We believe microcap stocks are an attractive asset class offering the opportunity to deliver outsized returns to investors and that they should be an important part of a diversified investment portfolio.
Made up of approximately 4,500 companies with market capitalizations of less than $250 million, microcaps are an underestimated and overlooked slice of the investment pie. They have small floats and low trading volume, which makes investing large amounts of capital practically impossible for funds with larger asset bases.
While most microcaps are listed on a national exchange such as the NASDAQ or NYSE, some companies trade over the counter, or OTC. For many funds and brokers, internal rules limit the ability to invest in stocks that do not have up-to-date financial statements, are not listed on a national exchange, and/or have stock prices that trade below $5 per share.
In short, the number of investor eyeballs digging into the businesses, financial statements and other important aspects of these microcap companies are significantly less than of companies with larger market capitalizations.
The same is true on the bank analyst side. Nearly 75% of companies in the microcap space are followed by fewer than three analysts. Our experience suggests that a vast majority of these names are not covered by any analyst. Why? The majority of analysts and institutional investors are simply unable to spend the requisite time to familiarize themselves with these opportunities due to position size limitations, liquidity restrictions, and overall capacity constraints.
This dynamic creates a compelling opportunity for microcap investors to be at the forefront of discovering overlooked, orphaned stories and to benefit from the forthcoming value/size appreciation that can follow if these companies can execute their businesses.
Outperformance, Diversification, and Opportunity
Microcaps offer a premium on both maximum annualized upside returns, over a subset of seventy-three 20-year rolling periods dating from 1926-2019. Looking at more recent data, while the micro-cap index has moved more in line with large caps in the last decade, for a variety of reasons (recession looming. low rates) there has been significant underperformance in the last 5 years (see charts).
Russell Microcap Index (white) vs. S&P 500 Index (orange)
10-year history through November 30, 2022
Russell Microcap Index (white) vs. S&P 500 Index (orange)
5-year history through November 30, 2022
Source: Bloomberg
We believe this diversion will self-correct as valuation for the microcap index, in some cases are at generation lows. Given their higher historical return profile and lower trading volume, it’s not surprising that microcap stocks tend to experience higher volatility. Taking that into account, however, microcap stocks (13.7% for microcap vs 11% in large-cap stocks) had superior performance over average annual 20-year annualized rolling return analysis from 1926-2019, and we believe this trend will continue into the future.
In addition to superior returns, microcap funds provide a much-needed offset to balance out portfolios that tend to own asset classes highly correlated to each other. A carefully constructed portfolio with the inclusion of microcap portfolios can provide diversification benefits as is evidenced by microcap’s historical correlation of 0.73 to large-cap stocks.
Fortunately, the lack of analyst coverage and investor attention is not in itself an indication of poor businesses or inferior management teams. In fact, one of the primary drivers of opportunity in this part of the market is the ability to identify situations where quality management teams are leading businesses that have fallen out-of-favor relative to the market, creating an asymmetric risk/return profile. Many of these opportunities can have several underlying catalysts that, when identified and pursued, can drive substantial value appreciation.
One outcome across the broader microcap space is M&A. Nearly 70% of acquisitions throughout the equity market involve small and microcap companies and properly identifying and positioning within this potential universe of targets typically introduces an opportunity for a clean investment exit at substantial premiums.
Beyond M&A, other catalysts include removing unwieldy capital structures, replacing old management teams, monetizing undervalued real estate assets, and even resolving prior legal or accounting issues. These catalysts have multiple things in common. They create the potential for a business to be undervalued relative to peers and current results. And it is often the case that microcap company management and boards are unsure of how to fix their problems to catalyze such value-enhancing events and are often on an island in terms of coming up with potential solutions.
The Role of Constructive Activism
Ideally, company executives and board members have identified these catalysts and are actively pursuing solutions. But even when management and boards are aware of the problem, solutions are often not obvious to them, as they have blinkers on or lack the experience or expertise to rectify them.
That’s where a multilayered constructive activist strategy can be deployed to pursue catalyst opportunities, unlock shareholder value and help management reach the “next level” in their company’s life cycle. Sometimes, constructive activism is about helping companies deliver proper communication and messaging to the broader investment community. Other situations may require a more hands-on approach to address issues such as misaligned incentive compensation programs, improper corporate governance protocols, or unwieldy legacy capital structures.
While each situation is unique, all present an opportunity to use activism constructively to unlock value creation for shareholders. Simply put, we believe using a constructive activism approach can enable us to drive suitable outcomes for the companies we invest in. Pairing deep value microcap investing with activism has enabled us to differentiate from other ‘passive’ microcap investors.
To summarize, the microcap market has historically provided higher levels of return than other equity markets, with low correlation, less sell-side involvement, and greater M&A activity. We believe that when combined with a constructive activist approach, the microcap market provides an extremely attractive return profile that should be a part of a broader investment portfolio.
Kevin M. Rendino is Chairman and Chief Executive Officer of 180 Degree Capital Corp. (NASDAQ:TURN), a publicly traded registered closed-end fund investing in substantially undervalued small, publicly traded companies that it believes have the potential for significant turnarounds.
© 180 Degree Capital
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