The author lays out a case for investing in micro cap stocks, and using factor investing to implement. He shows that the common index used in asset allocation optimizations, the Russell Microcap Index, is not very representative. A simple factor screening on ‘quality’ would yield a much higher performing, more attractive asset class. Further tilts to value and momentum would produce even stronger returns. He presents data showing factor differentials of smaller caps are much more robust than in larger caps. Since micro caps is an inefficient and persistently alpha-rich space, I think it would behoove smaller investors to look more closely at this oft-neglected sub-asset class, especially from a factor perspective. This paper would be useful as a reference as to the general factors that the author’s employer, O’Shaughnessy Asset management, uses in its own quantitative (and smaller cap) portfolios.
- Russell Microcap Index is not “true” micro cap. Since Russell Microcap Index contains the 2000th – 4000th ranked names, and Russell 2000 Index contains the 1000th -3000th ranked names, there is a roughly 90% overlap. This was purposely designed to minimize index churn. but leads to a 0.95 correlation between the two indices.
- Since the tail of micro caps are very illiquid and have high transactions costs, applying a $100K average daily volume cutoff improved returns by 0.8% (from 1982 to 2016).
- For the trailing 34-year period to 2016, micro caps have underperformed large caps to such an extent that in common asset allocation optimization, there would be no weight assigned to micro caps (and just a marginal weight to small caps).
- Three broad categories:
- New Ventures (~25%): startups (mostly biotech and software); either boom or bust; on average low returns and high risk
- Steady State (~60%): stable revenue-generating companies; many community banks; best overall performers
- Fallen Angels (~15%): distressed larger companies that have fallen in value; in general moderate performance
- By adjusting for quality (earnings quality, financial strength, earnings growth), the performance of micro caps increase 5.3% annually, with a Sharpe Ratio on par with large caps.
- Factor screening is much more effective in smaller cap stocks. Factor spreads (highest decile minus lowest decile) is 2-4 times higher in micro caps than in large caps. Value > momentum > earnings growth > financial strength.
- Three structural constraints supplying persistent alpha:
- Smaller free float: more insider block owners
- Low trading volume: prohibitive for large active managers; dollar volume 250x greater in large caps
- High transactions costs: commissions, market impact, bid-ask spread; micro caps ~100-200+ bps > large caps ~5bps
Finished: 19-Mar-2019. Rating: 6/10.