Micro cap – the edge of hedge

Micro cap - the edge of hedge

Laurence Davison

While arguments continue to rage over just how mature the hedge fund market has become, it is difficult to argue that even the more esoteric strategies used by individual managers are becoming increasingly well known. However, on the fringes of the hedge fund universe there remain some strategies that continue to fly under the radar of most investors.

One of those is micro cap investing – a technique that has found itself so peripheral in the wider world of hedge funds that managers find themselves having to defend its place in the hedge arena at all. Most micro cap hedge funds are predominantly long biased, and some observers argue that in reality they are simply specialist traditional investors and not truly hedge at all. However, with over 3,000 micro cap stocks in the US alone and only around 50 funds, managers argue that there is value to be added from solid fundamental analysis in this oft neglected market.

While precise definitions of micro cap stocks vary, a good benchmark is the one ascribed by Morningstar: Market capitalisation of $350 million or less. This leaves plenty of room for variety, with the market stretching from venture capital type startups in the high tech sector through to long established, if small, companies in traditional industries.

However, with many of these stocks trading on thin volume, making shorting difficult, micro cap hedge funds rarely operate in the traditional manner of long/short equity funds. In fact, their investment behaviour is generally significantly closer to mutual funds in the long only sector, at least in the sense that they are predominantly long the market. So why should micro cap be considered a hedge strategy at all, and why should micro cap funds get away with charging hedge fund fees?

To start with, the vast majority of mainstream and larger asset management houses do not look at micro cap – a fact that has become even more accentuated since the bursting of the tech bubble. Startups in high tech industries, the main focus of larger institutions’ micor cap efforts, are no longer a sexy investment, and the smaller companies market has once again disappeared off the institutional radar.

Institutional neglect

Micro cap managers point out that their investment universe is not only neglected by mainstream fund management houses, but the value that is available is simple not accessible to large funds by virtue of the lack of liquidity in the micro cap arena. According to Ian Ellis, president and portfolio manager of San Francisco’s Microcapital, “The largest 5000 companies are in the Wilshire 5,000 index. That index is sliced and diced lots of ways but one split is the Wilshire 2,500 and the small half of the universe which is the Wilshire microcap.

“The latter index has a weighted average market cap of about $160m and… a median in the $60-80m range. The important message here is that institutions generally do not have any material exposure to the microcap market. Though it only represents a mid single digit percentage of the overall 5,000, that can be significant: in 2002 the Wilshire microcap index was up 93%. [But] lack of scalability prevents traditional fee only institutions committing capital but perhaps more relevantly developing the expertise.”

The trick, according to Ellis and others, is to focus analysis in a universe of companies so small that mainstream analysts do not cover them. In that way, mispricings can be discovered and exploited. Many micro cap managers try to spot opportunities across the sector, since it is the high number of stocks and limited analyst coverage that creates undervaluation. Micro cap remains a sector where solid fundamental analysis can provide an edge.

Robert Sullivan, chief investment officer of Satuit Capital Management and portfolio manager of its Micro Cap Fund, typifies this approach. He says: “Our investment process is very, very bottom up, fundamentally driven stock-by-stock research – the really boring stuff.”

However, as most micro cap funds are relatively small operations themselves, it is difficult for them to perform detailed research across the whole market. For this reason, most firms reduce the number of stocks they analyse closely. Sullivan says that Satuit use quantitative analysis to reduce the market to a 300-500 company “focus list.”

Other firms use different approaches. For example, Fremont’s US Micro Cap fund, which has been running since 1994 and like many funds in the sector is now closed to investment, focuses on firms in four sectors: Technology, health care, and consumer goods and services.

Liquidity issues

There are of course pitfalls involved in investing in lesser-known companies, especially as a consequence of thin trading. While your fundamental analysis may be sound, it may take time and patience for value to be realised in share price; and as John Maynerd Keynes famously said, “the market can remain irrational for longer than you can remain solvent.” Ellis says, “The possibility that obscure stocks remain obscure or even get more obscure is the biggest non-fundamental risk in this sector.”

For this reason, Microcapital targets growth. The rationale is that over the course of time – the firm analyses companies in five year terms, and expect to gain the bulk of their return in two – growth will place a firm on the radar of larger managers. But patience is the key: Ellis explains that for many of the companies his firm invests in, realistic valuations may emerge just four times a year when an earnings report is submitted. The lack of interest from larger investors which provides the micro cap opportunity can also provide liquidity problems.

Sullivan agrees that micro cap companies fly under most investors’ radar: “A lot of buy side firms can’t create a scaleable micro cap product that makes sense for them; they’re looking for the next $10 billion fund, not the next $200 million fund. On the sell side, these companies get ignored because there isn’t a lot of investment banking business to do.”

The story, inevitably, is not just one of realised value in an under-analysed market. As one market commentator says, “very small companies can make fund managers look either very smart or very stupid.” If an investment decision proves wrong, it can be very hard for a micro cap manager to exit the trade without taking an even bigger proportional hit that would be the case in a more liquid stock.

This point is even more significant for hedge funds in the micro cap universe, because investment based on bottom-up fundamental analysis almost inevitably involves a smaller portfolio of holdings and only limited nods to hedging and indexing. While this entails the sector’s enduring appeal – every micro cap investor will tell you that the holy grail is “finding the next Microsoft” – it also brings volatility.

Size versus quality

Lack of liquidity, some believe, is one of the factors that makes micro cap a strategy naturally suited to hedge funds. For example, Palo Alto Investors – unusually, a Securities and Exchange Commission registered hedge fund – insists on a lock-in period for investors.

The fund explains, “With a long-term horizon we can make illiquidity work for us, buying at times others are forced to sell and holding until prices are fair. We feel our long-term horizon endows us with a tangible competitive advantage over our mutual fund competitors and is a major reason we have been able to outperform not only our competition in the micro-cap segment, but the broad market averages as well.”

Palo Alto also point out that illiquidity does not necessarily mean lack of credibility: “We bristle at the pundits who have said that low quality companies led the markets [last year]. While our holdings are smaller and in some cases less mature than S&P 500 companies, we feel that they are well run.

“We believe that bloated ‘corpocracies’ like Enron,Parmalat, Tyco and others not yet identified are in fact lower quality than most small companies in the US, and that many small companies have better corporate ethics and governance than the behemoths that pundits seem to equate with quality and safety.”

There is a possible comparison between micro cap and private equity investing. The long investment horizon, liquidity issues and irregular and potentially inaccurate valuations seem to give micro cap characteristics somewhere more akin to private than larger cap equity. Furthermore, many micro cap funds have a closer relationship with the firms they invest in than traditional equity investors.

There are differences, however. Sullivan is quick to point out that micro cap, while illiquid compared to mainstream equity, does not require the lock-up periods involved in private equity. He also says that most micro cap managers do not seek to become involved with company management to the same extent that private equity funds do. However, most micro cap managers also say that with less noise in the market, their analysts do get unusually good access to the companies they cover.

Ellis echoes this view. He says that Micropcapital’s positions average around 2% of the underlying firm’s available equity, and very rarely exceed the 10% mark. While he stresses the relationship-driven nature of the market in terms of finding opportunities, his firm also takes a hands-off approach after investment.

He is a micro cap evangelist, insisting that the sector belongs in its own place in the hedge fund world. He explains, “If we rule out traditional institutions then the natural owners of microcaps are hedge funds as [micro cap] companies are too immature for individuals. If you agree with this premise then there should be a separate category within the universe of hedge funds [for] long biased micro cap funds according to Microcapital’s model.

“They will have different styles – ours is growth – and specialisations. The characteristics will be more volatile than most hedge funds, but the alpha can be high and the correlation can be low. The world of hedge fund investors needs to focus on these opportunities, particularly as other strategies in the hedge fund world have become more competitive.”

Small is beautiful

The difficulty for micro cap hedge funds is attracting the right kind of investment. They freely admit that lack of scalability allows the kind of attractive mispricings that they thrive on, but this very lack makes it difficult to accept large allocations from institutional investors while retaining performance. There are only so many opportunities, even in a large universe. Add this to the fact that most funds cannot ride their winners all the way – even in the case of a “new Microsoft,” by the time the company hit the mutual fund radar, micro cap hedge funds would often trade out before losing their analytical edge – and a balancing act emerges.

Hedge fund managers would of course like to build their assets as far as possible to maximise their fee revenue. But in a sector that is defined by the need to be small, growth can only go so far. The consensus amongst managers is that any fund size over about $500m in micro cap becomes harder to manage. With the increasing institutionalisation of hedge fund investment, this figure begins to look insignificant.

Ellis, amongst others, admits that it can prove difficult to attract institutional money. He says that interested investors have sometimes found that an investment small enough for Microcapital to handle registers very little on the corporate balance – and performance – sheet. However, he argues that institutional investors need to be more creative about their allocations, if only to adequately reflect the breakdown by capitalisation of equity markets for indexing purposes.

After all, even if the micro cap universe represents only 7% of the US equity market, an investor with no allocation to that at all would seem to be running an unbalanced overall portfolio. However, many simply bundle micro, small and even mid cap together. While micro cap can never drive the returns of a large, diversified investor, managers in the sector insist that there is a place for it for those with an appetite for volatility.