approaches,  we  can  find  a  series  of  informationadvantage opportunities that may also be found in the micro caparena.
In  the  first  instance,  when  investors  engage  in  informationcollection before deciding whether to invest, in order to screenout unprofitable projects or bad entrepreneurs, a uniform opinionof a company often emerges. In the micro cap arena, a review of acompany  might  find  an  incompetent  management  team.  Or  itmight find a company that has an outdated and inferior productor  service.  This  uniform  opinion  can  become  the  “conventionalwisdom” about the company, and the company is often relegatedto the ranks of the walking dead among the micro cap universe.Larger  shareholders  in  a  micro  cap  company  faced  with  such  areputation have a very limited range of potential buyers for theirshares.
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In many ways, the agent of venture capital theory and the sell-ing  shareholder  of  the  micro  cap  company  are  similar.  In  eachcase, they have a relatively narrow universe of potential buyers,and these potential buyers are engaged in information collectionin an attempt to screen out bad companies or bad management.The real distinction is that the micro cap seller can estimate bythe current trading price the approximate price that a buyer mightbe  likely  to  pay,  and  the  seller  rather  than  the  company  willreceive the proceeds of the sale. The buyer, being one of only afew, can often extract a significant discount from the seller, muchlike the venture capital principal agent model.
In  the  second  venture  capital  instance,  the  investor  canengage in information collection and monitoring once the projectis under way. This is likewise true of the micro cap company. Inthe instance of the venture capital relationship, the availability ofadditional capital might be predicated on reaching certain mile-stones. The same is true of micro cap investing. A micro cap com-pany  might  announce  some  changes  to  its  business  or  strategy.This  might  create  some  additional  investor  interest  in  the  com-pany  but  not  cause  any  meaningful  change  in  the  value  of  thetraded shares. After the company achieves certain results, inter-ested  investors  might  then  begin  to  actively  buy  shares  in  thecompany. Micro cap portfolio managers are often monitoring theresults  of  a  select  list  of  companies  in  anticipation  of  a  certainmilestone  before  they  are  willing  to  buy  the  company  stock.Again,  this  is  very  similar  to  the  monitoring  in  which  a  venturecapital investor might engage prior to making a financial commit-ment or providing additional capital to a company. The principaldifference in this second transaction is who receives the invest-ment: an existing micro cap shareholder who is selling shares orthe  company.  Large  selling  shareholders  may  sense  a  liquidityopportunity that was otherwise absent. Buyers sense an emergingopportunity at a reasonable valuation.
In the third venture capital instance, where the allocation ofcash  flow  between  the  entrepreneur  and  the  investor  can  bedesigned  to  provide  incentives  for  the  entrepreneur  to  behaveprofitably,  there  is  also  a  similar  model  within  the  micro  caparena.  In  the  micro  cap  world,  shareholder  activism  is  a  dailyevent. In fact, later in this book we will discuss how to identifymicro  cap  opportunities  by  studying  who  is  taking  a  significant
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stake  within  a  company.  Like  the  venture  capital  model,  theactivist shareholder model in the micro cap arena seeks to alignthe  interests  of  management  and  its  shareholders.  The  perfor-mance is set by agreement prior to the investment. In the case ofthe  micro  cap  investor,  a  large  stake  in  the  company  is  usuallyacquired first, and then financial and legal pressure is brought tobear on management. This is often done by a small group of largeshareholders with the explicit message that things will change ormanagement  will  change.  In  most  instances,  the  managementsees the light and behaves in a way that is mutually beneficial tothem and the shareholders, just as in the venture capital model.
CONCLUSION
Micro  cap  stocks  have  some  unique  characteristics  that  are  aresult of their size. Like their larger capitalization publicly tradedcousins, micro caps live within the boundaries of efficient markettheory  but  behave  slightly  differently  than  their  larger  cousins.When compared to larger cap stocks, micro caps do not seem toreflect all available information as efficiently as larger cap publiccompanies.  This  results  in  higher  expected  returns  and  highervolatility than with large stocks. But the higher returns more thancompensate for the added volatility. This leads us to the theorythat there can be an information advantage available to diligentmicro cap investors because the micro cap sector is less efficientin  the  speed  at  which  it  reflects  information.  If  this  were  true,EMT would be called into question.
But when comparing the micro cap investment sector to ven-ture capital investing, the EMT inconsistencies within micro capscan be reconciled when considered in light of the principal agentventure capital model. This suggests that micro caps are a sectorunto themselves. The sector has many of the elements of largercapitalization  stocks  as  well  as  many  characteristics  of  venturecapital  investments.  In  many  ways,  the  micro  cap  sector  is  abridge between the public equity markets and the private venturecapital markets and displays the unified characteristics of both.Chapter 3 will discuss these unified characteristics in more detail.
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CHAPTER 3
Micro CapStocks as anAsset Class
This chapter will attempt to answer the following questions:
• Are  micro  cap  investors  adequately  rewarded  for  the  risk
undertaken?
• Are micro caps similar to venture capital?
INVESTMENT PERFORMANCE: SMALL VERSUS LARGE STOCKS
Among  all  the  academic  literature  about  finance  and  investing,some  of  the  most  well-known  and  often-cited  studies  are  thosethat concern the performance of small company stocks. Even themost  inexperienced  investor  seems  to  understand  that  smallercapitalization stocks outperform larger stocks over the long term.In  addition,  most  investors  seem  to  understand  that  the  perfor-mance of smaller stocks also carries a higher risk or more volatil-ity than that of their larger cousins. Even though investors realizethat small stocks outperform large stocks over the long run, theydon’t  seem  to  understand  that  this  performance  is  achievedwithin  significant  cycles  of  underperformance  and  outperfor-mance  relative  to  bigger  stocks.  It  is  the  very  instability  of  thisrelationship between the performance of large and small stocks
25
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THE MICRO CAP INVESTOR
FIGURE 3.1 Russell 2000 versus S&P 500, August 20, 1999 to August 11,2004.
that creates the investment value of small and micro cap stocks ina multiasset class portfolio.
As  shown  in  Figure  3.1,  the  relative  performance  of  smallstocks,  as  represented  by  the  Russell  2000  Index,  versus  largerstocks, as represented by the S&P 500 Index, is superior over longperiods of time. A number of important academic works regard-ing  small  cap  stocks  began  to  show  that  smaller  capitalizationstocks had historically provided superior returns over and abovewhat  could  be  explained  by  the  capital  asset  pricing  model.  Itappeared that even when adjusting for the higher risk of smallercap stocks, they provided superior returns.
To understand this phenomenon, it is worthwhile to make abrief  survey  of  the  key  constructs  of  the  capital  asset  pricingmodel  (CAPM)  and  related  market  theory,  as  well  as  how  theyevolved  over  time.  Readers  who  are  familiar  with  capital  assetpricing and market theory may want to skip over this section.
A SURVEY OF MODERN PORTFOLIO THEORY
Any discussion related to the history of the theory of stock pricebehavior generally starts with Harry Markowitz. In his pioneering
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book Portfolio Selection: Efficient Diversification of Investment(John Wiley & Sons, 1959), Markowitz sets forth some ground-breaking work based on earlier academic studies he had published.The Markowitz model is a single-period model, in which an investorforms a portfolio at the start of a given period. The investor’s objec-tive is to maximize the portfolio’s expected return, subject to anacceptable level of risk. Said differently, the investor seeks to mini-mize risk, subject to an acceptable expected rate of return. Theassumption of a single time period in conjunction with assumptionsabout the investor’s attitude toward risk allows risk to be definedby the variance or standard deviation of the portfolio’s return.
As additional securities are added to a portfolio, the expectedreturn and standard deviation change in very specific ways, basedon how the newly added securities co-vary with the other securi-ties in the portfolio. The best that an investor can do in theory isdefined by a curved frontier that is the upper half of a hyperbola,as shown in Figure 3.2. The curve is known as the efficient fron-tier. According  to  Markowitz,  investors  select  portfolios  alongthis curve, according to their tolerance for risk. An investor whocan  live  with  a  lot  of  risk  might  select  portfolio  1.  A  more  risk-averse investor would accept a lower return for correspondingly
Efficient Frontier
Stocks, bonds, bills, and REITs 1972–2003
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16
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%nruteR
launnAegarevA
Multi-Asset Portfolio
SmallStocks
REITs
Large Stocks
International Stocks
Bonds
T-Bills
0
51
15Risk (Annualized Quarterly Standard Deviation) %
20
0
25
30
FIGURE 3.2 The efficient frontier.
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THE MICRO CAP INVESTOR
lower risk and likely choose portfolio 2. One of the major insightsof the Markowitz model is that a security’s expected return, cou-pled with how it co-varies with other securities, determines howit is added to an investor portfolio.
Using the Markowitz framework, William Sharpe, along withJohn Lintner and Jan Mossin independently of one another, devel-oped the theoretical constructs for what is known as the capitalasset pricing model (CAPM). The CAPM assumes that investorsuse the basic logic of Markowitz in forming portfolios. It furtherassumes that there is a risk-free asset that has a certain return.With  a  risk-free  asset,  the  efficient  frontier  in  Figure  3.2  is  nolonger the best that investors can do. The straight line in Figure3.3 has the risk-free rate as its intercept. It is tangent to the effi-cient  frontier  and  represents  the  boundary  of  the  investmentopportunity  set.  Investors  choose  portfolios  along  the  capitalmarket  line,  which  shows  combinations  of  the  risk-free  assetand  the risky portfolio M. In order for markets to be in equilib-rium (quantity supplied = quantity demanded), portfolio M mustbe the market portfolio of all risky assets. So all investors com-bine the market portfolio and the risk-free asset, and the only risk
Efficient Frontier
Stocks, bonds, bills, and REITs 1972–2003
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16
14
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%nruteR
launnAegarevA
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Small Stocks
REITs
Large Stocks
Bonds
T-Bills
0
51
15Risk (Annualized Quarterly Standard Deviation) %
20
0
25
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FIGURE 3.3 The efficient frontier with opportunity boundary.
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Micro Cap Stocks as an Asset Class
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or premium that investors are paid for bearing is the risk associ-ated with the market portfolio.
From the CAPM emerges the concept of beta. The beta coeffi-cient is the measure of risk as it relates to the broader market. Sobeta represents the portion of an asset’s risk that cannot be diver-sified  away.  This  is  the  risk  that  investors  are  compensated  forbearing. The CAPM equation says that the expected return of anyrisky asset is a linear function of its tendency to co-vary with themarket portfolio. So if the CAPM is an accurate description of theway  assets  are  priced,  this  positive  linear  relation  should  beobserved when average portfolio returns are compared to portfo-lio betas. Said differently, the higher the beta of a portfolio, thehigher its return should be. Further, when beta is included as anexplanatory variable, in theory no other variable should be able toexplain  cross-sectional  differences  in  average  returns.  Betashould be all that matters in the CAPM.
The CAPM is a simple model based on simple financial rea-soning.  It  certainly  does  not  capture  the  dynamics  of  the  broadmarket, but rather tries to explain a central market mechanism.However, some of the assumptions that underlie the basic modelare not realistic. As a result, a number of permutations and exten-sions  of  the  basic  CAPM  have  been  proposed  that  relax  one  ormore of the CAPM assumptions. Instead of simply extending anexisting theory, Stephen Ross, another academic, addresses thisconcern  by  developing  a  completely  unrelated  model  known  asthe arbitrage pricing theory (APT). Unlike the CAPM, which is amodel of financial markets at equilibrium, the APT starts with thepremise that arbitrage opportunities should not be present in effi-cient  financial  markets.  This  assumption  is  less  restrictive  thanthose required to derive the CAPM.
The APT begins with the assumption that there are n numberof factors that cause asset returns to systematically deviate fromtheir expected values. The theory does not identify the factors orspecify how large the number n is. It simply reasons that these nfactors cause returns to vary together. There may be other, firm-specific, reasons for returns to differ from their expected values,but these firm-specific deviations are not related across all com-panies or stocks. Since the firm-specific deviations are not at allrelated to one another, all return variations not related to the ncommon factors could be diversified away. Ross concludes that
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in order to prevent arbitrage, an asset’s expected return must be alinear function of its sensitivity to the n common factors. As withthe CAPM, Ross created an expression for expected return thatis a linear function of the asset’s sensitivity to systematic or mar-ket risk. Under the assumptions of APT, there are n numbers ofsources of systematic risk, whereas there is only one in a CAPMworld.  The  conclusion  is  that  many  factors  impact  marketreturns, and many factors impact stock returns.
The theoretical flaw in both the CAPM and the APT is the factthat they are static, or single-period, models. They ignore the real-life  fact  that  capital  markets  are  multiperiod  in  nature.  RobertMerton’s  intertemporal  capital  asset  pricing  model (ICAPM)attempts  to  capture  this  multiperiod  aspect  of  financial  marketequilibrium.  The  ICAPM  framework  recognizes  that  the  invest-ment  opportunities  might  shift  over  time,  and  investors  wouldlike to hedge their investments against unfavorable shifts in theset of available investments. If a particular security tends to havehigh returns when bad things happen to the investment opportu-nity  set,  investors  would  want  to  hold  this  security  as  a  hedge.This increased demand would result in a higher equilibrium pricefor  the  security,  with  all  other  factors  held  constant.  While  theAPT gives little guidance as to the number and nature of factors,the  factors  that  appear  in  the  ICAPM  satisfy  the  condition  bydescribing the evolution of the investment opportunity over timeand  identify  the  fact  that  investors  are  sufficiently  concernedabout these factors and want to hedge against their effects.
For example, this explains why there might be a price factorfor unexpected changes in the real market interest rate. Such achange would clearly cause a shift in the investment opportunityset,  and  the  impact  would  be  pervasive  enough  that  all  rationalinvestors  would  want  to  protect  themselves  from  the  negativeconsequences. No one yet tells us exactly how many factors thereare, but the ICAPM at least gives us some guidance.
The  CAPM  and  its  various  subtle  flavors,  as  previouslydescribed, have since become the departure point for many aca-demic  studies  that  attempt  to  identify  the  specific  factors  thatimpact  the  capital  asset  pricing  equation  within  the  markets.These factors are then often studied in relation to their separateimpact on large and small stocks. The result of this is a large bodyof  academic  work  that  supports  CAPM  and  its  variants  and  an
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equally large body of work that raises many questions about thevalidity of the work. Within these contradictory studies is foundsome very interesting work about small and micro cap stocks.
Another  scholar,  Rolf  Banz,  discovered  an  apparent  contra-diction of the CAPM. In his work, Banz shows that the stocks offirms  with  small  market  capitalization  have  higher  averagereturns than large cap stocks. Proponents of the CAPM will pointout that small firms tend to have higher betas than large firms, sowe  would  expect  to  see  higher  average  returns  for  small  firms.However,  Banz  shows  that  the  beta  differences  are  not  largeenough  to  explain  the  observed  return  differences.  Other  aca-demic work shows that the smaller the market cap, the more pro-nounced the unexplained difference becomes.
From Banz, the body of academic literature begins to developa  framework  that  suggests  that  small  and  micro  cap  stocksbehave  differently  than  their  large  cap  counterparts.  A  growingbody of academic research suggests that certain structural issuesrelated  to  transaction  costs  have  a  large  impact  on  small  andmicro  cap  stocks.  According  to  a  study  done  by  Andre  Perold(“The Implementation Shortfall: Paper versus Reality,” Journal ofPortfolio Management, Spring 1988), there are four elements oftransaction  costs  that  affect  the  efficiency  of  a  stock’s  return:commissions, taxes, market impact, and opportunity cost. Com-missions and taxes are relatively simple to estimate, while marketimpact and opportunity costs can be difficult to quantify. Marketimpact is the change in a stock’s price due to trading volume thatis larger than the stock’s typical average trading volume. The ideais  that  bigger-than-average  buying  or  selling  volume  in  a  givenstock  can  disrupt  the  normal  market  clearing  process,  causingchanges in the bid-and-ask spread and resulting in performanceloss because the investor must buy at a higher price or sell at alower price due to the abnormal trading volume.
Opportunity cost is the theoretical cost of not completing atrade within a specific time frame. For example, a portfolio man-ager who wanted to buy 50,000 shares of a given stock that trades5,000 shares per day could be faced with opportunity cost. Themanager could attempt to buy the stock more quickly, creatingan increase in the bid-and-ask spread and resulting in higher mar-ket impact costs, or the investor could take 10 or more days tocomplete  the  trade  at  the  normal  average  daily  trading  volume.
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But  the  stock  might  increase  in  price  during  those  10  daysbecause  of  fundamental  or  market  events.  The  loss  in  perfor-mance  over  that  period  during  which  the  50,000-share  positionwas being filled is the opportunity cost. Because micro cap stockstrade  with  less  frequency  and  in  smaller  volumes  than  largerstocks,  micro  cap  investors  should  be  aware  of  both  marketimpact and the opportunity cost of their potential trades.
An interesting study done by Merrill Lynch examined the his-torical  performance  of  stocks  by  market  capitalization.  Thestudy followed a universe of 6,000 stocks on a quarter-by-quarterbasis. The performance was broken down by market capitaliza-tion  and  rebalanced  annually  from  1974  through  1993.  A  sum-mary  of  the  return  and  risk  measures  for  each  quarter  ispresented in Table 3-1.
In reviewing the data, it is apparent that risk, as measured bystandard deviation, increases as returns increase. These observa-tions are consistent with the CAPM, as discussed earlier in thissection.  However,  a  number  of  studies  have  shown  that  whenmeasuring risk using the Sharpe ratio, mid cap stocks provide thebest risk-adjusted return. The Sharpe ratio is simply the amountof  return  achieved  for  each  unit  of  risk  or  standard  deviationundertaken. But micro cap stocks provide the second-best Sharperatio with just slightly more risks per unit of return than mid capstocks. It should be noted, however, that both absolute return andthe amount of risk as measured by standard deviation of returnincrease  dramatically  for  micro  cap  stocks,  even  though  theSharpe ratio for micro cap versus mid cap appears relatively sim-ilar. More important, micro cap returns have a low correlation tomid cap and other broad stock market returns. This makes micro
TABLE 3-1 Risk/Return Characteristics by Market Capitalization, 1974–1993
MarketCap
Large Cap
Mid Cap
Small Cap
Micro Cap
Source: Merrill Lynch
AnnualReturn
11.0%
14.3%
15.4%
19.0%
StandardDeviation
15.9%
17.3%
19.1%
23.4%
SharpeRatio
0.691
0.827
0.806
0.812
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cap  stocks  an  excellent  diversification  tool  in  the  context  of  amultiasset class portfolio.
ASSET ALLOCATION AND MODERN PORTFOLIO THEORY
Over  the  past  20  years,  an  entire  industry  has  been  developedfrom the simple concept that Markowitz put forth that the major-ity of the total performance of a portfolio results from the mix ofinvestment asset classes contained in the portfolio. This simpleconcept  is  the  cornerstone  of  modern  portfolio  theory (MPT).The industry spawned by the advent of MPT is known as invest-ment management consulting. This group of consultants standsready to advise the investing community on the correct allocationof different investment vehicles that should properly be held in aportfolio  to  achieve  the  stated  investment  policy.  As  is  true  ofmost objectives, there is normally a multitude of ways to achievethe stated goal. Through consultation with the client and study ofmarket history, the investment consultant will design a portfolioallocation  model  that  will  drive  the  investment  returns  of  theclient  toward  a  stated  goal.  The  consultant  will  also  assist  theinvestor  in  developing  a  stated  goal  or  policy  that  is  consistentwith  the  asset  allocation  model.  Institutional  investors  such  aspension plans, endowments, and wealthy individuals have histor-ically  hired  investment  consultants  to  address  long-term  invest-ment objectives and policy questions related to asset allocationissues. These institutional investors have a fiduciary obligation toprotect  the  interest  of  their  investors.  One  way  to  protect  theinterest  of  their  investors  as  well  as  reduce  their  own  potentialliability is to hire a consultant to monitor the investment-relatedissues. The consultant’s job is to advise the client on the correctmix  of  investments  and  monitor  the  underlying  performance  ofthose investments to be certain that they remain consistent withthe policy objective.
In the past, the complex mathematics embedded in the con-sultant’s  practice,  along  with  the  myriad  of  data  required  to perform the asset allocation analysis, limited the accessibility ofinvestment consulting to larger institutional investors. However,
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the  rapid  growth  in  the  power  of  the  personal  computer  alongwith the democratization of data via the Internet and the accessi-bility  of  modestly  priced  statistical  software  have  combined  tobring  asset  allocation  modeling  within  the  reach  of  even  thesmallest  individual  investor.  Web  sites  offering  asset  allocationadvice and online calculations have proliferated. Modestly pricedfinancial  planning  and  asset  allocation  software  is  widely  avail-able. Traditional Wall Street brokerage firms as well as discountbrokerage firms have asset allocation investment programs avail-able  to  their  clients  in  some  form.  Mutual  fund  complexes  and401(k) providers often offer asset allocation advice to their clientsas well. The practical application and administration of the assetallocation  process  is  more  difficult  than  most  people  realize.There can be many ways to arrive at the same goal, but there areoften practical constraints in getting to the stated objective.
ASSET ALLOCATION AND MICRO CAPS
Total  portfolio  performance  is  impacted  by  three  variables  thatcan be attributed to any given investment class:
1. Long-term expected and historical rates of return2. Volatility of the return, typically referred to as the standard
deviation of return
3. Correlation of returns to other investments
When considering an asset class as a possible investment in aportfolio, a consultant will first study the rate of return to deter-mine whether the historic and expected returns are high enoughto compete with other available investments. This return analysisis then tempered with a review of how volatile the return patternsare over time. The higher the volatility of a potential return, oftencalled  risk, the  higher  the  required  rate  of  return  becomes  inorder to achieve a position in the investment program. Stated sim-ply, the higher the risk of an investment, the higher the expectedreturn should be. If the expected returns are high enough and thecorrelation  of  returns  to  other  investments  is  low  enough,  then
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the potential investment might gain an allocation position withinthe theoretical portfolio.
The  classic  implementation  of  asset  allocations  is  the  stockand bond mix of a typical balanced portfolio. Both the stock andthe  bond  asset  classes  have  reasonable  expected  and  historicalrates of return over the long term. Bond returns are lower thanstock  returns,  but  bond  returns  are  less  volatile  than  stockreturns,  and  the  correlation  between  stocks  and  bonds  is  rela-tively low. So during periods when stocks may be underperform-ing their historical expected rate of return, bonds have a tendencyto outperform their long-term historical rate of return. This trade-off  between  risk  and  return  tends  to  lower  the  volatility  of  theentire portfolio while increasing the total return for each unit ofrisk undertaken within the given portfolio.
As seen in Table 3-2, the returns for micro cap stocks are noth-ing short of spectacular. With an annualized return of 19 percentfor the 20-year period from 1974 through 1993, micro caps werethe return leader in the equity sector. With a standard deviation ofreturn  for  the  same  period  of  23.4  percent,  they  were  also  themost volatile segment of the equity sector. The micro cap sectoralso  looked  favorable  over  the  last  10  years.  During  the  periodfrom 1992 through 2002, micro cap stocks had an average annualreturn  of  11.72  percent  with  a  standard  deviation  for  the  sameperiod of 12.1 percent. This continues to compare favorably withother equity market