For the first installment of this series, I dove into the Russell Microcap Index to understand its construction and behavior. I showed that Russell's definition of micro cap is flawed in that it is predominantly representative of small-cap stocks and includes highly illiquid names that drag on performance. From an allocator's point of view, the index return is lackluster when compared to large-cap stocks. For this post, I think more fundamentally about what drives the opportunity set of "true" micro-cap stocks.
For the remainder of this series, I diverge from the Russell index definitions to get a better sense of the composition of micro-cap and the alpha opportunity available. I define micro-cap stocks as those trading on U.S. exchanges with an inflation-adjusted market capitalization between $50 million and $200 million.1 This micro-cap universe is also equal-weighted, as opposed to cap-weighted. This provides a "pure" view of the micro-cap market that has minimal overlap with small-cap stocks. This group of about 1,300 stocks represents a disproportionately small 0.4% of total U.S. market capitalization. With average daily volume of just $700 thousand and a cumulative market cap of about $100 billion, the group is a mixture of exciting growth opportunities and the land of misfit toys. Once I screen out companies with unreasonable liquidity and non-U.S. firms, the list dwindles to about 500 investable stocks.
For comparison purposes, I periodically refer to a large stocks universe. Large stocks consist of U.S. firms with a market capitalization greater than the average capitalization for the total market - currently, those stocks above an inflation-adjusted $7 billion market cap. This group is instructive, as it represents the bulk of investor's U.S. equity allocation. It is analogous to the S&P 500 Index on an equal-weighted basis.
Unique aspects of the micro-cap universe
An investor cannot fully appreciate the micro-cap space without understanding how stocks have come to fall on the micro-cap spectrum. Whereas most large stocks have succeeded in attempts to grow their businesses, as recognized by their multi-billion dollar valuations, micro-cap stocks are on a completely different playing field. These businesses range from biotech startups to failing businesses that have depreciated to their current middling market cap. From an empirical perspective, the result is a lot of noise in the data.
To demonstrate, let's look at one of the most fundamental metrics for a firm sales growth. Though its efficacy as an investment factor is marginal, sales are the lifeblood of any firm and have a cascading effect on all other elements of the financial statements. The chart below compares the distribution of 3-year sales growth across large- and micro-cap stocks.
Notice the significantly fatter tails for micro-cap relative to large-cap stocks. If growth in sales is the most basic assessment of the state of a firm, this suggests much greater dispersion in the underlying metrics of micro caps. The popular rhetoric is often that small- and micro-cap stocks are junkier than their large-cap counterparts. While this is true on average, a wide dispersion in fundamental metrics obscures many phenomenal businesses in meaningless averages.
A deeper dive reveals a disparate group of constantly evolving (and devolving) businesses
Investors have widely accepted that there exist many different types of private equity-angel investing, venture, early-stage, late-stage, mezzanine, LBOs, distressed. Interestingly, in the private space, these labels represent the need of the firm receiving the investment. Just as there are many sub-classes of venture capital and private equity, such is the case with micro-cap stocks, but for whatever reason, we do not view these businesses with the same categorical lens as we do private investments.
The micro-cap universe can be divided into three broad categories: New Ventures that have become revenue generating within the last three years, distressed Fallen Angels that have descended into the micro cap universe from small cap - and sometimes large cap - and those in a Steady State that have been micro caps for at least three years.
From 1982 to 2016, New Ventures represented 25% of the micro-cap universe, while 16% were Fallen Angels, and 59% were Steady State. Effectively, 41% of the universe is in some sort of transition - from startup to established firm, or from established firm to potential liquidation. When you think about micro cap, think of a revolving door where firms are constantly entering and leaving for different reasons.
This simplistic perspective on the universe is relevant because it sheds light on the strong inherent biases that skew the underlying fundamental characteristics. Below is the same distribution of sales growth for micro cap broken down by these three categories.2 These disparate groups possess fundamentally different metrics that, when averaged together, obscure a lot of noise in micro-cap stocks.
New Ventures, with their small sales bases, are highly skewed towards positive sales growth. Unsurprisingly, new ventures tend to be comprised of Information Technology and Health Care stocks - most notably biotech, software and pharmaceuticals. Currently, these industries represent a rather large 20% of the micro-cap universe. The average annualized return of this group from 1982-2016 is 4.7%, woefully short of the micro-cap universe average of 8.9%. Adding insult to injury, annualized volatility for this group is 27.8%. This likely has to do with the nature of outcomes in the space. Biotech firms generally succeed or fail in what amounts to binary outcomes, leaving investors with staggering gains or maximum losses.
Steady State firms are more centered in the distribution, but still positively skewed. At 59% of the overall universe, a good proportion of Steady State firms are Commercial Banks and Thrifts. These two industries represent 20% of the universe currently. Banks are the least volatile micro-cap industry and one of the top performers. The remainder of firms in this category tend to be widely dispersed across industries. Steady State firms are the best-performing of the three categories, with an annualized return of 10.1% and volatility of 22.8%.
Fallen Angels skew significantly in the negative growth direction. This group is a smattering of firms across industries. Currently, the oil & gas industry has the highest representation in this category. It tends to offer representation of groups of stocks that suffered in the previous cyclical business downturn. This group delivered an annualized return of 8.0% from 1982-2016 with volatility of 27.4%.
Our task as factor investors is to develop empirical criteria that enable us to cut through the noise to separate the good from the bad within the space. Given the perspective above, we know that there are reasonable fundamental explanations for the "junk-ish" nature of micro-cap stocks. Quite simply, a lot of micro-cap stocks possess poor business characteristics, whether that be weak cash flow generation, too much leverage, or dwindling and unprofitable revenues. By categorically identifying and removing firms with poor characteristics, we can improve the investor's base rate for success.
For the third installment on micro-cap investing, I'll suggest some screening criteria that will aid in parsing out some of the "junkiness" of micro caps. Surprisingly, eliminating low quality puts risk-adjusted returns for micro caps on par with large-cap stocks.
1 This would be analogous to the approximately 2,600th to 4,000th stock using Russell's ordinal market cap ranking methodology.
2 An analysis on 3-year earnings growth yields similar patterns, though with greater noise.