How To Implement A True Microcap Strategy That Works – Data Driven by Tim du Toit, Quant Investing

In March 2016 Jim O’Shaughnessy (O’Shaughnessy Asset Management) published an interesting research paper called A True Microcap Strategy.

The paper made a really convincing argument for investing in microcap companies (for exact returns continue reading), it is also the strategy they follow in their Micro Cap investment strategy.

Microcap Strategy
Photo by stevepb (Pixabay)

What is a microcap company?

In the paper Jim defined a microcap companies as companies with a market value of between $50m and $200m.

As a private investor microcaps are one of the few market areas where you have an advantage over fund managers and other large investors, because these companies are simply too small for them to be able to invest a meaningful amount of money in.

They are also never mentioned in the media which also keeps then under the radar of most investors.

For example, when was the last time you heard anybody on television or a popular website speak or write about a company with a market value of less than $200 million.

It simply doesn’t happen.

Why are microcap companies attractive?

These are the reasons Jim gave why microcap companies can give you consistent long term market beating returns:

  • Little or no research published on these companies
  • Investment and hedge funds can’t invest in these companies because they are just too small. An investment in microcap companies is too small to make a difference to their returns.
  • In the past microcap companies have proven to be the highest source of market outperformance in the US markets.
  • Because these companies get so little interest from investors they very often trade a lot lower than what they are really worth.
  • Because there are such a large number of microcap companies they are ideally suited to a quantitative investment process.
  • Other research Jim has done has shown that microcap companies are a good alternative to private equity investments.
  • Microcap companies are very good takeover candidates as proven by more than 17 companies in Jim’s microcap portfolio that have been taken over between 2012 and 2016.

Also if you follow a microcap strategy it doesn’t mean that your portfolio is illiquid. Jim found that these companies trade enough for you to buy and sell on a daily basis.

How many microcap companies are there?

When Jim published the research paper in March 2016 he calculated that they were 1,108 microcap companies in the US. The market value of all these companies together was less than the market value of Pfizer alone.

Apart from the USA the screener database has a total of 5,563 companies with a market value of between $50m and $200m. And all these companies together have a market value of $22.6 billion.

Companies in the screener with a market value of between $50m and $200m

[I do not know why the screener shows 2665 microcap companies compared to the 1108 Jim mentioned. He may have referred to only quality microcap companies.]

Microcap Strategy Data Driven

Just 5% of the market value of Microsoft

$22.6 billion is only 5.2% of the market value of Microsoft Corporation, or equal to the market value of Devon Energy Corp. a company you have probably never heard of (I haven’t).

This just shows you why microcap companies are of no interest to large fund managers or hedge funds. They simply cannot invest a large enough amount of money in these companies.

This means they are perfect for private investors like you and me.

But how do you select high return market beating microcap companies you may be thinking?

Quality is very important

I’m sure if you’ve even just taken a slight interest in microcap companies you would have realised that a lot of these companies are really junk.

With junk I mean they have low or no profits, high debt, generate a low return on equity, have no or low earnings growth and have weak or no cash flow generation.

That’s why you must make sure that you only look at high quality companies.
Jim used the following ratios to find high quality microcap companies:

  • Change in debt
  • Net external financing
  • Return on Equity
  • One year earnings growth
  • Non-cash earnings to assets
  • Free cash flow yield

Do not worry if this looks intimidating. The screener makes it easy for you to find high quality microcap companies, you simply select the ratios and the screener shows you only high quality companies of which you can select the most undervalued.

But more on that later…

Value and momentum work well with small companies

After getting rid of low quality companies Jim used a few valuation and momentum ratios (he suggest you use more than two ratios for both) to select microcap companies to invest in.

To find undervalued companies he used:

  • Price to earnings
  • Price to sales
  • Free cash flow to enterprise value
  • EBITDA to enterprise value

He says that even though each of these ratios may not always work, the combination of ratios gives you the best indication that a company is cheap.

Momentum and volatility

To identify companies with good (upward moving) price momentum Jim used 3, 6 and 9 month momentum as well as 12 month return volatility to select companies with low price volatility (large up and down movements in price).

Does it work?

I have left the most important question for last.

Does Jim’s microcap strategy work?

Here is a summary of the back tests Jim did:

Microcap Strategy Data Driven

Source: O’Shaughnessy Asset Management

Buying the cheapest

Jim back tested investing in the cheapest 10% US microcap companies in the 45 year period between 1970 and 2015.

If you invested $10,000 in this strategy in 1970 in 2015, adjusted for inflation, your portfolio would have grown to $6.5 million.

That is total return of 64900% and an average compound yearly return of 15.5% which would have given you 650 times your original capital.

If you over the same period invested the same $10,000 in the most undervalued 10% of large companies your portfolio would have grown to only $1.5 million, a return of 14900% or annual compound return of 11.8%.

I am not sure of this S&P 500 return

Over the same 45 year period the S&P 500 returned 263.5% or 2.9% per year.

This looks quite low but Jim did not give the index returns and I could not find a better after inflation return calculator for the S&P 500. Please let me know if you have a better source.

Buying those with the best momentum

Jim also tested the microcap strategy if you only invested in companies with the highest price momentum.

If you invested $10,000 in a microcap high momentum strategy over the 45 year period from 1970 to 2015 your $10,000 investment would have grown to an inflation-adjusted $2.7 million.

That is total return of 26900% and an average compound yearly return of 15.5% which would have given you 270 times your original capital.

The same investment made in large companies with strong momentum grew to only $609,000 after inflation. That is total return of 5990% and an average compound yearly return of 9.6%.

Combining value and momentum

Jim

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