So far in this series, we’ve covered faulty benchmark construction, the wide array of fundamental drivers, and the critical importance of quality in cutting through the noise among micro cap stocks. Now, we turn to the largest factor spreads I’ve come across in any segment of the market, real world considerations for implementation, and why the dichotomy of scale versus alpha could result in a persistent opportunity for outperformance.

Factor investing is more effective in micro than any other cap range

Though factor investing has rooted itself squarely in large cap equities, it significantly more effective in eclectic corners of the market—small and micro cap. Thus far, we touched on quality themes like financial strength, earnings quality, and earnings growth to screen stocks out. Let’s turn our focus to a broader suite of multi-factor themes by bringing value and momentum into the arena. While value and momentum are also effective in negative screening, they are most effective in identifying which stocks to select.

In an analysis of the performance of each multifactor theme from 1982-2016, shown below, there are enormous differentials in the return spread between high and low-ranking stocks. Spreads serve as a proxy for robustness of a factor. In the academic literature, these are hypothetical long-short portfolios that suggest the size of a systematic return premium.

The table below displays the spread between the return of high and low deciles in Large, Small, and Micro stocks on each theme. Using this lens, it is readily apparent that factors are more robust in micro than large, and even small stocks. Within the micro cap space, the smallest spread (Earnings Quality, 14.5%) is wider than the largest in Large Stocks (Value, 12.5%). This again highlights the importance of quality in microcap. As measured by the spread, quality is 3-4x more important in Micro as Large.