Microcaps: Maximizing the Value of Active Management
Introduction
Factor investing is an investment discipline that involves focusing on specific drivers of returns. Factors can help improve portfolio outcomes, reduce volatility, and enhance diversification. Classic examples of Style Factors include Value, Momentum, Quality, Size, and Minimum Volatility.
While there is extensive research examining the efficacy of combining Value and Momentum (see citations), we found that the size of the stocks can have an impact on the potency of these factors.
While factors can be used across all market capitalizations, our research suggests that the inefficiencies in the Small cap and Micro cap space have historically provided the greatest opportunities to generate excess returns.
Value Factor
Value Investing is the process of identifying underpriced stocks based on their price compared to an accounting metric such as Earnings, Book Value, or Sales. For our study, we define Value as the stock’s price to book ratio. Stocks with a price below book value are generally considered cheap. Stocks trading for many times book value are considered expensive.
Over time, investors who bought cheap stocks have been rewarded. In general, cheaper valuations resulted in greater returns (Figure 1). We found that as the size of a stock decreases, the impact of the Value Factor grows. For large and mega-cap stocks, investors are rewarded with a 1% value premium compared to similarly sized stocks, while micro and small-cap stocks offer value premiums of 6% and 3%, respectively (Figure 2).
Momentum Factor
According to Sir Isaac Newton’s 2nd Law of Motion, objects in motion tend to stay in motion. This is true both in the physical universe as well as the financial markets. As opposed to Value Investing which tends to pick stocks that are out of favor, Momentum Investing is typically defined as buying stocks that already are winners.
As with Value, we found that this strategy has been effective across all market caps but again becomes more pronounced as the size of the companies decrease (Figure 3). For mega-cap stocks, investors are rewarded with a 4% momentum premium, while micro-cap stocks offer a momentum premium of 7% (Figure 4).
