segments, as shown in Table 3-2.
The volatility of micro caps looks favorable when comparedto  the  volatility  of  small,  mid,  and  large  cap  stocks  as  well  asbonds. When adjusted for the Sharpe ratio, they move into a tiefor  first  place  with  mid  cap  stocks,  delivering  more  return  foreach unit of risk than any other equity asset class over the last 20,10, and 5 years. So micro caps can provide very competitive long-term  historical  rates  of  return  on  both  an  absolute  and  a  risk-adjusted basis.
Although micro caps provide a performance advantage overtheir  larger  cap  counterparts  over  time,  there  are  clearly  peaksand  troughs  in  their  performance.  It  is  important  to  be  awareof  these  micro  cap  cycles  because  investing  at  cyclical  peaks can substantially reduce the return profile over short and inter-mediate time horizons. The cyclical nature of micro caps is best 
12035_Imperiale_c03.f.qxd  11/24/04  9:20 AM  Page 36
namheL
sdnoB
paC
llamS
ygolonhceTgnigremE
etagerggA
0002llessuR
etisopmoCqadsaN
paCegraL
005P&S
erihsli
W
paCorciM
nruteR
launnA
noitaiveDdradnatS
nruteR
launnA
noitaiveDdradnatS
nruteR
launnA
noitaiveDdradnatS
nruteR
launnA
noitaiveDdradnatS
nruteR
launnA
noitaiveDdradnatS
69
.
39
.
79
.
88
.
.
501
.
111
.
722
.
132
.
992
.
611
.
511
34
.
.
491
.
802
.
533
17
.
07
.
.
23−
.
461
.
071
.
612
.
721
39
.
.
60−
.
641
.
121
.
212
.
321
.
711
46
.
emT
i
doireP
2002–3891
2002–3991
2002–8991
sdnoB
dna
skcotS
fo
ytilitaloVdna
snruteRevitarapmoC
-
23ELBAT
36
                          12035_Imperiale_c03.f.qxd  11/24/04  9:20 AM  Page 37
Micro Cap Stocks as an Asset Class
37
measured  by  comparing  the  performance  of  micro  caps  to  theperformance of large cap stocks such as the S&P 500. When look-ing back, it appears there have been nine outperformance cyclessince  1926.  As  can  be  seen  in  Table  3-3,  during  the  nine  cyclesmicro  cap  stocks  have  provided  gains  slightly  twice  those  oflarger stocks. These outperformance cycles have lasted on aver-age about four years, with the shortest cycle lasting about a yearand a half and the longest cycle being over nine years in duration.The downward cycles can be more pronounced and tend tolast  longer  than  the  outperformance  cycles.  During  downturns,micro  caps  have  declined  an  average  of  6.5  percent  per  year,while large stocks have gained on average about 5 percent. Thisaverage  performance  gap  of  1,150  basis  points  can  be  painfulbecause  on  average  it  lasts  for  nearly  five  years.  Although  itshould  be  noted  that  during  half  of  these  underperformancecycles, micro caps actually provided positive investment returns,they were just lower returns than those of large cap stocks. Thisdata  is  also  slightly  skewed  because  of  the  very  large  and  longdeclines of the great depression and the micro cap bear market ofthe  early  1970s.  Nonetheless,  the  data  show  that  there  are  verylong periods when micro caps behave very differently than theirlarger stock cousins.
Due to the volatility of the micro cap sector, there are oftensome  short,  sharp  corrections  within  both  outperformance  andunderperformance cycles. These short changes in relative perfor-mance  tend  to  last  about  four  months  and  are  often  correlatedwith  broader  market  dips.  In  these  instances,  stocks  in  generaltend  to  be  in  a  downturn,  and  small  stocks  tend  to  suffer  by  agreater magnitude than large stocks.
It is critical to remember that time is an important ally in theinvestment process. A dollar invested in micro caps in 1926 wouldhave grown to $5,865 by the end of 2002, while the same dollarinvested in the S&P 500 would have grown to $1,226. This is a dra-matic result and has the effect of showing some very deep bearmarkets  as  well  as  the  subsequent  rebounds  from  those  deeptroughs.  But  as  seen  in  Table  3-4,  the  historical  probability  ofmicro  caps  outperforming  large  caps  is  quite  high  as  time  hori-zons expand.
As noted, in over 78 percent of the rolling 120-month periodssince 1926, micro cap stocks have outperformed their large cap
12035_Imperiale_c03.f.qxd  11/24/04  9:20 AM  Page 38
snruteRetulosbA
lautcA
orciM
llamS
paCdiM
egraL
ll
A
launnA
pacorciM
noitaruD
skcotSpaC
skcotSpaC
skcotS
skcotS
skcotS
nruteRevitaleR
nruteRevitaleR
sraeYni
doireP
emT
i
2002–6291
,selcyCecnamrofreptuOskcotS
paCorciM
-
33ELBAT
.
128
.
227
.
165
.
146
.
155
.
943
.
003
.
023
46
.
.
184
.
065
.
184
.
515
.
555
.
874
.
052
.
472
.
892
34
.
.
483
.
334
.
963
.
534
.
625
.
324
.
381
.
322
.
372
21
.
.
023
.
292
.
832
.
873
.
444
.
182
88
.
.
411
.
461
.
60−
.
122
.
613
.
962
.
593
.
364
.
903
.
911
.
441
.
791
30
.
.
642
.
483
.
753
.
911
.
421
.
481
.
502
.
631
.
301
.
212
.
302
.
6393
.
2582
.
591
.
641
.
352
.
5851
.
0912
.
583
.
4551
.
5541
94
.
44
.
61
.
21
.
31
.
15
.
19
.
33
.
05
.
04
.
5591yraurbeF–4591yraunaJ
9591hcraM–7591rebmeceD
9691yraunaJ–4691yraunaJ
3891yluJ–4791yluJ
4991yraurbeF–0991rebmevoN
2002rebmeceD–8991yraunaJ
egarevA
6491yaM–2491yraunaJ
1591yraunaJ–9491yluJ
7391hcraM–2391yaM
.oC&redorhcS
dna
,.cn
I
,nalpnU
i
:ecruoS
38
                                       12035_Imperiale_c03.f.qxd  11/24/04  9:20 AM  Page 39
Micro Cap Stocks as an Asset Class
39
TABLE 3-4 Probability of Micro Cap Stocks Outperforming Large Cap Stocks,
Rolling Return Periods, 1926–2002
Rolling Periodin Years
Probability ofOutperformance
20
15
10
5
3
1
98%
89%
78%
54%
39%
21%
cousins. Even dropping down to any given rolling five-year period,the odds are still better than even that the micro cap sector willoutperform.  If  an  investor  is  willing  to  make  a  20-year  commit-ment, there are only four observations out of 224 rolling 20-yearperiods,  where  the  return  on  micro  cap  stocks  was  lower  thanthat  of  large  caps.  This  translates  into  a  better  than  98  percentprobability  that  over  any  given  20-year  period,  micro  caps  willoutperform large cap stocks.
Economic Linkage
The remaining issue from a portfolio construction point of view iscorrelation. How do micro caps behave relative to other availableinvestment asset classes?
VENTURE CAPITAL AND PRIVATE EQUITY
Private equity or venture capital is an asset class that large invest-ment institutions have formally embraced as part of their portfo-lios  for  the  past  50  years.  Among  institutional  investors,  it’s  nosecret that high-quality private equity deals provide an excellentlong-term  return  on  investment  as  well  as  significant  portfoliodiversification characteristics.
The  two  principal  components  of  venture  capital  investingare focused on venture strategies and buyout opportunities. The
12035_Imperiale_c03.f.qxd  11/24/04  9:20 AM  Page 40
40
THE MICRO CAP INVESTOR
growth  of  assets  available  to  fund  smaller  fast-growth  privatecompanies  has  been  the  principal  focus  of  venture  capitalinvestors for the past decade. The surge in the flow of dollars intothe private equity or venture capital arena has been stunning overthe past decade (see Figure 3.4).
The  opportunity  to  earn  high  returns  from  getting  in  on  theground  floor  of  new  ventures,  particularly  those  with  the  neweconomy at their core, has attracted much of this capital. Many ofthese venture capital opportunities will ultimately find their wayinto  the  public  markets  as  a  source  of  liquidity  for  the  venturecapital community.
Even though the stories of high returns have gained the atten-tion of investors and the public, the information available on pri-vate equity deals continues to be elusive. As the name connotes,information about private equity returns and asset values is typi-cally  private  and,  as  a  result,  difficult  to  obtain  and  relativelyunreliable.  Compare  this  with  the  public  markets,  particularlylarge capitalization stocks, where disclosure is broad and liquid-ity is good. This public/private information disparity makes it dif-ficult to draw comparisons of public and private assets. However,there  are  many  similarities  between  private  equities  and  themicro cap market, where the flow of information and liquidity aremuch more modest and resemble those of private investing ratherthan large cap investing. The similarities in information flow andliquidity create a linkage between the private equity market andthe micro cap market.
FIGURE 3.4 Venture capital funds raised.
12035_Imperiale_c03.f.qxd  11/24/04  9:20 AM  Page 41
Micro Cap Stocks as an Asset Class
41
MICRO CAP VERSUS VENTURE CAPITAL
In  many  ways,  the  story  of  venture  capital  is  the  story  of  com-merce  itself.  Every  venture  capitalist  will  tell  you  that  the  busi-ness begins in the fifteenth century, when Christopher Columbussought  to  travel  westward  instead  of  eastward  from  Europe  toreach India. His visionary idea did not find favor with the king ofPortugal, who refused to finance his venture. After visiting manymerchant banks, Queen Isabella of Spain decided to “fund” himfor  his  venture.  And  so  the  story  goes:  The  concept  of  venturecapital was born.
The  modern  venture  capital  industry  as  we  know  it  todaybegan taking shape in the post–World War II era. In 1946, Ameri-can  Research  and  Development  Corporation  was  founded  withthe explicit goal of making investments in promising new compa-nies. They evolved the basic business model for the venture capi-tal industry. Their venture capital investment in Digital Equipmentprovided them with an astounding 101 percent annualized returnon investment. Suddenly, many large capital pools embraced theidea of allocating a portion of their investment capital into newbusiness ventures.
In the mid-1950s, the U.S. government recognized the need forrisk capital and promoted small business investment companies(SBICs).  This  gave  rise  to  an  entire  era  of  public  SBICs  thatinvested  shareholder  capital  into  small  private  ventures.  In  thelate 1960s, the SBIC industry followed the seven-year slump of theU.S.  stock  market,  and  most  of  the  small  business  investmentsthey made also failed. The situation began to look up in the late1970s, based on a massive reduction in the capital gains tax rateand a number of high-profile IPOs by venture-backed companiessuch as Federal Express and Apple Computer.
The public market valuations for small and micro cap firmssend  a  signal  to  the  private  equity  investor  about  whether  themarkets  are  ready  and  able  to  absorb  new  IPO  opportunities.The  IPO  is  potentially  the  most  lucrative  exit  strategy  for  theventure capitalist. If the expectation in the small and micro caparena is of multiple expansions, venture capitalists have a directmarket  signal  to  be  more  aggressive  in  raising  and  cultivating
12035_Imperiale_c03.f.qxd  11/24/04  9:20 AM  Page 42
42
THE MICRO CAP INVESTOR
opportunities that will ultimately appear in the public markets.This  creates  a  certain  boom-and-bust  cycle  that  is  an  accuratebarometer of the outlook for both venture capital and micro capinvestments.
Venture capital investing is a long-term proposal. The typicalholding period for a private venture capital investment is 3 to 7years, although many venture capital investment partnerships arestructured to last 10 years or longer. So the typical venture capitalinvestor  has  a  long-term  time  horizon  and  the  ability  to  beinvolved in an investment vehicle that may show little opportu-nity for liquidity over 7 years or more. And because institutionalinvestors are generally the only ones who have the size and scaleto  make  these  types  of  investments,  the  minimum  investmentamounts are often $1 million or more. It takes real money just toget to the table in venture capital investing. That is not the casefor micro cap investing.
As we have discussed, diversification is important in the con-text of the overall investment portfolio. It is also important in thecontext  of  the  venture  capital  investment.  As  a  venture  capitalmanager described it, most venture capital investment pools arecomposed of one or two home runs and one or two losers, andthe  balance  are  the  walking  dead!  The  statistics  about  venturecapital  from  a  number  of  comprehensive  studies  confirm  thatdescription.  About  7  percent  of  the  venture  deals  in  any  givenpool provide over 50 percent of the portfolio total returns. Thesewould  be  the  home  runs.  On  average,  about  15  percent  of  thedeals  go  broke  or  produce  a  total  loss  of  the  invested  capital.These are the losers. The walking dead are the real problem forthe venture capitalist. These are the approximately 40 percent ofthe deals that produce a loss on the investment or the remaining38 percent that produce a below hurdle rate of return and thatmay offer little or no hope for a meaningful exit strategy for theventure capital investor. The ways the probabilities work suggestthat  single  venture  capital  investment  has  about  a  fifty-fiftychance of producing some loss for the investor. The typical fidu-ciary representing an institutional investor in the venture capitalsector normally responds to these odds by being invested acrossa  sufficient  number  of  venture  capital  pools  to  create  a  well-diversified portfolio of venture capital opportunities. In addition,
12035_Imperiale_c03.f.qxd  11/24/04  9:20 AM  Page 43
Micro Cap Stocks as an Asset Class
43
the  institutional  investor  often  invests  in  venture  capital  poolsthat target different venture strategies. More on this subject willappear  in  Chapter  12.  These  issues  are  more  easily  resolved  inthe context of a single micro cap portfolio. Chapter 4 will discussstrategies  for  adding  the  micro  cap  sector  to  your  investmentportfolio.
12035_Imperiale_c03.f.qxd  11/24/04  9:20 AM  Page 44
12035_Imperiale_c04.f.qxd  11/24/04  9:20 AM  Page 45
CHAPTER 4
The Micro CapAsset Class andPortfolioConstruction
This chapter will attempt to answer the following questions:
• Can  micro  cap  stocks  add  value  to  a  multiasset  class  port-
folio?
• What is the correct allocation to micro cap stocks in a typical
portfolio?
Let’s briefly summarize why micro caps might be of interest to asmall  institutional  or  individual  investor  looking  for  higherreturns  and  added  portfolio  diversification.  In  looking  at  theopportunities  among  U.S.  domestic  stocks,  there  is  a  group  ofstocks that numbers roughly twice as many as small cap stocks.They are micro cap stocks. Some of these companies will expandin  market  capitalization  to  the  size  where  they  will  become  ofinterest to the thousands of small cap managers who manage bil-lions of dollars in portfolio assets. The opportunity to own thesecompanies in advance of that growth would likely provide signif-icant returns for an investor.
However,  the  efficient  market  theory  suggests  that  it  is  notpossible for an investor to outperform an index of stocks over along  period  of  time.  But  as  the  market  capitalization  of  stocksbecomes smaller, the EMT becomes more questionable. In fact, itappears that a diligent investor can gain an information advantage
45
12035_Imperiale_c04.f.qxd  11/24/04  9:20 AM  Page 46
46
THE MICRO CAP INVESTOR
when dealing with very small public companies. This informationadvantage seems to be explained when examined in the context ofthe venture capital theory known as the principal agent problem.It  is  also  well  known  that  over  time  smaller  stocks  providehigher returns than larger stocks. This is consistent with the cap-ital asset pricing model and the idea that investors require higherreturns for taking larger risks. Risk as measured by volatility ofreturn grows larger as stocks get smaller. However, modern port-folio theory (MPT) suggests that by mixing certain highly volatileasset classes together the risk within a portfolio can be reduced.This has to do with how these risky asset classes behave or cor-relate relative to one another. The good news is that micro capstocks appear to be sensitive to broad economic cycles and don’tseem  to  have  a  very  high  correlation  to  either  larger  stocks  orbonds. Thus the micro cap asset class can be an excellent diversi-fication tool within a multiasset class portfolio.
Micro cap stocks not only provide added diversification, butalso  provide  very  competitive  returns  on  an  absolute  and  risk-adjusted basis. They outperform larger stocks 78 percent of thetime when looked at over a 10-year period and 98 percent of thetime when taken over a 20-year period. When compared to ven-ture capital, micro cap stocks appear to have a similar return pro-file.  This  is  likely  due  to  the  relationship  between  the  venturecapital sector and the market for initial public offerings of com-pany stock.
The cumulative effect of these stocks leads to the conclusionthat micro cap stocks are in many ways a bridge between the pub-lic  and  private  capital  markets.  They  behave  more  like  privateequity capital in terms of their pricing mechanisms and their cor-relation  to  other  asset  classes.  This  creates  the  opportunity  forsmall  investors  to  add  an  asset  class  to  their  portfolios  thatbehaves  like  private  venture  capital  but  has  the  advantage  ofsome amount of daily liquidity and market-based pricing.
MICRO CAPS IN THE PORTFOLIO ASSET ALLOCATION
The  notion  of  asset  allocation  has  increased  in  complexity  andscope over the past decade. In the beginning it was stocks versus
12035_Imperiale_c04.f.qxd  11/24/04  9:20 AM  Page 47
The Micro Cap Asset Class and Portfolio Construction
47
bonds  and  how  much  of  each  was  appropriate  for  a  giveninvestor.  Over  time,  many  other  asset  classes  were  introduced.Oftentimes  these  other  asset  classes  were  recognized  becausethey  started  out  in  the  portfolios  of  a  narrow  group  of  institu-tional  investors.  As  the  diversification  benefit  of  these  assetclasses  became  more  widely  known,  they  moved  into  a  largernumber of investors’ portfolios. Over time, indexes were createdto  track  the  performance  of  these  new  asset  classes,  and  theinvestments became available to an ever larger number of smallerinvestors.
Real  estate  is  a  good  example  of  this  asset  class  evolution.When  originally  introduced  to  institutional  investors,  only  thelargest and most progressive used real estate in their portfolios.As real estate’s low correlation to stocks and bonds became bet-ter known, the asset class found its way into a larger number ofinstitutional  portfolios.  Over  time,  no  self-respecting  fiduciarywould have a diversified portfolio if it did not include real estate.The  emergence  of  the  real  estate  investment  trust  (REIT)  assetclass  over  the  past  20  years  has  made  it  possible  for  smallerinvestors to enjoy the benefits of owning an interest in a diversi-fied portfolio of real estate. Now even the smallest retail investorscan include a REIT mutual fund among their holdings and havethe positive diversification of real estate. In many ways, the emer-gence of the micro cap asset class will allow smaller investors tobenefit  from  the  diversification  of  venture  capital  through  theinclusion of micro cap investments in their portfolios just as theemergence of REITs as an asset class has allowed a similar diver-sification  into  real  estate.  The  largest  and  most  sophisticatedinstitutional investors have allocated a portion of their portfoliosto venture capital. A study done by Uniplan Consulting found thatas of December 31, 2003, pension plans in the $1 billion to $10 bil-lion range had allocated on average 7 percent of their assets toventure capital. This was down from 11 percent as of December 31,1999,  which  was  likely  the  peak  of  venture  capital  investingamong these institutions, and that peak largely coincided with thepeak in technology and Internet investing.
The Portfolio Contribution of Micro Caps
The simplest way to demonstrate the contribution of micro capsto the asset allocation process is to look at some simple what-if
12035_Imperiale_c04.f.qxd  11/24/04  9:20 AM  Page 48
48
THE MICRO CAP INVESTOR
simulations  involving  micro  cap  stocks  along  with  other  largeasset classes. In this instance, the portfolio benefit of micro capsis  examined,  but  the  analysis  can  easily  extend  to  showing  thebenefit of other asset classes such as international stocks and realestate investment trusts. The examples are designed to be simpleand to prove the case that micro caps as an asset class add valuein the multiasset portfolio.
In the case of real-life asset allocation situations, consultantsand  fiduciaries  put  constraints  on  the  minimum  and  maximumasset allocation for any given asset class. The specific investmentpolicy  and  existing  nature  of  the  portfolio  dictate  these  con-straints. The tax status of a portfolio may have an effect on theamount of income-producing assets that might be targeted for aportfolio.  In  a  taxable  portfolio,  the  allocation  may  be  skewedmore heavily toward investments that produce capital gains suchas common stocks. In a tax-exempt portfolio, it is likely that thepolicy guidelines might be more biased toward higher allocationsof income-producing assets. Total asset size is also a potential fac-tor  when  considering  allocation  targets.  Very  large  institutionalportfolios may not be able to effectively use smaller and less liq-uid asset classes such as micro caps as a part of their overall strat-egy due to their varying size or liquidity needs.
With  the  goal  of  avoiding  overly  complex  math,  it  is  worthexamining the potential portfolio contribution of micro caps byconstructing  a  simple  set  of  what-if  portfolios  using  stocks,bonds, and micro caps. These what-if portfolio simulations takesimple allocations and add micro caps in varying amounts overdiffering time periods in an attempt to determine their potentialinvestment contribution to portfolio performance. In this simula-tion  we  use  the  following  asset  classes.  Large  stocks  are  repre-sented by the S&P 500, and bonds are represented by the LehmanIntermediate Government Corporate Bond Index, both of whichare very large liquid benchmarks used by institutional investors.Micro  cap  stocks  are  represented  by  the  Wilshire  Micro  CapIndex, an unmanaged index of micro cap stocks that representsthe  smallest  10  percent  of  market  capitalization  in  the  Wilshire5000,  a  broad-based  U.S.  stock  market  index.  The  time  periodused is the 25 years ended December 31, 2003, which is about asfar back as the Wilshire Micro Cap Index extends.
The what-if scenario begins using the classic balanced portfolio
12035_Imperiale_c04.f.qxd  11/24/04  9:20 AM  Page 49
The Micro Cap Asset Class and Portfolio Construction
49
that is 60 percent stocks and 40 percent bonds. This case wouldhave provided the investor a return of 7.7 percent, with an annualstandard deviation of 13.3 percent before fees and expenses. This is  the  de  facto  generic  standard  balanced  portfolio  that  is  usedalmost universally as the point of departure for institutional port-folio  performance  measurement.  The  question  is  then  posed: How  would  the  outcome  have  differed  if  the  portfolio  containedmicro  cap  stocks?  For  our  purposes,  we  will  add  micro  cap stocks  in  5  percent  increments  to  the  portfolio  while  lowering the stock component by a similar amount. The outcome is shownin Table 4-1.
It is remarkable to see that by simply adding the first 5 per-cent allocation of micro caps, the overall return in the portfoliojumps to 8.2 percent while the annual volatility drops modestly to12.7 percent. Thus, a very modest allocation of micro caps beginsto have an immediate and substantial positive impact on the stan-dard balanced portfolio. Moving the allocation of micro caps to 10 percent continues to add benefit as the annual return moves up to 8.7 percent, but more important, the annual standard devia-tion drops sharply to 11.6 percent, a 100-basis-point decrease in
TABLE 4-1 Microcap Contribution, Stock Bond Portfolio, 25 years as of
12/31/03
Allocation
Stocks
Bonds
Microcaps
Annual Return
Standard Deviation
60
55
50
45
40
35
30
25
20
15
40
40
40
40
40
40
40
40
40
40
0
5
10
15
