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Although there are many reasons to consider micro-cap stocks, they’re not for everyone, especially investors who lack patience.

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A new year is a great time for advisors to explore new approaches for driving better investment outcomes. That’s why they should consider publicly held micro-cap companies as part of their investment strategy in 2021. This asset class is one of the least efficient areas of the equity markets and warrants a deeper look given its potential to generate outsized returns.

Burgeoning, publicly traded micro-cap companies provide a viable alternative to private equity, which has become a major component of institutional and high-net-worth investors’ portfolios. They have much in common. Both asset classes provide access to early-stage growth companies, management teams with substantial personal investments in their firms and added returns captured from an illiquidity premium.

So, why don’t micro-caps attract the outsized attention they deserve?

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There simply isn’t an audience paying attention to them. The analyst community is mostly dedicated to serving institutional investors, which ignore micro-caps because these businesses cannot accommodate the size of investment required by large asset managers or pension funds. As a result, the investor following is small and the ecosystem is misunderstood.

Even small-cap asset managers tend to ignore the micro-cap market, which doesn’t require a separate portfolio allocation from most institutions. Instead, they favour the larger half of the small-cap market – or, more aptly, the mid-cap market – particularly as their assets under management grow. In other words, investment funds must allocate capital into bigger small- to mid-cap stocks because they’re the only areas of this market large enough to absorb substantial pools of capital efficiently. In turn, they ignore micro-caps in the process.

Consider Information Services Corp. (ISV-T), a growing, profitable and highly free cash-flow generating company that provides registry and information management services for public data and records, primarily on behalf of the Province of Saskatchewan under a 20-year master service agreement.

The company, which Fax Capital Corp. holds in its portfolio, has a market cap of roughly $350-million and represents a world-class, growth-oriented infrastructure asset that’s highly coveted by private infrastructure investors. Most portfolio managers aren’t aware that this Canadian-listed company is a global leader and may look past it simply because of minimum market cap requirements or liquidity concerns.

Furthermore, even though micro-caps have many similarities to private equity, they have notable advantages over those holdings.

To begin with, even though micro-cap public equities are less liquid than their large-cap counterparts, they are still more liquid than private equity, thereby creating greater investment flexibility.

They can also be less risky. Private equity-backed businesses rely on substantial amounts of debt as a critical component of their investment returns, which can carry additional risks when compared to listed micro-cap companies that tend to employ a more conservative capital structure.

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According to Bain & Co. Inc.’s Global Private Equity Report 2020, 75 per cent of all private equity buyout transactions had a leverage multiple greater than six. Almost no investible public company carries anywhere near that amount of financial risk.

In addition, performance reporting for illiquid private equity investments isn’t as transparent. That’s much less of a concern for publicly traded micro-caps, which are subject to strict disclosure requirements and have years of financial and operating performance information available to investors.

There are also advantages in terms of how these two asset classes differ, particularly in terms of capital flows. Roughly three-quarters of all Canadian publicly listed companies fall into micro-cap territory and have a market cap of $400-million or less, which illustrates the sizeable breadth in this part of the market. Yet, the amount of institutional capital dedicated to Canadian small-cap strategies has declined by 19 per cent since 2014.

Conversely, private equity continues to attract capital at a faster rate than financial sponsors can deploy it. According to the Bain & Co. report, private equity funds are sitting on a record US$2.5-trillion of unspent capital trying to find a home. That creates imbalances that favour the inefficiencies seen in the public micro-cap space, and the lack of dedicated capital coupled with the absence of investors’ attention results in valuations that often do not reflect the intrinsic value or growth potential of the underlying assets.

To be clear, investing in micro-cap stocks isn’t for everyone, especially investors who lack patience. You need to be able to stay invested for the long run. Permanent capital is ideal for investing in this space because it provides the time commitment necessary for smaller companies to scale, which can lead to significant multiple expansion. That’s the value.

Blair Driscoll is director and chief executive officer at Fax Capital in Toronto.

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