For the first installment of this series, I dove into the Russell Microcap® Index to understand it's construction and behavior. I showed that Russell’s definition of micro cap is flawed in that it is predominantly representative of small cap stocks, and includes highly illiquid names that drag on performance. From an allocator's point of view, the index return is lackluster when compared to large cap stocks. For this post, I think more fundamentally about what drives the opportunity set of “true” micro cap stocks.

For the remainder of this series, I diverge from the Russell index definitions to get a better sense of the composition of micro cap and the alpha opportunity available. I define micro cap stocks as those trading on U.S. exchanges with an inflation-adjusted market capitalization between $50 million and $200 million.[1] This micro cap universe is also equal-weighted, as opposed to cap-weighted. This provides a “pure” view of the micro cap market that has minimal overlap with small cap stocks. This group of about 1,300 stocks represents a disproportionately small 0.4% of total U.S. market capitalization. With average daily volume of just $700 thousand and a cumulative market cap of about $100 billion, the group is a mixture of exciting growth opportunities and the land of misfit toys. Once I screen out companies with unreasonable liquidity and non-U.S. firms, the list dwindles to about 500 investable stocks.

For comparison purposes, I periodically refer to a Large Stocks universe. Large stocks consist of U.S. firms with a market capitalization greater than the average capitalization for the total market, currently those stocks above an inflation-adjusted $7 billion market cap. This group is instructive as it represents the bulk of investor’s U.S. equity allocation. It is analogous to the S&P 500 Index on an equal-weighted basis.

Unique aspects of the micro cap universe

An investor cannot fully appreciate the micro cap space without understanding how stocks have come to fall on the micro cap spectrum. Whereas, most large stocks have succeeded in attempts to grow their businesses, as recognized by their multi-billion dollar valuations, micro cap stocks are on a completely different playing field. These businesses range from biotech startups to failing businesses that have depreciated to their current middling market cap. From an empirical perspective, the result is a lot of noise in the data.

To demonstrate, let’s look at one of the most fundamental metrics for a firm, sales growth. Though its efficacy as an investment factor is marginal, sales are the lifeblood of any firm and have a cascading effect on all other elements of the financial statements. The chart below compares the distribution of 3-year sales growth across large and micro cap stocks.