Equities: Punching above their weight
Investing broadly across geographies, investment styles, and market capitalizations remains one of the oldest and most important tenants for equity investors. Still, many investors could be overlooking an entire category of equities—domestic micro-cap stocks—that may offer an array of enviable attributes. This niche asset class, loosely defined as small publicly traded companies with a market capitalization between $30 million and $1 billion, has demonstrated an ability to enhance the long-term return profile of an equities portfolio (as evidenced by the graph below) while also improving diversification characteristics.
We believe there is a significant opportunity for investors by moving down the capitalization spectrum and including an allocation to some of the smallest publicly traded companies that not only may be innovative and disruptive, but also could potentially be on the verge of a long runway of earnings growth.
Although we all know that past performance does not guarantee future results, our enthusiasm for micro caps stems (partly) from their track record. Looking back all the way to 1925, we see that investors who allocated to micro-cap segments of the US market (defined as the ninth and tenth deciles by market cap), far outperformed their larger and more recognizable counterparts.
Perhaps this reflects the general “neglect” from Wall Street sell-side analysts. After all, there’s no doubt that there are more analysts following the mega caps like Amazon, Apple and Microsoft versus any fledgling company no matter how much buzz it is generating.
Smaller-cap companies simply do not generate the investment banking economics typically needed to justify coverage from sell-side brokerage firms. And while this may create a lack of efficiency in terms of price discovery, it also makes micro-caps very interesting from an active managers’ perspective. Specifically, we believe that investing in profitable smaller, high-quality companies that finance growth through internally generated cash flows, as opposed to excessively dilutive means at the expense of shareholders, may offer attractive risk/return profiles.
It’s not just about lack of coverage and inefficiencies. There are other reasons why we believe that micro caps deserve a place in a broader investment portfolio. Consider that as of year-end 2021, almost 60% of the constituents in the Russell Microcap Index had no net debt* , which suggests there is a large pool of well-run, well capitalized small companies that might be less susceptible to rising interest rates given their balance sheet position.
Moreover, micro caps also tend to have high levels of insider ownership, which creates a strong economic alignment between management and shareholders. As of the end of 2021, there were more than 400 companies in the Russell Microcap Index with insider ownership greater than 10% of shares outstanding, as compared to only 19 companies in the S&P 500 Index. In our opinion, micro-cap management teams tend to be entrepreneurial and nimble, and their personal wealth is usually more dependent on company stock appreciation than it is for their larger cap counterparts. This alignment of interest is a net positive.
Diversification is yet another key feature of microcaps not to be overlooked. Investors often desire uncorrelated return streams in order to make an investment portfolio less volatile (on the whole) and better positioned for success at various points of the economic cycle. This is one of the calling cards of micro-cap equities. During last 20 years, the Russell Microcap Index has demonstrated the lowest correlation among the other major domestic stock indexes (including the S&P 500 Index) as well as a negative correlation to bonds (represented by Bloomberg US Aggregate Bond Index). The fact that micro caps have proven to move relatively independently of these other asset classes might be especially valuable in 2022 when both bonds and equities have run into headwinds.
So while the economic backdrop, interest rate environment, and other factors that impact investor sentiment still matter, we believe that most investors could benefit from an allocation to micro-cap equities. Don’t underestimate the potential of these small companies.
*Aggregate Statistics (Non-Financial, Non-Utilities, Non-Real Estate)