I’ve recently been exploring the world of micro cap stock investing. You don’t hear much about this space except from the occasional banner ad promising a 10,000% return in a week by buying penny stocks. So I think micro cap gets a bad wrap. The truth is that you don’t hear about micro caps because the large fund and ETF providers generally shy away from the space. At just around $100 billion in total market cap, as opposed to over $20 Trillion for the rest of the market, it truly is a tiny corner of eclectic firms. Liquidity is low and transaction costs are high at scale. These things are anathema to product providers that are constantly seeking the next blockbuster hit ETF that can accommodate tens of billions in assets.
This is the first in a series on micro caps. When I began working at Western Asset in 2008, my then boss had me spend my first week studying the core bond benchmark, the Lehman (now Barclays) Aggregate–how it was constructed, what sectors existed, rules for inclusion, etc. As an active manager, we got paid to beat the benchmark, so understanding our bogey’s behavior was critically important. For the first installment, I dive into the Russell Microcap Index to understand it’s construction and behavior. The second part will leave the benchmark behind and think more fundamentally about what drives the opportunity set of microcap stocks. The thirdpart in the series will apply some fundamental criteria (factors) to control for the universe’s biases to drive (hopefully) outperformance. The final installment is a discussion of the real world application of the theory discussed in the first three installments, and an argument for the persistence of alpha in the space.
Enjoy, comment, send me feedback and questions!
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Micro cap stocks represent a fraction of the total U.S. market—literally less than 1% of total capitalization. These stocks are under-covered, unloved, and under-owned. Since the late 1990’s, micro cap’s share of the total U.S. equity market has been cut in half—though it was small to begin with. A key culprit, the proliferation of passive and “Smart Beta” investment products has resulted in disproportionate flows into the large cap space, and therefore, away from small and micro cap stocks. Below is a chart of the share for large (market cap above average) and small (market cap below average) for the U.S. market. Large is dominating. This is the wealth effect in stocks. The big keep getting bigger.
Though there are many unique considerations as it relates to liquidity and tradability at the smaller end of the market, as factor investors who constantly seek ways to tilt the probabilities of investment success the investor’s favor, we simply can’t look away from the opportunity that capacity constrained corners of the market—like micro cap—provide.