The Next Big Thing Could Be Really Small: An Introduction To Global Micro-Cap Stocks

Brandes Institute

Brandes Investment Partners

August 2014

Brandes Institute Research Paper No. 2014-06

 

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Abstract:

Global micro-cap stocks have provided greater diversification benefits and a more robust long-term value premium than small- and mid- to large-cap stocks. Among the features contributing to these benefits for micro caps worldwide:

  • a large, diverse universe with little sell-side research coverage
  • lower correlations between individual micro-cap stocks as well as other asset classes
  • a larger empirical value premium than other equity universes

Together, these attributes have created attractive opportunities for active managers. While some institutional investors have made moderate commitments to micro-cap stocks, the allocations have tended to be country or regionally focused. The opportunity set globally is vast and compelling.

The Next Big Thing Could Be Really Small: An Introduction To Global Micro-Cap Stocks

In this research report, the Brandes Institute and Metis Global Partners collaborate to explore the potential benefits of investing in global micro-cap stocks. Machel Allen, CFA, is President and Chief Investment Officer at Metis Global Partners and a member of the Brandes Institute’s Advisory Board.

It’s a Big, Small World

Th ere are more than 20,000 publicly traded companies around the world with a market capitalization of $50 million or greater. More than 60% of those companies are micro caps (companies with a market capitalization between $50 million and $500 million). As shown in Exhibit 1, the universe of micro-cap companies is nearly twice as large as the global small- to mid-cap stock universe, and more than six times as large as the large-cap universe.

However among micro caps globally, there tends to be little sell-side analyst coverage. Less than half of global micro-cap companies have any analyst coverage at all. For those that do, there are only three sell-side analysts on average providing coverage. Th is is far fewer than larger-cap companies around the world and likely stems from a lack of sufficient revenues for brokerage firms trading these small and sometimes illiquid companies to justify the commitment of research resources. While this lack of coverage certainly adds to the investor challenge of obtaining insightful or even necessary information, it may also create pricing inefficiencies to be exploited by fundamental investors.

Micro-Cap Stocks

Differences Between U.S. and Non-U.S. Micro Caps

While the opportunity set for micro caps worldwide is vast, it’s largely outside of the United States. Only 15% of global micro caps are U.S.-based companies vs. 35% domiciled in frontier or emerging countries and 50% in developed non-U.S. markets. See Exhibit 2.

Micro-Cap Stocks

Th ere are a number of key distinctions between U.S. and non-U.S. micro caps – and these differences highlight the attractive traits of micro caps outside the United States. Non-U.S. micro caps tend to be more mature and, on average, their fundamental characteristics have been more attractive. As shown in Exhibit 3, on the follwing page, non-U.S. micro caps have had higher returns on equity (ROE) and higher operating margins1 than U.S. micro caps. Additionally almost 60% of international micro-cap companies had positive 3-year free cash fl ow, debunking the myth that micro caps are largely start up or early stage growth companies.

Micro-Cap Stocks

Diversification differences are more attractive for micro caps outside the United States, as well. Th e top three industries for U.S. micro caps account for 28% of the U.S. universe: banks (13%); biotechnology (9%); and oil, gas & consumable fuels (6%). Among non-U.S. micro caps, no one industry accounts for more than 6% of the universe; the top three non-U.S. industries are metals & mining (6%); real estate management & development (5%); and electronic equipment, instruments & components (5%).2 Having an opportunity set that is well diversified with no one industry greatly influencing the performance of the overall universe, active investors may be better rewarded for pursuing high conviction allocations different than a market index with less concern for benchmark weights.

Micro-Cap Stocks

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