Should I Consider Investing in Micro Cap Stocks?

As originally published in Worth

Micro caps, the smallest investable companies in the U.S. equity market, scare off some investors who perceive them to be too volatile. We believe this risk has been exaggerated and their potential rewards overlooked. All stocks by their nature are risky. But if your risk tolerance allows for small caps in your portfolio, you should consider micro caps because there is no meaningful difference from small caps in risk or volatility.

This widely neglected segment of the U.S. equities landscape—comprising stocks with market capitalizations of roughly $500 million and under— offers compelling opportunities for long-term investors, particularly when investments are made through skilled active managers. Micro caps over the long term have been shown to deliver strong returns and outperform all other market-cap asset classes.

Other advantages of micro caps: Their lack of analyst coverage makes it possible to gain an informational advantage. Active micro cap managers add more value than active small-cap managers. They offer greater potential for growth and acquisition. And insider ownership tends to be high, helping align the interests of shareholders and company management.

Besides the time-tested advantages, recent market analytics add still other positive factors:

Shift in market cap focus: While technically a subset of small stocks, micro caps effectively are in an asset class of their own since small-cap managers increasingly focus on the higher end of the capitalization range. The average market cap (price per share of a stock times the number of shares outstanding) for small-cap stocks has doubled in the past 12 years, to nearly $1.4 billion. With asset managers focused on a higher cap size, micro cap managers have an expanded universe of under-researched stocks to choose from. Effectively, micro caps are the small caps of 15 years ago.

Access to nimble managers: Regardless of how enticing this category may be, success is predicated on having access to top managers at a reasonable cost. Active managers of separate accounts have proven particularly adept in recent years, even when the collective micro cap performance has lagged. Active separate account managers outperformed the Russell Microcap Index by an average 2.6 percentage points per year (net of fees) over the past 10 years while charging an average annual management fee of 1.2 percentage points. This is better than active micro cap mutual funds, which outperformed by an average 1.7 percentage points per year while charging an average 26 percent more in annual fees.

Growing need for excess returns: Widespread expectations of more modest equity returns in the years ahead make it increasingly important to find excess returns within your investments. Unconventional monetary policies carried out by the Federal Reserve and global central banks in recent years have boosted asset prices at the expense of future returns.

If micro caps are so great, you may ask, why do some of the biggest investors steer clear of them?

Institutional investors, who comprise more than two-thirds of the market, shy away for several reasons: The costs of analyzing very small companies cannot be justified; micro cap managers have limited capacity; there are so many that it would require a disproportionate share of their research time; and their limited size means their price can be easily moved by bulk share purchases and sales.

The absence of these large investors means less competition for those analyzing micro caps and a higher likelihood of providing greater risk-adjusted returns.

For all these reasons, we believe adding micro caps to portfolios is a timely investment in stocks that are under-followed and overlooked. We believe that micro caps provide opportunities to obtain growth where others are not looking or will not venture.

The material shown is for informational purposes only and should not be construed as accounting, legal, or tax advice.  Altair Advisers LLC is a registered investment adviser with the Securities and Exchange Commission; registration does not imply a certain level of skill or training.  While efforts are made to ensure information contained herein is accurate, Altair Advisers cannot guarantee the accuracy of all such information presented.