By Harry Gakidis
Micro-cap stocks represent one of the least efficient sectors of global public equity markets. For active managers who can successfully negotiate the associated trading and risk challenges, micro-caps may offer attractive stock selection opportunities at institutional capacity.
Micro-cap refers to the segment of the smallest stocks. While exact definitions vary, a representative market cap range might be $50m to $500m. This capitalisation band contains about 20,000 stocks in developed markets worldwide, and we consider 7,700 to be institutionally investable. Of these, 5,900 are outside the US.
An attractive feature of micro-cap companies is that they offer a natural bridge between public and private markets. Due to their ownership structure, management has “skin in the game” more frequently. We estimate that the percent of market cap held by insiders and private investors steadily increases from approximately 3% for large-cap stocks to 6% for small-cap stocks to 15% for micro-caps. Many investors believe that these ownership characteristics drive a greater focus on shareholder returns. For these reasons, micro-caps are often put forth as a liquid alternative to private equity.
At the index level, micro-caps have had similar risk and return characteristics to small-caps over time. However, individual micro-caps exhibit both higher volatility and lower quality. This average “junkiness” of micro-caps belies the great dispersion of quality within their large investment universe. Combined with low analyst coverage and similarly wide spreads in valuation, the real potential for this inefficient asset class lies with active stock selection.
THE CASE FOR ACTIVE MICRO-CAP INVESTING
BREADTH
Micro-caps have a number of distinctive qualities that make the asset class ideal for active management. The first is the exceptional size of the universe. The micro-cap universe, comprised of 7,700 institutionally investable stocks, has roughly double the number of investable stocks as the small-cap universe and close to five times the number of investable large-caps. With this greater breadth, a skilled manager has the potential to generate superior risk-adjusted active returns.
INEFFICIENCY
Given the vast size of the investment universe, many micro-cap stocks are underfollowed or ignored by analysts. While the average number of analysts covering a stock in MSCI World is 17, and the average number covering a stock in MSCI World Small Cap is seven, the average analyst coverage for a company in the corresponding micro-cap universe is two. We estimate that 58% of the companies in MSCI World Micro-cap have no analyst coverage at all.
The lack of coverage makes sense, given the limited scope of most fundamental research organisations. It is simply too expensive to extend an investment universe that far. We believe the benefit for active managers who have the ability to cover a broad universe is that mispricings among micro-caps are more persistent.
Given the relatively sparse information environment, we would expect to find evidence of mispricing in the micro-cap universe. And we do in fact see this. Taking valuation as an example, we see greater dispersion across our micro-cap universe compared to larger stocks. This suggests that the micro-cap arena does indeed offer the potential to uncover undervalued stock opportunities.
INVESTMENT PROCESS CONSIDERATION
Given the unique characteristics of micro-caps, not every investment approach is going to be successful in effectively managing these assets. Taking advantage of the inherent breadth and inefficiency of the asset class requires not only identifying the superior stock selection opportunities among the thousands of micro-cap stocks, but also systematically balancing these opportunities against the more challenging liquidity and risk profile of these stocks.
As noted above, there is sparse fundamental research on the scope of the micro-cap universe. This makes micro-caps a natural fit for a quantitative approach, which can access data and leverage the insights of analysis across many thousands of stocks.
Micro-cap stocks can also pose challenges with regard to effective trading. Individually, micro-caps are less liquid than larger stocks and have correspondingly high transaction costs. According to our micro-cap trading data that stretches back to the 1990s, the average bid-ask spread for micro-caps is close to four times as large as that of small-cap stocks. But as an asset class, the total daily trade volume we observe for global micro-caps is roughly half the volume of small caps, $14bn versus $30bn. That is large enough to accommodate institutional-sized trading for investment managers with the information set and precise techniques needed for transaction cost control.
Finally, micro-cap stocks are on average more volatile, as they exhibit much higher idiosyncratic risk. An additional benefit of a quantitative approach is that it can attempt to reduce this source of risk by holding a diversified portfolio.
Harry Gakidis is a portfolio manager at Acadian Asset Management
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