Factor Investing in Micro & Small Caps

Treasure Hunting in the Wild West of Equity Markets

October 2018. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Micro caps are commonly perceived as highly risky, but potentially also highly rewarding
  • Smalls caps generate more attractive risk-return ratios than micro caps on index level
  • Focusing on factors improves risk-adjusted returns across market cap segments

INTRODUCTION

FAANG stocks like Apple (AAPL) are covered by dozens of highly trained financial analysts. Galaxy Gaming (GLXZ), on the other hand, is followed by exactly zero analysts.

Galaxy Gaming who?

Galaxy Gaming, which produces table games and betting platforms for the casino industry, has a market capitalization of $50 million and trades over the counter (OTC). Unfortunately for such companies, analyst coverage of US stocks has been steadily decreasing since the 2000s due to tighter Wall Street regulations, among other factors.

But the lack of analyst coverage might offer alpha-generating opportunities. Could the less-covered areas of the equity markets be worth an extra look?

Although analyzing thousands of micro- and small-cap stocks by hand is not a sensible strategy, investors can apply systematic frameworks to uncover hidden gems. So does factor investing in micro- and small-cap stocks in the United States offer any additional alpha?

METHODOLOGY

To find out, we divided the US equity market into three segments based on market capitalization. Together these three segments approximate the Russell 3000 universe:

  • Micro caps include about 800 stocks, each with $100 million to $500 million in market capitalization.
  • Small caps feature about 400 stocks with $500 million to $1 billion in market capitalization.
  • Mid and large caps have market capitalizations in excess of $1 billion and number about 1,800 stocks in total

We created market cap-weighted and equal-weighted indices as well as three equal-weighted factor portfolios composed of the top 10% of stocks ranked by each factor. We define Value as a combination of price-to-book and price-to-earnings multiples and Quality as a combination of return-on-equity and debt-over-equity (rea