Architects can show stunning vistas and create stimulating environments when they place ceiling-to-floor windows in office buildings. It is something I experienced this week while pecking away at a Bloomberg terminal perched next to such a window.
Peering down at the city from 15 storeys up motivated more than a bit of vertigo. Some investors have problems with a similar kind of nausea when considering purchasing microcap stocks. It was fascination with this shunned segment of the marketplace which drew me into the edge of the abyss to perform a small back-testing.
My ascent into insanity was motivated by a recent paper Named Microcap as an Alternative to Private Equity by O’Shaughnessy Asset Management’s Chris Meredith, CFA, and Patrick O’Shaughnessy, CFA. They assert that pension funds should invest in smaller businesses via the public markets instead of via private equity businesses.
The potential advantages of microcaps over private equity funds include better liquidity and reduced finance fees. Naturally, by making these things the authors are speaking up their company’s offerings. But they also have findings that are of interest to small stock aficionados on the way.
As an example, they conducted a series of back-tests from the U.S. microcap space using several composite positions. Their worth composite combines rankings based on shareholder yield combined with those based on earnings, earnings, free cash flow and EBITDA multiples. (EBITDA represents earnings before interest, taxes, depreciation and amortization.) Likewise, their momentum composite combines rankings based on comparative performance over the previous three to nine months. To get a picture of the broad market they used their way to select U.S. stocks with market capitalizations in excess of $200-million (U.S.).
The cheapest 10 percent of stocks based on the value composite outperformed the market by an average of 5.7 percentage points annually from 1969 to 2016. The top 10 percent of momentum stocks provided an average yearly yield rise of 4.1 percentage points over the same period. In other words, momentum and value worked well in the wide market.
The returns were even bigger when the identical strategy was applied to microcap stocks with market capitalizations from $50-million to $200-million. In cases like this the inexpensive value stocks outperformed by a mean of 10.1 percentage points annually as well as the powerful momentum stocks outperformed by 6.3 percentage points annually.
The U.S. numbers seem enticing, but I wanted to test a similar — but easier — strategy in Canada. My back-test began with TSX-listed stocks in similar assortment of market capitalizations from about $50-million to $200-million (Canadian). Every year 20 stocks with the lowest price-to-earnings ratios were chosen. Those with the lowest yields over the previous year were lost and the 10 remaining stocks with the greatest prior returns were bought, held for 12 weeks, and then the entire process was repeated.
My simple strategy generated average compound yields of 21 percent (without trading frictions) by the beginning of 2000 to the end of 2016. By means of contrast, the Samp;P/TSX composite index gained an average of 6.1 percent over the same period.
Before you become entranced by the massive theoretical yields you should understand that it was not all roses for the microcap stocks. They fared badly in the 2008 recession and dropped an average of 46 percent, which eclipsed the 33 percent decline experienced by the industry index that year. It’s something to remember if you are inclined to chase after little stocks in what is currently an aging bull market.
I was also a bit leery of supplying a recent collection of such stocks because of their risky nature. However, despite my misgivings, the courageous and the curious can get the 10 stocks that passed the low-P/E and momentum test this week at the accompanying table.
It’s essential to be extraordinarily cautious in regards to microcaps. Care has to be taken when trading them and every one must be examined extensively before buy. It’s a place which is, honestly, best left to experienced investors.
Even then, if volatility makes you woozy or you are prone to panic during downturns, then microcaps should be avoided in much the same manner as an acrophobe stops sitting alongside windows in tall buildings.
Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.