Architects can reveal stunning vistas and create stimulating environments when they put ceiling-to-floor windows in office buildings. It's 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 inspired more than a touch of vertigo. Some investors suffer from a similar sort of nausea when thinking about buying microcap stocks. It was curiosity about this shunned segment of the market that drew me to the edge of the abyss to do a little back-testing.
My ascent into madness was inspired by a recent paper called Microcap as an Alternative to Private Equity by O'Shaughnessy Asset Management's Chris Meredith, CFA, and Patrick O'Shaughnessy, CFA. They argue that pension funds should invest in small companies via the public markets rather than via private equity firms.
The potential benefits of microcaps over private equity funds include better liquidity and lower fund fees. Naturally, by making these points the authors are talking up their firm's offerings. But they also include findings that are of interest to small stock aficionados along the way.
For instance, they ran a series of back-tests in the U.S. microcap space using several composite rankings. Their value composite combines rankings based on shareholder yield along with those based on sales, earnings, free cash flow and EBITDA multiples. (EBITDA represents earnings before interest, taxes, depreciation and amortization.) Similarly, their momentum composite combines rankings based on relative performance over the past three to nine months. To get a picture of the broad market they used their method to pick U.S. stocks with market capitalizations in excess of $200-million (U.S.).
The cheapest 10 per cent 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 per cent of momentum stocks provided an average annual return boost of 4.1 percentage points over the same period. That is, value and momentum worked well in the broad market.
The returns were even larger when the same approach was applied to microcap stocks with market capitalizations from $50-million to $200-million. In this case the cheap value stocks outperformed by an average of 10.1 percentage points annually and the strong momentum stocks outperformed by 6.3 percentage points annually.
The U.S. numbers sound enticing, but I wanted to test a similar – but simpler – approach in Canada. My back-test started with TSX-listed stocks in similar range of market capitalizations from about $50-million to $200-million (Canadian). Each year 20 stocks with the lowest price-to-earnings ratios were selected. Those with the lowest returns over the prior year were discarded and the 10 remaining stocks with the best prior returns were purchased, held for 12 months, and then the whole process was repeated.
My simple approach generated average compound returns of 21 per cent (without trading frictions) from the start of 2000 to the end of 2016. By way of comparison, the S&P/TSX composite index gained an average of 6.1 per cent over the same period.
Before you become entranced by the big theoretical returns you should know that it wasn't all roses for the microcap stocks. They fared poorly in the 2008 downturn and lost an average of 46 per cent, which eclipsed the 33 per cent decline experienced by the market index that year. It's something to keep in mind if you're inclined to chase after small stocks in what is now an aging bull market.
I was also a little leery of providing a recent list of such stocks due to their risky nature. But, despite my misgivings, the brave and the curious can find the 10 stocks that passed the low-P/E plus momentum test this week in the accompanying table.
It is important to be extraordinarily cautious when it comes to microcaps. Care needs to be taken when trading them and each one has to be examined extensively before purchase. It's an area that is, frankly, best left to very experienced investors.
Even then, if volatility makes you woozy or you're prone to panic during downturns, then microcaps should be avoided in much the same way as an acrophobe avoids sitting next to windows in tall buildings.
Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.