I’ve been a champion for microcaps for the whole of my investing career.  My affinity for undervalued, smaller capitalized stocks in large drove the success I have had investing in the stock market since the late 1980’s.  If you are a large cap investor, you mostly likely have not noticed that microcap investors over the course of the last several years had become disenfranchised due to the investment community’s overall lack of trust in the space, thus making it more of an impotent investment option for portfolio-driven wealth seekers, until now.

 

Photo by skys the limit2

For me and other avid microcap investors, being a proponent of microcaps has kind of been like rooting for your home team.  You always wear their jersey, regardless of their record, through the peaks and valleys, wins and losses.  You stand by your conviction that you’ve made the right choice to stay the path even though at times things may look hopeless or bleak.  You witness one group jumping ship from your team to the crowd favorite, while yet another group scoffs at your undying commitment.

Planet Microcap with Robert Kraft

Things are changing. To convey my position on the state of microcaps, I once again had a chance to speak with Robert Kraft of Planet Microcap, someone with whom I’ve developed a good relationship, given our mutual “team spirit.”  He had me revisiting some of the fundamental reasons why I continue to favor microcap stocks, and picked my brain on some of the catalysts that have recently driven these stocks to healthily outperform the major indices.

He was already aware that in 2015 I thought that the micocap space was starting to heat up, but even leading into the first half of 2016, the stocks that I followed were not living up to their potentials.  It was taking a lot of time for stocks to react to good news, and the lack of liquidity in microcaps resulted in very muted performance profiles.

To say that being a stock picker in the microcaps has been challenging is an understatement.  Time horizons for investors have gotten a lot shorter. In the years prior to 2008, investors may have held stocks for up to 6 and a half years, while today that time horizon might be less than 6 months.  Add to that the volatility and general broad skepticism, and you get less money being invested in microcaps.

 See more on micro-cap investing from ValueWalk here

Enter Brexit

But things started to change during the last half of 2016, after the British exit from the EU, aptly (and for the sake of the press) named Brexit. A rotation of money into microcaps started to occur after it became evident that these stocks did not react as negatively to the event as larger cap companies that are exposed to global risks during what ended up being a post-Brexit 5% pull back.

However, microcaps were not yet out of the water.  There was still a capitulation of sorts prior to the US Presidential election that saw large percentage drops in some microcap stocks, with uncertainty taking front stage as the nation teetered between two candidates whose views couldn’t be farther apart from one another.  The experts implied that a Trump win would decimate the market.  Heck, I heard it so many times that even I started to believe it.  It was hard not to be cynical given the voice that I had whole-heartedly adopted over the course of the last several years calling for a much-awaited microcap revival that had still yet to fully surface.

Microcaps Finally Living Up to Their Potential?

Of course, now that you’ve seen what happened with the smaller indexes such as iShares Micro-Cap (IWC) and iShares Russell 2000 (IWM) after the election, we can with some degree of confidence attribute this historic market rise to the domestic policy overhaul that Trump wants to implement across the board.  Companies are even holding their gains and starting to raise money – a very healthy sign that fundamental investment has once again entered the picture.  I am optimistic that this trend has the potential to continue into 2017.  Even though over the last couple of years it has been an overall tough time to be a full-time microcap investor, a survey I recently published on Twitter illustrates that there is interest in these stocks, a near 50/50 split, and a stark contrast to decreased popularity that has plagued the space.

Healthy Market

Robert was curious as to how I gauged the health of the market.  I tend not to complicate things, staying away from technical triggers for the most part.  In my view, a healthy market is one that consists of good earnings reports and investors who find and pick up shares in these companies.  There are positive reactions to healthy fundamentals. In other words, investors care about the health and outlook of the companies they are investing in. Imagine that.

Of course, we’ve seen stocks with no technical issues to speak of accrue healthy gains over the course of longer periods of time, only to lose most of those gains in a few days.  So as much as it pains me, it goes without saying that this is enough reason to maintain a guarded attitude towards the space, and even the market as a whole.

Reversion to the mean

History has shown us the word “forever” won’t be found in any investment dictionary.  When things seem bad, you can count on a catalyst to turn things around.  In the case of microcaps, we expect safe money to flow into the space in the face of chaotic global triggers – oil price uncertainty, currency fluctuations, interest rate hikes – most of which are bad for larger caps’ balance sheets.

It would have been nice to see increased stability, excitement and institutional investments come into microcaps a little earlier in the transition from 2015 to 2016.  Heading into mid-2016, we started to see private equity firms and hedge funds, who are typically activists investing in larger caps, make their way down the food chain to smaller companies.  This tells you that eventually, undervaluation does not go unnoticed.  On a positive note, this gives microcaps steam going into 2017 as I strongly believe that we will see these firms play a bigger role in the companies that I, my company and my peers follow.  When merger activity becomes evident, and I believe this is a real possibility, this is when the true representation of value will come to light in some undiscovered and underfollowed microcaps.

Winning Characteristics

It drives me crazy when companies mismanage their businesses and don’t treat shareholders the way they should. Companies that have winning characteristics have management teams that understand how to run their businesses and can clearly communicate this to their investors.  The maximization of shareholder value comes naturally in the process of running the company responsibly.  Companies like this should fare well in any market environment.  Take for example a company that performs well in an underperforming sector.  Much of this can

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