This Basket Of Microcap Stocks Is Poised To Outperform

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Includes: ACY, ALN, AMS, ARCI, CNR, CPSS, DIA, EGT, ERS, IWC, LEE, MCEP, MN, NOA, RYI, SEII, SORL, YGE, ZEUS
by: Jussi Hiltunen

Summary

Microcaps have historically provided better returns than the overall market - at increased risk.

A carefully selected basket of micro cap stocks has historically significantly outperformed the markets.

I provide a list of potential lucrative microcaps with a possibility for good returns.

When compared to historical valuation metrics, blue-chip stocks seem to be currently overvalued. An investor might in this kind of a situation ask where (s)he should turn to in order to find value or get better diversification? One possibility to achieve this is the microcap segment. This segment could provide better diversification and possibility for better future investment returns for a portfolio. Depending on your broker and country, microcap usually refers to stocks with a market capitalization of less than $ 300 million but in this article I will draw the line to $250 million.

Why should an investor add microcaps to his/hers portfolio? It is academically studied that smaller market capitalization stocks have historically produced better returns than large cap counterparts. However, this outperformance has meant higher risk in the form of stock price volatility and business performance (see Fama and French). In addition, as this asset class has historically had a lower correlation when compared to S&P 500, international equity and fixed-income security (source), having this kind of a satellite portfolio next to your core one is a viable option in the quest for additional diversification and extra return. In this article I will demonstrate how well a carefully selected basket of microcap stocks has performed in the history. In addition, if a reader would be interested in trying out this type of a strategy, I will as well reveal how this kind of a basket would look at the moment.

How come microcaps are able to outperform large caps? One factor often offered by the academics is that greater risk requires greater return. One other logical reason could be that as the coverage of microcaps by major investment banks is non-existing - due to the fact that microcaps do not generate fat enough banking fees - all information is not immediately priced correctly into the microcap stock. Even though the information were publicly available. However, as the source of information is much scarcer when compared to large caps, analyzing microcap stocks can take much more time and effort. The analysis could start out with an assessment of the current stock price whether it is trading near its 52-week high/low followed by inspection of publicly available valuation ratios, such as the PE, P/FCF or P/B. In addition, you probably should also review the security's financial statements to get a better understanding of company fundamentals, trends, growth factor, debt level and so on.

I do not know about you but at least for me the previously mentioned groundwork can be a bit too tedious process. Since microcap stocks are often extremely illiquid, it is difficult for an investor to make larger initial lump sum investments. Therefore, as the rewards are smaller, the previously mentioned analysis process should be automated somehow. One possibility is to rely on purely mechanical approaches when filtering stocks in the microcap universe. This of course removes the qualitative factor from the process as mechanical approaches can rely only on quantitative factors. One approach for the mechanical filtering could be to once a year sort stocks based on a certain valuation ratio and then additionally sort the cheapest stocks based on historical price performance. For the valuation factor, I would prefer to use cash flow instead of net income. The reason for this is that cash flow provides a better and more reliable picture of company fundamentals. For example dividends, debt and investments are paid from cash flow and not from net income. Net income could be much higher than free cash flow, but if the cash flow is negative there is just not any money left for shareholders in the form of dividends. In addition, combining the P/FCF ratio with a six or twelve month price change eliminates the risk of catching a falling knife. This kind of a rebalancing should be as well performed once a year since the business environment and therefore share price can quickly change courses for a microcap stock. One possibility for the rebalancing could be during April as majority of corporations have already published last fiscal year's financial figures. So, in short the rules of the microcap strategy would be the following:

  • Market capitalization less than $250 million.
  • Sort all of the previous stocks based on their P/FCF ratio, excluding all companies with negative cash flow.
  • Choose 50 stocks with the lowest P/FCF ratio and purchase 20 of them with the strongest six months price gain.
  • Do the sorting and purchasing on first trading day of April. Before purchasing any new stocks, old ones are naturally sold first.

When I backtested the above strategy in QuantumTester, I was able to generate quite nice results. From 1988 to present, the above strategy performed extremely well against DIA in the backtester. 25% indexed annual performance after taxes and trading costs is quite exceptional. As a reference, the market (NYSEARCA:DIA) delivered only 10% annual performance during this same period. The microcap strategy has as well greatly outperformed similar publicly available microcap ETF (NYSEARCA:IWC). You can see table and graph versions of the backtested strategy below. In addition, the correlation between the microcap strategy and DIA was non-existing (0.29) and the strategy outperformed DIA 67% of the time. All of this means that the previously stated microcap strategy is an extremely good addition to anyone's portfolio. However, it still has to be noted that as the extra return did not come without much higher risk, an investor should assign only a small portion of total portfolio to this strategy.

(Source: quantumtester.com)

(Source: quantumtester.com)

In order to validate my theory, I as well ran the same strategy using Finnish micro/small cap stocks for the last six years. This manual backtest provided very similar results and you can check the results below.

For readers interested in how the US microcap portfolio would currently look like, you can see it here (values are from the time of writing):

Company Name Symbol Share Price ($) Market Cap ($ M)
AeroCentury ACY 10.6 16
American Lorain ALN 0.6 22
American Shared Hospital Services AMS 3.8 20
Appliance Recycling Centers of America ARCI 1.1 8
Cleantech Solutions International CLNT 0.7 4
China Metro Rural Holdings CNR 1.1 86
Consumer Portfolio Services CPSS 4.9 117
Entertainment Gaming Asia EGT 1.4 20
Empire Resources ERS 6.2 51
Lee Enterprises LEE 3.2 179
Mid-Con Energy Partners MCEP 3 86
Manning and Napier MN 7.2 110
North American Energy Partners NOA 4.5 140
Ryerson Holding RYI 10.8 380
Sorl Auto Parts SORL 2.9 54
Yingli Green Energy Holding YGE 2.8 50
Olympic Steel ZEUS 23.52 240

SUMMARY
A microcap portfolio - which includes stocks with low P/FCF value and strong six months price performance - has during the last 30 years significantly outperformed the market (25% p.a. vs. 10% p.a. of DIA). In addition, this kind of a microcap strategy has had an extremely low correlation (0.29) when compared to DIA. Considering the previous backtested results, it could be beneficial for an investor to create a satellite portfolio using the previously mentioned rules. Even though I am not personally using the above mentioned strategy (yet), I will definitely study this a bit more and seriously consider starting using it.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.