In the previous post in this microcap series, I established that the fundamental drivers of micro cap businesses are widely varied, at least in part, due to their state of being—new venture, steady state, and fallen angel. This poses a challenge for stock pickers. It creates a lot of noise in the data, as we saw in the previous post, and requires expertise in many different types of situations—venture, growth, distressed, etc. One could argue that stock picking in microcap requires a broader analytic skill set than for more stable large stocks. This post attempts to cut through some of the noise inherent in micro caps to level the playing field.

Let’s take a step back to build intuition for stock selection regardless of where a company falls on the business life cycle. In our research, we have found several quality metrics to be indicative of good businesses. Generally, businesses should be profitable, growing at a reasonable pace, and appropriately capitalized. Individually, these metrics are effective, but when used together thematically, they provide a powerful framework for eliminating poor quality stocks. The table below compares several characteristics for Large and Mirocap stocks.

In each case, a simple average of characteristics for Micro cap stocks betrays the universe’s lower quality nature relative to Large Stocks. One would assume from looking at the Microcap Stocks column that these businesses are rapidly growing their asset base (Change in Net Operating Assets), not particularly profitable (ROIC), taking on tremendous debt (1-Year Debt Change), and generating negative free cash flow (Free Cash Flow-to-Enterprise Value). All of these would seemingly signal starvation for cash, a particularly bad thing for small businesses.

Change in Net Operating Assets (NOA) measures the growth in assets required to run the business. If a small consumer products company, for example, hit the jackpot with a new contract at a huge retailer and then had to ramp up production to fulfill the order, this metric would increase. Sales growth requires large investment for raw materials, inventory, delivery of finished goods, and equipment for ongoing production. The challenge with growth is that it requires huge cash outlays. This cash is all outlaid before revenue occurs. Dramatic growth in operating assets can be indicative of stress, as it leaves the business in a tenuous cash position. This state of affairs appears to be the norm for micro cap stocks with an average change in NOA of 44.3%—close to twice the rate for Large Stocks.

Few small firms have enough internal capital to fund such large investments. They then turn to capital providers to fund growth—equity offerings or taking on debt. Keep in mind that many micro cap stocks have no analyst coverage, so the ability to tap equity capital markets is limited and expensive. Debt becomes the default source of capital. The average 1-Year Change in Debt for the universe is 32.6%, and debt-to-equity is on par with Large Stocks. The ROIC of just 13.2% indicates that capital, of which debt is a part, is not being as efficiently invested as with Large Stocks. A free cash flow yield of -4.5% suggests economic value is being destroyed, rather than created.

Each of these characteristics are components of multi-factor themes that can be used to assess the quality of a firm: Earnings Quality (NOA), Financial Strength (D/E, Change in Debt), and Earnings Growth (ROIC). To level the playing field for comparison to Large Stocks, we can rank stocks in the micro cap universe based on these themes and eliminate the lowest ranking decile. Firms falling into these poorly-ranked groups tend to be poorly capitalized and have low profitability and weak earnings quality.

By adjusting the micro cap universe, the overall metrics dramatically improve, and in some cases, are actually better than Large Stocks. Quality Adjusted Microcap Stocks reveal much more moderate growth rates in NOA. An average 13.7% is indicative of businesses that are more likely to handle organic business growth without needing to seek substantial funding from debt or equity issuance. The improvement in the 1-Year Debt Change metric after adjusting for quality supports this logic. A large 32.6% increase in debt decreases to just 12.1%—lower than the average for Large Stocks.

Clearly, the universe quality metrics have improved, but how does this translate into investor returns? It turns out that elimination of poor quality boosts the return of our universe by 5.3% annualized with a 0.7% reduction in annual volatility (table below).

Incorporating quality criteria to eliminate stocks from consideration has a dramatic impact on micro cap stocks. Performing a quality assessment highlights the importance of a less appreciated aspect of factor investing. While many researchers focus on the outperformance associated with factors, the avoidance of groups of stocks can be just as positive a contributor to investor returns. After controlling for quality, the risk-adjusted returns available are in-line with large stocks. In the first post of this series, I mentioned that the historical return and risk of the Russell Microcap® Index did not merit an allocation according to mean-variance optimization. This simple quality screen alters the space’s characteristics to such an extent that it becomes a viable source of differentiated return for investors.

Now that we’ve leveled the playing field for micro cap investors by controlling for quality, my next post will dive into the effectiveness of selection factors—like value and momentum—and present a comprehensive look at the real-world hurdles to managing micro cap portfolios.