Factor Investing

Factor Investing In Micro & Small Caps

Treasure Hunting in the Wild West of Equity Markets

This research note was originally published by the CFA Institute’s Enterprising Investor blog. Here is the link.

Get The Full Warren Buffett Series in PDF

Get the entire 10-part series on Warren Buffett in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.

We respect your email privacy

Q3 hedge fund letters, conference, scoops etc

SUMMARY

  • Micro caps are commonly perceived as highly risky, but potentially also highly rewarding
  • Smalls caps generate more attractive risk-return ratios than micro caps on index level
  • Focusing on factors improves risk-adjusted returns across market cap segments

INTRODUCTION

FAANG stocks like Apple (AAPL) are covered by dozens of highly trained financial analysts. Galaxy Gaming (GLXZ), on the other hand, is followed by exactly zero analysts.

Galaxy Gaming who?

Galaxy Gaming, which produces table games and betting platforms for the casino industry, has a market capitalization of $50 million and trades over the counter (OTC). Unfortunately for such companies, analyst coverage of US stocks has been steadily decreasing since the 2000s due to tighter Wall Street regulations, among other factors.

But the lack of analyst coverage might offer alpha-generating opportunities. Could the less-covered areas of the equity markets be worth an extra look?

Although analyzing thousands of micro- and small-cap stocks by hand is not a sensible strategy, investors can apply systematic frameworks to uncover hidden gems. So does factor investing in micro- and small-cap stocks in the United States offer any additional alpha?

METHODOLOGY

To find out, we divided the US equity market into three segments based on market capitalization. Together these three segments approximate the Russell 3000 universe:

  • Micro caps include about 800 stocks, each with $100 million to $500 million in market capitalization.
  • Small caps feature about 400 stocks with $500 million to $1 billion in market capitalization.
  • Mid and large caps have market capitalizations in excess of $1 billion and number about 1,800 stocks in total

We created market cap-weighted and equal-weighted indices as well as three equal-weighted factor portfolios composed of the top 10% of stocks ranked by each factor. We define Value as a combination of price-to-book and price-to-earnings multiples and Quality as a combination of return-on-equity and debt-over-equity. Momentum is measured by the performance over the last 12 months, excluding the most recent month. The indices are rebalanced quarterly and the factor portfolios monthly.

Transaction costs are 1% for micro caps, 0.5% for small caps, and 0.1% for mid and large caps. Since shorting micro- and small-cap stocks is expensive and frequently impossible, we focused on long-only portfolios.

FACTOR INVESTING IN MICRO CAPS

The small-cap companies generally come in two varieties: a small number of firms that recently went public and a large cohort whose businesses are in decline.

The characteristics of the universe are reflected by the performance of the Quality portfolio, which successfully reduces exposure to less healthy companies by focusing on profitable and lowly levered stocks. Cheap companies also outperformed the indices, while the Momentum portfolio underperformed post-2009, reflecting the severe Momentum crash that followed the financial crisis.

Factor Investing

Source: FactorResearch

FACTOR INVESTING IN SMALL CAPS

Small caps generated more attractive returns than micro caps from 2000 to 2018. Only the Value portfolio outperformed the indices, with most of the outperformance coming between 2000 and 2003, when the tech bubble imploded. Cheap stocks were unpopular during the tech bubble but rebounded significantly thereafter.

Factor Investing

Source: FactorResearch

FACTOR INVESTING IN MID & LARGE CAPS

The mid-and large-cap universe is composed of mostly successful companies. As with micro and small caps, only cheap companies outperformed the indices. It is worth noting that the factor performance across market caps is relatively homogenous, which partially depends on the starting point of the analysis.

Factor Investing

Source: FactorResearch

COMPARISON ACROSS MARKET CAP SEGMENTS

Analyzing the returns across the different market-cap segments yields the following takeaways:

  • Index returns were highest for mid and large caps when weighted equally (EW), but highest for small caps when weighted by market cap (MW).
  • Micro caps did not generate attractive returns at the index level regardless of the weighting methodology.
  • CAGRS from the Value factor portfolio increased linearly with market capitalization. This is likely because the Value rebound after the tech bubble was stronger in mid and large caps.
  • The Quality factor is most effective in micro caps, successfully screening out the deteriorating businesses.
  • Momentum was impacted by the Momentum crash of 2009 across market cap segments.

Factor Investing

Source: FactorResearch

Returns can be normalized by transforming them into risk-return ratios. This demonstrates factor investing works just as well with mid and large caps as it does with small stocks.

Other researchers have shown that small caps generate the largest factor returns. Why do our results differ? Probably because we have different definitions of the market-cap segments, lookback periods, and transaction cost assumptions.

Factor Investing

Source: FactorResearch

FURTHER THOUGHTS

Fortunately for most investors, our results demonstrate that factor returns are not exclusive to smaller companies.

So as alluring as they may be, US micro-caps — the Galaxy Gamings of the world — can safely be ignored.

RELATED RESEARCH

FACTOR RETURNS: SMALL VS LARGE CAPS

ABOUT THE AUTHOR

Nicolas Rabener is the Managing Director of FactorResearch, which provides quantitative solutions for factor investing. Previously he founded Jackdaw Capital, an award-winning quantitative investment manager focused on equity market neutral strategies. Before that Nicolas worked at GIC (Government of Singapore Investment Corporation) in London focused on real estate investments across the capital structure. He started his career working in investment banking at Citigroup in London and New York. Nicolas holds a Master of Finance from HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100km Ultramarathon, Mont Blanc, Mount Kilimanjaro).

Connect with me on LinkedIn or Twitter.

Article by Factor Research


Saved Articles
X
TextTExtLInkTextTExtLInk

The Life and Career of Charlie Munger

Charlie is more than just Warren Buffett’s friend and Berkshire Hathaway’s Vice Chairman – Buffett has actually credited him with redefining how he looks at investing. Now you can learn from Charlie firsthand via this incredible ebook and over a dozen other famous investor studies by signing up below:

  • Learn from the best and forever change your investing perspective
  • One incredible tidbit of knowledge after another in the page-turning masterpiece of a book
  • Discover the secrets to Charlie’s success and how to apply it to your investing
Never Miss A Story!
Subscribe to ValueWalk Newsletter. We respect your privacy.

Congrats! Are you a smart person?

We have an exclusive targeted for being a sophisticated and loyal reader.

Sign up for ValueWalkPremium today and get our exclusive content for 35% off.

Use coupon code vip19 or click on the button below

Limited time offer only ENDS 12/31/2019 or after next 25 subscribers take advantage whichever comes first – please do not share this discount with others

 

0