Microcap Stocks – There’s A Lot To Like About Them

| February 7, 2017

“If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”

– Warren Buffett, 1999

When I read this Buffett quote for the first time it struck me as peculiar. What would cause the normally conservative Warren Buffett to make such a statement?  Is it simply that he knew he would never actually have to prove it, or are there important intuitions to be gained from this quote? Understand that a 50% return in any given year should mean nothing to you if you accept the randomness involved in short-term investment performance. Randomly picked portfolios can have 50% up-years, but I infer from Buffett’s statement that 50% is his average return expectation.

The Buffett quote does not directly imply that you should invest in microcaps, but the structural advantage that Buffett mentions can be very well played in smallcap and microcap stocks. After all, some of the best investors of all time, including Warren Buffett, Peter Lynch, Joel Greenblatt, and many others started their careers investing in microcaps and enjoyed the best returns when they were pursuing opportunities in small capitalized companies.

I don’t mean to discriminate between smallcaps (market cap 300m – 1bn), microcaps (market cap between 50m and 300m), and nanocaps (market cap sub 50m), but I want to lay out general intuitions for why small public companies can offer attractive investment opportunities, and why smaller is often better.

You Can Understand What You’re Buying

If you are a fundamental investor, you want to know what you own. You want to understand what is going on in the business and the moving pieces that make it tick.

Something small and simple is inherently easier to understand than something big and complex. I can understand a small business with two product lines, two main distributors, and maybe three important suppliers.

Can I get a truly realistic understanding of Goldman Sachs’ derivative book, and all the other moving parts of this business? I don’t think I can, and I seriously question the people who claim they can (especially those that claim high or absolute certainty). In fact, I deem many of the big cap companies to be too complex to be thoroughly understood and wonder about analysts making forecasts to the third decimal. I don’t mean to say that there is anything close to certainty in small stocks. The future is always uncertain and quarter-to-quarter results can be very volatile in microcaps. I feel I can make long-term predictions on a business level with a higher degree of confidence if I understand the moving pieces.  More importantly, I can better gauge how much randomness exists in the business.

Access to Management of Microcap Stocks

Many great investors, including Warren Buffett, stress the importance of investing in companies run by quality management teams.  You might argue that in small companies the quality of management is of even greater importance.

If you subscribe to the idea that management is a main driver of company value, you certainly want to perform due diligence on the management teams you invest in. During that due diligence process, personal contact can be an enormously helpful tool. GeoInvesting founder Maj Soueidan stresses the importance of management interviews, and has developed an intuitive interview technique over a long investing career. Other great investors like Guy Spier have said that they shy away from personal contact with senior management because of their fear of becoming influenced by charismatic personalities.

If you like to have personal contact with company management during the research process, you will often find that the smaller the company, the more accessible management will likely be. I can call the CEO of a small company I am invested in, and he’ll be happy to explain how a newly announced contract impacts his business. Good luck getting Tim Cook, CEO of Apple Inc. (NMS:AAPL) on the phone.

In addition to accessibility, microcap company management teams tend to own a higher percentage of company shares. While this does not guarantee success, it makes sense to assume that high insider ownership helps to align management interests with those of the company’s investors.

More Growth Potential

Similar to animals, companies have natural size limitations and must abide by the laws of larger numbers. Coca Cola cannot organically double its revenue over the next few years. There is only so much people can drink in a day. By contrast, many microcap companies can easily increase their revenues tenfold without having any material impact on the overall industry. The best companies might even be those that occupy a dominant spot in a small but growing industry. Remember that almost every company started as a small company. In fact, some of the best-performing public companies ever, including Berkshire Hathaway (BRK-B), Wal-Mart (NYSE:WMT), Amgen (NMS:AMGN), Netflix (NMS:NFLX), and many others were once microcap companies.

New growth often requires doing things differently. In other words, innovation. Numerous studies have discussed how and why big companies fail to innovate.

There are of course many factors contributing to the ability to innovate, and it is certainly wrong to generalize that all small companies are innovative. I believe the basic intuition holds true: the smaller the company, the more potential it has for growth, and the more innovative it can be.

More Opportunities in Microcap Stocks

Microcap companies represent roughly 50% of all publicly traded companies in North America. There are around 12,000 publicly traded microcap companies in the US and Canada alone and many more internationally. Most investors restrict themselves to a universe of very few big cap companies and ignore the majority of publicly traded companies. Generally speaking, the more opportunities, the higher the probability that something extraordinary will be hiding among them.

Just think of a distribution with a certain volatility and mean. The more data points you have, the higher the chance that one of them is far off the mean. This intuition is also reflected in Peter Lynch’s stock discovery process. Lynch believed in “turning over as many rocks” as possible.

The Incremental Buyer

When you buy a share of stock at $0.50 that is worth $1, you are a heroic value investor, right? But who is eventually going to pay you $1? This idea is related to important questions every investor should ask before initiating a position. How does my view differ from the consensus view? What is going to cause the market to adopt my view? Who is the incremental buyer that will buy my shares at a higher price?

Microcap stocks have the attractive feature that they are not investable for many institutional buyers for a multitude of reasons (current lack of liquidity in the stock, fund mandates, not enough revenue to garner interest from a potential suiter), but will become investible at some point. If the company keeps performing well on a business level, there is a good chance that the stock will attract more investors and soon be liquid enough to attract institutional money managers. Investors who are restricted from certain opportunities for non-fundamental reasons make for great catalysts when such restrictions are lifted. I get excited when I see a growing microcap company without institutional holders, because I understand that the eventual institutional buying can be a catalyst for a position taken ahead of time.

Think of it as an index arbitrage; imagine there is an index fund with the mandate to buy a company’s stock only once it reaches a $250 million market capitalization, but not below that threshold. The (very simplified) idea is that you buy the company before it reaches its threshold and take advantage of the buying pressure that will arrive once the $250 million market capitalization is reached. Of course, in reality, thresholds are a lot less clear-cut and there are certainly more factors at play than market cap to impact purchase decisions.

This is similar to when a microcap stock that doesn’t report to the SEC finally starts reporting financials. Once SEC financials are officially filed, the company then screens properly for those who find their investments through automated digital quantitative means. This can also occur in companies that have just undergone acquisitions or divestitures.

The incremental buyer can also be strategic. Small size creates an environment for a bigger group of potential strategic buyers. Many microcaps get acquired by bigger competitors after they reach a certain size. Since 1993, roughly 50% of all public market M&A transactions involved microcap stocks.  Since its inception in 2007, GeoInvesting has brought to its members over 40 stock ideas that have been acquired at elevated premiums.

Avoid Competition

Every time you buy a stock, you are making a somewhat arrogant move. With every market transaction under normal conditions, you are essentially saying that you have a better understanding of the value of the business than the aggregate wisdom of the market.

Choose your competition carefully, because for every buyer there is a seller.  Investment management as a whole (at least to the market participants) is a zero sum game. There is an old saying among gamblers that goes: “If you are looking around you and you can’t find the sucker, you are the sucker.” Logically, the more you move up the market capitalization, the more resources are being spent by the people with which you are competing for returns.  It consequentially  becomes harder to get an edge.  Many microcap companies have no institutional investors at all. Less competition leads to less efficient markets, which means you will have better chances of finding a great opportunity before others do.

Market Inefficiency

Efficient markets need to meet certain conditions to be truly efficient. By efficient I don’t mean that the price is always right or that the market participants are free of behavioral biases, but that new information is quickly and correctly priced in.

Many of these conditions are not met in the smaller cap universe, most notably perfect information flow, and liquidity “advantage.” In other words, many microcaps are underfollowed and get punished for being illiquid, and have therefore a greater propensity to being mispriced. Smaller capitalized companies tend to be less liquid (higher indirect transaction cost) and less followed.

This is why “information arbitrage” opportunities can be found in the microcap space. Geo co-founder Maj Soueidan has redefined the phrase “information arbitrage” and I have to admit, being a former finance graduate student of efficient-market school University of Rochester, that I was initially highly skeptical of the concept.

Maj has shown me repeatedly that there is information available that is not in press releases, earnings releases, and announcements – information that is clearly not correctly factored into the price stocks for hours, days, sometimes weeks, until the market takes notice.  We at GeoInvesting can take advantage of that by digging through filings and being on top of our analysis.

The Small Firm Effect

The small firm effect was first discovered by University of Chicago doctoral student Rolf Banz, and is incorporated in the Fama-French three-factor model. The basic idea is quite straight-forward. The data shows that historically, small cap stocks have outperformed large cap stocks. The outperformance cannot be directly attributed to the extra risk that the higher returns of small stocks could compensate for. It seems like you get outperformance for free just for being invested in small companies. Efficient market economists have come up with mostly unsatisfying explanations for the small firm effect since its discovery, attributing the excess performance to improperly pricing liquidity risk, bankruptcy risk, etc.

In the end it seems that “Data snooping is considered to be a sin, and coming up with ad hoc risk measures to explain returns should be regarded as no less of a sin” (Louis K.C. Chan and Josef Lakonishok , FAJ 2004). To be fair, this very article tries in some respect to explain the small firm effect, although it puts less emphasis on outperformance due to risk considerations as much as efficient market economists would.

Trading Costs/Implementation Costs

Let’s face it, you and I are not managing billions of dollars yet. In fact, most of us manage significantly less (If you belong to the handful of billionaires who appreciate the benefits of microcap stocks, give us a call).

Trading costs are often ignored by practitioners, but are in practice very relevant to long-term investment performance. Trading costs include execution (commissions, moving the price) and opportunity costs (cost of not executing the trade). For a great and concise examination on trading costs, see Andre Perold’s 1988 paper “The Implementation Shortfall: Paper versus Reality”.

In practice, trading costs are significant, and the bigger your assets under management the more trading costs are likely to be a drag on your performance.

In their 1991 research paper, “The right amount of Assets under Management,” Andre Perold and Robert Salomon explain how growing assets diminish your percentage returns, because investment opportunities have a limited overall size. Keep in mind that the total microcap opportunity is not that gigantic; Even though there are roughly 12,000 publicly traded microcap companies in North America, their total market capitalization is only about 500bn, which is less than the current market capitalization of Google.

The small firm effect is often solely attributed to an illiquidity discount that exists in microcap stocks as illustrated by Lubos Pastor and Robert Stambaugh in their 2001 working paper published in The Center for Research in Security Prices.

In light of these insights, long-term investors of relatively smaller capitalized stocks should gain a strategic advantage in small caps. If you are an investor in “small” companies, it will be easier for you to establish and exit meaningful (meaningful to your overall portfolio) positions without moving the price too much.  Put another way, long-term investors, who allow themselves time to build and exit a position, can use the lack of urgency in their trading to establish positions in illiquid stocks that are not attractive to their more actively trading counterparts.

Low Correlation and High Volatility

Microcap stocks have historically shown lower correlation to both large cap companies and small cap companies, making them an attractive addition to institutional portfolios. The low correlation can be partly rationalized by the irregular trading behavior of illiquid stocks. They also experience very vast swings and great volatility in the short run, making them attractive targets for traders and speculators.

On a fundamental level, high volatility and low correlation to the overall market can be explained by the fact that small companies are often dependent on fewer product lines. In other words, the lack of product diversification causes a higher degree of unsystematic risk.

While a high degree of unsystematic risk may be bothersome to company management, it can be dealt with by investors who maintain well diversified portfolios. Also, stock pickers with long-term horizons should embrace the volatility in microcap stocks to provide liquidity during temporary stock declines.

Conclusion

There are many reasons why investors should look for opportunities among small capitalized companies. Whether you are a stock picker or quantitative investor, retail investor or big billion-dollar fund, going small can offer multiple benefits to your investment process.

The described relationships are by no means linear.  Some are overlapping, leading to endless scenarios that can lend to discussions not touched upon here. Hopefully, this article gives you reasons to believe why looking for investment ideas amongst small public companies might be a good idea. Please be aware that I consider stock picking in microcaps an activity for people who have a certain level of experience, and make sure you know the specific ins and outs of the microcap market before executing your decisions. In the end, the biggest risk is not knowing what you are doing. With that said, even novice investors can begin to add value to their investing journey by dipping their feet into microcap stocks – after all, every journey must begin somewhere.

 

Note: This article was contributed to ValueWalk.com by Maj Soueidan of GeoInvesting.

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Category: Investing in Penny Stocks

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The author of this article is a contributor to ValueWalk.com. ValueWalk is your everyday source of breaking and evergreen news on everything hedge funds and value investing.