense for smaller companies to be more reliant on the capital markets for funding, investors should be wary of owning the most levered microcap names.
  4. The OSAM Value composite ranks a stock on five ratios, including price-to-earnings, price-to-sales, free cash flow-to-enterprise value, EBITDA-to-enterprise value, and Shareholder Yield.
  5. The OSAM Momentum composite ranks a stock on its three-, six-, and nine-month momentum, as well as its 12-month return volatility.
  6. Large Stocks Universe = stocks with greater than average market cap.
  7. As of 11/30/16.
  8. Read our paper “Microcap as an Alternative to Private Equity” (see osamlibrary.com).
  9. As noted above, 70 of the stocks in our Micro Cap portfolio have been acquired by other companies since 2012.