Microcap Q&A: Small but Mighty Stocks

Published:

Authors:
Michael Santelli, CFA, Director, Portfolio Manager
Matt Scullen, CFA, Vice President, Portfolio Manager


Microcap stock investing requires unique skills and can offer many potential benefits to a portfolio. We sat down with Michael Santelli and Matt Scullen, co-portfolio managers of Ancora’s strategy that focuses on microcap stocks, to discuss the outlook for the asset class and how they go about creating value for investors.

Q: For starters, can you define microcap investing for our readers?

A: While there is no official definition, the simplest explanation is that investing in microcap stocks means investing in the smallest companies of the total stock market. The Center for Research in Security Prices (CRSP) defines the microcap segment of the market as the bottom 2% of investable market capitalization. Our team’s definition is similar. Despite the small size of the market, opportunities in the microcap range abound. While the S&P 500 is limited to approximately 500 companies, there are roughly 1,500 to 2,000 microcap companies at any given time in the investable universe.

Q: What role do you believe microcap stocks can play in a portfolio?

A: We believe microcap stocks can enhance returns in a portfolio. In particular, microcap value, as measured by low price to earnings or price to book value, is the best performing segment of the market going back decades. We have seen that an allocation to microcap stocks may have diversification benefits, as microcap stocks have a lower correlation to large cap stocks. This could enhance the return to a greater degree than risk is increased. Individually, microcap stocks are more volatile than their larger capitalization peers, so our research indicates that the sweet spot is allocating approximately 10% of an equity portfolio to microcap. This may improve the return/risk ratio, but going past 15% will begin to increase the risk relative to return.

Q: What unique analytical skills do you believe investors need to be successful in the microcap range?

A: The analysis of a microcap company and a large cap company follows the same general process, though there are a few important differences. For starters, the management teams of microcap companies can be more important to the success of the company. From an analytical perspective, this means understanding incentives and evaluating management decisions becomes critical. Fortunately, investors in microcap companies typically are granted a great deal of access to the top executives. Additionally, financial strength is generally more important to examine for microcap companies. The sales of microcap companies can be more volatile than large companies and they may have a higher percentage of fixed costs, which can stress profitability during economic slowdowns. We like to see low debt and sufficient cash so there is no question of survivability in the companies we invest in. Finally, and perhaps most importantly, there is minimal coverage in this area by Wall Street firms, so you can’t rely on outside research. In our view, this is a source of advantage for diligent microcap investors as thorough research can lead to significant rewards due to the low attention from Wall Street and larger investors.

Q: Some have drawn comparisons between investing in microcap stocks and private equity investing. What is the basis for that comparison?

A: We believe the comparison is fair against the segment of private equity known as growth equity. The basis of this goes back to the opportunity for enhanced risk-adjusted returns. Both private equity and microcap can accomplish this. Each strategy invests in smaller companies with opportunities to grow. Both private equity and microcap offer diversification benefits to a portfolio, though microcap does offer some benefits that private equity cannot, such as daily liquidity whereas private equity typically requires a long-term lockup of capital. Private equity generally has higher and more complex fee structures than microcap strategies and will often use a high degree of leverage to boost their returns while microcap strategies are capable of achieving similar returns with far less leverage. Lastly, gaining access to the top performers in private equity can be very difficult. Most microcap strategies can be easily accessed through mutual funds or separately managed accounts.

Q: What misconceptions do you believe exist regarding investing in microcap stocks?

A: One of the biggest misconceptions is that microcap stocks are penny stocks, which has a negative connotation. The companies we invest in rarely trade below a dollar and typically trade on a reputable exchange like NASDAQ or NYSE. All the companies we invest in file with the SEC and are audited by a credible accounting firm, just like S&P 500 companies.

Q: What is your view on the active vs. passive investing debate when it comes to microcaps?

A: We are strong proponents of active investing, and there are several reasons for this. As mentioned, microcap stocks have less coverage from Wall Street and are often overlooked by large investors. We refer to this coverage problem as “institutional constraints” and we believe it can create wider mispricing in microcap companies as fundamental changes can go unnoticed. This means there are opportunities for investors who can spot the mispricing. There is a big universe of microcap companies, many of which can be lower quality, meaning less profitable or highly indebted. We think the number of stocks in the universe combined with the need to be highly critical of lesser-quality companies makes passive investing in instruments that mimic the index a poor choice. Active managers can filter for high quality companies with growing cash flows over time while passive options are stuck with a lot of low quality, speculative holdings. Index-tracking ETFs are known for low fees because they are passive and offer zero opportunity to outperform. You might pay three basis points expense to invest in an S&P 500 Index ETF, but the Russell Microcap Index ETF from iShares is much more expensive to access at 60 basis points. We believe those dollars would be better spent allocating to an active microcap strategy.

Q: In closing, what is your outlook for the asset class considering valuations and the economy?

A: We think the next five to ten years look bright for microcap equities. Today, after over a decade of underperformance versus large caps, small cap equities trade at one of the lowest valuations on record relative to large cap equities. The last time we saw relative valuations of small versus large like we have today was around 2000. Small cap equities went on to significantly outperform large cap equities during that cycle. With very attractive valuations and potential for higher economic growth in the future, we believe this is a great set up for microcap equities.

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