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[Correction: This article originally stated incorrectly that there wasn't an objective micro-cap benchmark until the launch of the Russell Microcap Index in 2005. In fact, Wilshire Associates launched the Wilshire Micro-Cap Index in 1996.]
It is largely accepted that markets become less efficient as total market capitalization declines. Small-cap stocks in general and micro-cap stocks in particular provide investors with a rich pool in which to attempt to generate excess returns. The primary advantage micro-cap investors have comes from the informational inefficiency. While the data for a smaller company is available since all public companies listed on regulated exchanges, large or small, have to file with the Securities and Exchange Commission, it takes effort and skill to synthesize the information necessary to determine whether or not a company is mispriced.
Micro-cap stocks, generally defined as those that range between a market capitalization of $50 million and $500 million, tend to be largely ignored by Wall Street analysts, so investors have to do their own fundamental analysis. Small companies also tend to have relatively simple business models with limited products and end-markets, however, which makes the task of evaluation somewhat less burdensome. Furthermore, while a company’s senior management won’t disclose nonpublic information, the CEO or CFO of a smaller company is more likely to actually pick up the phone and answer questions, as they are eager for exposure and recognition from the marketplace. For an investor, the increased likelihood of contact with a key decision-maker is just one example of an opportunity to develop superior insight on a stock.
For those willing to put in the effort, there are thousands of investment opportunities in the micro-cap space. Have managers been able to take advantage of the opportunity? The short answer is yes. Money managers that invest in the micro-cap space have consistently achieved better benchmark-relative results than their larger-cap-focused peers. In seven of the past nine very volatile years, the benchmark-relative excess return for the average micro-cap manager has exceeded that of small-, mid- and large-cap managers.
It is important to keep in mind that viewing the micro-cap space as a separate investment category is a fairly recent development, and there simply aren’t that many products that are categorized as micro-cap. The performance results in Figure 1 come from the “frozen” Russell universes, meaning they include only the performance of products that were actually in the universe at the time and not the backfilled results of the current members of the universe.
Since the launch of the Russell Microcap Index in 2005, approximately 30 managers have had their products included in the micro-cap manager performance universe each year, compared with only 15 in 2001. There are numerous theories as to why the market has been slow to more fully embrace the micro-cap space. For individual money managers, even if they are able to charge higher fees for a micro-cap product, it may not make economic sense for the firm to offer a product, as the available capacity should be quite limited due to the relative illiquidity of the space. Larger institutional clients, on the other hand, often find it difficult to invest enough money in the space to meaningfully impact their overall portfolio’s returns. The limited number of products included in the performance universe also reflects certain restrictions such as a minimum level of assets under management and that the product is fully invested.
As has been historically the case, the market’s most recent recovery has been led by micro-cap stocks. From the low of March 9, 2009, through the end of the first quarter of 2010, the Russell Microcap and small-cap Russell 2000 indexes have produced cumulative returns of 90.9 percent and 88.7 percent, respectively, and each has outperformed the large-cap Russell 1000 Index by 17.3 percent and 20.5 percent, respectively. Even in this environment, micro-cap managers have been able to add considerable value. As seen in Figure 2, there were clear longer-term advantages that could have been capitalized upon when invested in micro-cap stocks.
Of course, free lunches get eaten and there is certainly greater volatility in the Russell Microcap Index. However, the magnitude of the difference may be surprisingly small. The nine-year annualized standard deviation for the Russell Microcap Index is 26.2 compared with 23.4 for the Russell 2000 Index and 21.7 for the Russell Midcap Index. Interestingly, the longer-term risk-adjusted return is the same for the Russell Microcap and Russell 2000, and both exceed that of the Russell 1000.
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