I focus on the microcap space (market cap below $250 million) because it is one of the most inefficient and "alpha rich" areas of the global equity market, which provides the greatest opportunity to generate alpha through fundamental research. I use a bottom up, investment decision making process. The ideal investment has an asymmetric risk/return profile with a limited downside (e.g. high net cash balance, strong cash flow) and significant upside (e.g. asset value extraction, overlooked business model transition). Microcaps are particularly attractive to the following groups: Activist investors. A small absolute investment (on a dollar basis) can be leveraged into a relatively large position (as a percentage of shares outstanding), which provides a greater ability to demand change. Private equity firms. The persistent microcap discount can be “arbed away” via an LBO with the new owners accruing all of the gains for themselves. The small absolute size of many microcaps on an EV basis significantly expands the number of firms able to pursue this strategy. This inefficiency exists for several reasons. A lack of analyst coverage due to lower trading volume (less soft dollars from HF/MF), the global settlement that permanently severed the link between research/banking and the rise in electronic trading/decimalization. Moreover, none of these trends are likely to reverse for the foreseeable future (if ever). A lack of institutional products given the natural capacity constraint for new/existing managers. An inability to effectively implement a passive approach (e.g. ETFs, index funds) due to the lower liquidity and wider bid/ask spread. However, each of these obstacles can be overcome by using a combination of electronic trading tools (e.g. algos) and patience in building a positive size. Inaccurate and persistent misconceptions about microcaps (e.g. they are riskier than larger cap stocks). I currently trade for my personal account but would like to move into the investment management side of the industry.
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