Many overlook the potential opportunity that micro caps provide because many do not have an effective means of investing in them. At Tarsier Capital Management our goal is to provide that opportunity. The risks associated with these small stocks have been exaggerated and too many everyday investors are missing an important source of diversification and return. In this paper, I discuss the advantages of micro cap stocks, why these advantages exist, and the risks.
A micro cap stock is generally defined as a company whose market capitalization is under $500 million. There are over 20,000 publicly traded companies and over 60% of those are micro caps. While they make up the vast majority of publicly traded companies, micro caps make up under 3% of total market value. Another way to look at it is that Apple is over 1.5 times larger than all micro cap companies put together. These small companies are often family businesses; the entire micro cap segment is over 26% owner operator controlled.
The big advantages of investing in micro cap stocks are portfolio diversification and increased returns. These stocks can reduce overall risk in a portfolio of assets. In addition, micro caps significantly outperform the broader market. From June 30, 1926 to November 30, 2013, the smallest decile of U.S. stocks returned 12.91% annually, while the largest decile returned 9.37%. In addition, a study by Acuitas Investments revealed an average alpha of almost 3% from active management of micro caps, 3 times that of large cap managers1. Alpha refers to the ability of active stock pickers to find hidden gems that outperform the market.
Micro Caps have a low correlation with the S&P 500, meaning that their prices do not move in close tandem with large cap stocks. On top of that, in a down market when most stock prices are falling, the correlation with larger stocks goes down further. The up-market correlation between 1992 and 2010 was 56%, and the down-market correlation was 34%. I have found that many small companies have a small investor base. That base does not sell off when the market goes down because they know the value of their stock. Over 26% of the stock in these companies is family owned and they are the least likely to sell off. Micro caps are not highly reliant on international markets to sell their products, which also reduces risk, especially since the dollar is and has historically been strong. Lastly, micro caps are more focused and sometimes only have a few products. They do not spend money diversifying their business and they are often less exposed to operational risk.
With rate hikes looming in 2015, an important consideration is how micro cap stocks will react. In the 12 months following the last six federal funds interest rate hikes, the Russell 2000 (small stock index) averaged a 15.6% return. I believe that as the economy improves on its own in 2015 without the help of the Fed, it will instill faith in the capital markets and investors will move into the micro cap space. As the segment gains demand, valuations will increase.
Micro Caps have returned on average over 3% more than the broader market since 1926. During that time risk has come down considerably too. Regulation, including Sarbanes Oxley, has weeded out many risky companies.
So many micro cap companies are not closely followed, which makes it easier to find hidden gems. If you are willing to spend the time looking, you can find stocks that offer impressive risk adjusted returns. It is possible to find forgotten companies that trade at a deep discount, value stocks. Another option is seeking companies that are growing quickly and have not yet been discovered, growth stocks. In addition, Micro caps have more growth potential than their larger counter parts. It is easier to compound earnings of a small business than that of a more mature business. A $20 million contract is meaningless to Amazon, for example, but could double earnings for a micro cap.
In the investing business, where knowledge is king, the micro cap space is the most inefficient and the easiest place to gain an information advantage. With thorough due diligence you can find information before other investors. It is also easier to access management of smaller companies for conversations. This access provides a significant advantage to those who use it.
It is not a well-kept secret that smaller stocks outperform larger stocks on a risk adjusted basis. It just gets harder to invest in them as you have more money. For the institutional investors, such as mutual funds and endowments, it becomes nearly impossible. In a 1999 interview with BusinessWeek, Warren Buffet was quoted speaking about the advantages of investing in small stocks. “If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”
Why These Advantages Exist
The fact that micro cap stocks outperform larger companies on a risk-adjusted basis has come to be known as The Micro Cap Effect. In addition to outperforming the broader market by over 3% on an annual basis, micro caps have outperformed large cap stocks on a 20-year rolling basis in 59 out of 69 periods. There are many factors that go into causing this effect including, Wall Street neglect by analysts and institutions, liquidity premiums, better owner manager alignment, more mergers and acquisitions, and growth opportunities.
Large institutional investors ignore micro cap stocks because they have too much capital to allocate. If a mutual fund, for instance, has $1 billion to invest, it can’t put a meaningful amount of capital to work in micro cap stocks without negatively impacting the supply and demand dynamics that determine prices. Wall Street analysts ignore micro caps because their largest clients, institutions, ignore them. These large institutions control over two-thirds of the money. The job of Wall Street analysts is to put out research that will drive trading activity at their bank. When the banks execute a trade, they take a commission. This commission comes in the price they charge to execute the trade and the difference in the bid and ask price of the stock. There is a lot more commission to be had on a large cap stock that trades millions of shares a day than a micro cap that trades thousands. Since banks lack a financial incentive to do the work, interested investors must read the SEC filings because Wall Street does not publish many reports. Over 40% of micro cap stocks are not covered at all. The absence of attention distorts risk verse return characteristics. In a study titled, “ The Neglected And Small Firm Effects” Professors Arbel and Strebel proved that the lower the concentration of analyst coverage, the higher the returns2.
Micro cap stocks are not as liquid as their larger counterparts. They do not trade as many shares per day. A study by Roger Ibbotson, indicated that an average annual return premium of 5.34% exists for the least liquid stocks3. That is the difference between the least liquid and most liquid stocks between 1972 and 2011. What this means is that it may take a week instead of one trade to buy in or sell out of a position, depending on the size. This lack of liquidity is a major concern for larger players. It keeps institutions out and keeps prices down.
Having management and shareholder interests aligned is key to strong performance. As mentioned before in the micro cap space management owns more than 26% of their companies. Management acts in shareholders’ best interests because they are major shareholders themselves and want the stock price to increase as much or more than outside investors do. Having this extra incentive is what ensures that management is doing everything they can to protect and grow your investment. In contrast, small cap stocks between $500 million and $3 billion in market capitalization, have less than 16% insider ownership and large caps, over $10 billion, have less than 7%.
Largely due to their small size, micro caps have a high potential for rapid growth and a larger chance of being acquired. Over 50% of mergers and acquisitions occurred at the micro cap level between 1993 and 2013. Another reason for this is that many micro caps are pure-play companies, which are easier to purchase and integrate. Generally companies are acquired at a significant premium to their stock price.
I also believe that exaggerated risks deter many individual investors from the smallest stocks. When combined with the neglect from institutions, the lack of demand creates lower valuations for micro caps and hence higher returns. If earnings are constant and you pay less, then your return increases, since return = earnings/price.
A Chicago PhD student, Rolf Banz, first noted The Micro Cap Effect in 19784. Others followed with further studies. Then came the emergence of institutions seeking to capitalize on these findings. Mutual funds formed that were focused on micro caps but as the funds grew assets under management so grew the companies that these funds invested in. Many micro funds now hold companies as large as $2 billion or more. Not many true micro cap mutual funds exist and those that do mostly invest in the most liquid stocks, which Ibbotson proved have the worst returns. The main problem that I have with exchange traded funds (ETF) in the micro cap space is that they invest too broadly. ETFs seek to mirror the return of an entire index of stocks. The problem is that only 15% of the U.S micro cap stocks are even profitable. I prefer to invest in the profitable 15% as opposed to the increased risk of pre-revenue or struggling businesses. Private investments in public equities or PIPE deals offer enough liquidity for institutions to invest in micro caps. Larger players often partake in these deals, but again they are generally focused on unprofitable businesses that need money.
When contemplating an investment it is always recommended to thoroughly study the risks in addition to the advantages. I believe that most investors would find the risks associated with micro caps to be much more palatable than expected. Common risks associated with this segment include volatility, illiquidity, and fraud.
While still significant, volatility in the segment has come down over time. Micro cap stocks have the same standard deviation of returns as small caps. Many investors have exposure to small cap stocks, which have lower returns. Price swings can also be mitigated. The most liquid micro caps are the stocks held by institutions. These stocks are the first to get sold off when concern about the market rises. Portfolio managers get rid of the micro caps that they own, creating a down swing in price. These are also the stocks that can get pumped up the most. My advice for micro cap investors who are trying to avoid volatility is to avoid the most liquid stocks. It is the least liquid stocks that perform the best over time and that and hold their value in a down market.
Illiquidity is a blessing and a curse. It keeps the big players out and it protects the existence of The Micro Cap Effect, but it can also make entering and exiting a position difficult. If you have a significant amount invested and want to pull your money out quickly, it will likely negatively impact the price. Those who are patient and who do not mind sometimes waiting a week to make an orderly exit are rewarded generously for the lack of liquidity. The greatest risk is that in a recession bid ask spreads can widen dramatically and stocks can go days without trading.
Because the micro cap space is less regulated you have to be mindful of pump-and-dumps and companies with no business model. These stocks can largely be avoided by investing in only profitable businesses. If you do thorough due diligence avoiding these companies should not be a problem. If the company does not communicate with investors then it is a red flag.
The last risk is more distant. The size of the micro cap space is contracting. There is not enough incentive for good small companies to go public. Larger companies acquire some micro caps and others grow into small caps, but they are not being replaced by new initial public offerings. This trend could begin to diminish the returns of micro caps over time.
Investments must be balanced with risk tolerances, but everyone’s portfolio would benefit from having a concentration of some of the least liquid stocks. That being said it is too much risk for many to tolerate to have all their assets in micro cap stocks. Everyday investors are overexposed to large cap stocks and would receive diversification benefits and higher return potential by adding micro cap investments. These small companies are domestically focused and provide a lifeline to the American economy. They also prosper the most from the strength of the dollar.
Always consider the risks and be willing to hold positions over a full economic cycle to realize benefits. There are pockets of micro cap under-performance but over time they outperform larger cap investments. To invest in micro caps you must do your own homework or find a manager who is willing to keep his assets under management low. To exploit the structural advantages in the micro cap space you must be small. At Tarsier Capital Management we manage two micro cap strategies capped at $10 million and $5 million. Assets are managed in separate client accounts. We are here to help improve your returns please contact us with further questions.
1.) Dennis Jensen, Acuitas Investment, Shrinking Risk Budgets and Smart Beta – Using Microcap and International Small Cap to Improve Returns, 2013
2.) Avner Arbel and Paul Strebel, The Neglected And Small Firm Effects, 1982
3.) Ibbotson and Associates, (2010)” Liquidity as an investment style.” Working paper.
4.) Rolf Banz, The Relationship Between Return and Market Value of Common Stocks, 1980