The Advantages of Micro Cap Equities for Investors
A micro cap stock is a publicly-traded company with, by most definitions, a total U.S. dollar value of outstanding shares valued between $50 million and $300 million. Micro cap companies have greater market capitalization than nano caps and less than small cap companies. The price of the stock itself does not indicate a company’s capitalization; for example, a company with shares trading at $2.50 and 25 million shares outstanding is larger than a company trading at $10 with 10 million outstanding shares.
The Small Firm Effect
A theory called “the small firm effect,” backed by empirical evidence, suggests there is a risk premium placed on smaller firms. The theory holds that the effect of this risk premium, perhaps coupled with larger management stakes in these small firms, on the group, allows smaller companies to outperform larger corporations over time.
The phenomenon has also been explained by the ability of smaller companies to have a sharper focus and the ability to be more nimble after seeing an opportunity or upcoming trends. While equity shares issued by smaller companies often experience more volatility, the small firm effect states that the opportunity to appreciate company shares may be superior versus those that are considered less risky and trade with less volatility.
Smaller firms are necessarily more streamlined and efficient. Their business model often dictates reducing waste and “dead-wood” employees. This could put the smaller firms at a more competitive advantage when competing with larger firms within their space. A leaner, perhaps more simplistic model can also add to the company’s success in that decision making can be quicker with fewer people involved. A perceived opportunity in the marketplace can be capitalized on with little wasted motion, meetings, and memos. This translates to an increased ability to be first and be best. This allows capturing market share early and the momentum to hold onto and grow that market share even when the larger players step in to compete.
Investor Benefits
Small firms have been shown to have a positive impact on the potential returns of investors. While smaller companies lack the capital assets and distribution channels of large, deep-pocketed, and more established businesses, the ability to make decisions quickly on what might be a short-term event can add earnings to the bottom line. The earnings are a much more significant percentage of total revenue compared to larger firms. The effect over time is the shares of stock issued by smaller firms could rise as the increase in earnings are understood and known. The companies’ valuation would respond accordingly, as more deem them worthy of consideration for purchase as an investment. While investors have more volatility, the possible returns can often balance that risk and make allocations in select small cap stocks a good strategy for investors.
Many of the stocks that meet the definition of micro cap are not widely reported on and may even be lacking equity research coverage from reputable organizations. This lack of opportunity and being known can depress equity valuations as investors are less likely to take on assets they don’t clearly understand. Or understand on a surface level while trusting the expertise and regular reports of an industry analyst covering the company.
Take-Away
While the small firm effect is a theory that has been backed up with decades of both data and anecdotal reports, there are differences in thought on how to best measure it. The different measurements return different results. One large difficulty in quantifying data is the time frame. Suppose one looks at measurements on a year-to-year basis of companies that meet small capitalization criteria. In that case, each year may be excluding the greatest winners as they grow out of the definition. The same drawback to accuracy is on the downside, a study would also be eliminating those that dropped below the $50-$300 million set of companies.
The past year has brought tremendous focus on the performance of the most highly capitalized public companies. All of them were once micro cap and considered risky. These mega cap giants will all likely be dethroned one day by innovations coming about by companies that are barely on investors radar right now.
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Sources:
Correlation and Micro Cap Equities
