Microcap, one of the newest terms in the language of investing, refers to stocks with market capitalizations of less than $250 million that have attracted renewed interest because of the burgeoning of IPOs and the refinement of market systems for trading smaller capitalized stocks.
INTRODUCTION
The increase in the issues of emerging company stocks since 1996 has regenerated interest in these smallest capitalized equity issues. Some academics and investment professionals have argued that the risk/return characteristics of these microcaps qualify them as distinct alternatives and portfolio enhancements to large market cap investment programs.
The purpose of this us is to revisit that argument. We will also discuss whether new market structures and recent regulations have changed how these stocks are valued, issued, and traded. In the course of this discussion, we will touch on that most sensitive issue of modern investment theory: investment manager skill.
INTRODUCTION
The increase in the issues of emerging company stocks since 1996 has regenerated interest in these smallest capitalized equity issues. Some academics and investment professionals have argued that the risk/return characteristics of these microcaps qualify them as distinct alternatives and portfolio enhancements to large market cap investment programs.
The purpose of this us is to revisit that argument. We will also discuss whether new market structures and recent regulations have changed how these stocks are valued, issued, and traded. In the course of this discussion, we will touch on that most sensitive issue of modern investment theory: investment manager skill.
NEWEST ALTERNATIVE
Microcap is one of the newest terms in the language of investing. The authors first encountered the word when it was used by John Marquise (founder of the American Association of Individual Investors) on “Adam Smith’s” Money World in 1996. The first conference for institutional investors on these stocks was also held in 1996. The term is so new that there is more than one accepted spelling. We use the spelling that has been consistently used by the Bloomberg Press, a division of the financial data and commonactions company, Bloomberg, L. P.
We accept the Frank Russell Company classification of microcap stocks as those having market capitalizations of less than $250 million. The median market cap for this category is $120 million. The focus of this chapter is only on the stocks of emerging companies in the United States, the microcap growth stocks. The equities of “reemerging” microcap stocks are most likely to have the characteristics of the distressed securities discussed in the chapter on this topic in this book.
We have also omitted from this chapter the over-the-counter bulletin board (OTCBB) stocks. We consider these speculative stocks inappropriate for any reasoned investment strategy.
EVOLUTION OF MICROCAP GROWTH INVESTING
Among the many changes and events occurring in the capital markets in the 1990s, two factors created the renewed interest in this unique class of common stocks: (1) the burgeoning of initial public offerings (IPOs) and (2) the refinement of market systems for trading smaller capitalized stocks.
Burgeoning IPOs
A convergence of situations and events in the 1990s created one of the most favorable environments for investing in stocks in the history of capital markets. This happy set of circumstances has been the subject of hundreds of articles and, recently, dozens of books. Key factors were the demand for stocks and stock funds by members of defined contribution retirement plans, a reduction in capital gains taxes, and low inflation rates. What distinguished that bull market from previous sustained periods of enthusiasm was the great demand for small-capitalization stocks.
The rapid advances in information and biological technology were being created, for the most part, among small groups of academics, inno-vators, and inventors. Few were working within the confines of the estab-
lished corporations that have been the dominant forces in business and indus-try. These new enterprises needed capital. Because there were increasing demands for new investment opportunities, the time was right for acquir-ing capital. Most of the capital was acquired from venture investors whose aims were to eventually take the firms public for more money than they put up. Recent history records that many of those companies did go public, resulting in an exploding secondary market for those companies’ stocks.
New and Improved Market Systems
The National Association of Securities Dealers Automated Quotations (Nasdaq) system was established in 1971. It quickly became the predominant negotiated marketplace for stocks. The success of the system required continued refinements. In 1982 the National Market System evolved from the original structure to facilitate the trading of stocks of emerging companies that met certain requirements.
The American Stock Exchange (AMEX) also provided the opportunity to selected emerging companies to list their securities if they met the same standards. In addition to meeting these standards, companies were required to follow the filing and disclosure dictates of the Securities and Exchange Commission (SEC) with respect to financial information.
Investors now had marketplaces in which they could trade the smaller capitalized stocks of these emerging companies. They were also assured that the financial information about these companies would be available as readily as the information about the larger capitalized issues. Because seasoned stocks of the established companies were trading at record highs in the late 1990s, investors had to look at the stocks of these newer and smaller companies for the prospects of higher returns.
The demand for these stocks drove their prices up and attracted more money. Thus, an alternative to seasoned equities evolved for institutional investors. The dramatic increase in microcap investing among the professional investors raised the question about whether the historical risk/return relationships were still appropriate for measuring the performance of these particular equities.
MICROCAP RISK AND RETURN
The fact that dividends are not a factor simplifies our discussion about the returns from microcap stocks.
On the most commonly used graph that plots risk and return for com-mon stocks, analysts sometimes like to divide the graph into four equal compass quadrants. Microcap equities are unquestionably found in the “Northeast” quadrant (see Figure 1).
If Figure 1 were an approxi-mation of a map of the continental United States, the argument would be whether these stocks are clustered around Albany, New York, or Bangor, Maine. This depends on what issues are included in the category. If one includes the most recent Center for Research in Securities Prices (CRSP) data for their deciles 9 and 10, then Bangor is the spot. The CRSP deciles are created by taking all of the New York Stock Exchange (NYSE) stocks (other than ADRs, REITs, and closed-end funds) and dividing them into 10 groups ranked by market cap. Decile “1” is composed of the largest com-panies. The AMEX and Nasdaq stocks are then added to the appropriate deciles.
If one were to segment deciles 9 and 10 into the style classes of growth or value, then the microcap growth stocks are likely to be clustered north-east of Bangor, and the value microcap stocks would likely be clustered some-where closer to Albany. We have used the imprecise term “likely” because categorizing and characterizing the risk and reward relationships among microcap stocks is a very recent research activity. Academics and investment managers are revisiting the research because of the emergence of all those listed microcap stocks in the 1990s. The research activity has been compli-cated by the changing market valuations that have occurred since the fall of 2000 and by the effects of new regulations governing trading and reporting.
If one were to segment deciles 9 and 10 into the style classes of growth or value, then the microcap growth stocks are likely to be clustered north-east of Bangor, and the value microcap stocks would likely be clustered some-where closer to Albany. We have used the imprecise term “likely” because categorizing and characterizing the risk and reward relationships among microcap stocks is a very recent research activity. Academics and investment managers are revisiting the research because of the emergence of all those listed microcap stocks in the 1990s. The research activity has been compli-cated by the changing market valuations that have occurred since the fall of 2000 and by the effects of new regulations governing trading and reporting.
Revisiting The Research
In the late 1970s, Rolf W. Banz at the University of Chicago began study-ing the returns of stocks based on their market capitalization. His research suggested that, even after adjusting for risk, small company stocks seemed to do better than the stocks of large companies. Banz and Marc R. Reinganum subsequently published papers in the March 1981 issue of the Journal of Financial Economics1, 2 that argued that those stocks in the small-est cap CRSP deciles generated returns more than 5 percent higher than returns of the larger cap stocks over the same periods. They construed this excess return as the risk premium for holding the smaller capitalized stocks. This observation was discussed among academics in the context of the Capital Asset Pricing Model (CAPM) and became known as the size effect.
The risk/return aspects of the size effect have been debated frequently over the last 20 years. There is always the question of the actual costs of buying or selling the smallest capitalized stocks. These thinly issued stocks are in relatively short supply, and an investor is always at a disadvantage when posting a buy or sell order for one of these stocks. Critics of the conclusions of the size effect postulate argue that these inherent transaction costs cancel out any supposed risk premium.
Transaction Costs
It is undisputed that the costs of transactions involving the smallest cap stocks are much higher than costs associated with the trading of the larger cap stocks. Not only market cap size but also investment manager style will impact transaction costs. Other than brokerage commissions, what other transaction costs are there? Wayne Wagner and Steven Glass of The Plexus Group, a Los Angeles research and consulting firm, identified and explained those other transaction costs in an article in The Journal of Investment Consulting3:
Market impact cost is measured by taking the difference in the quoted price of a stock when the manager placed an order and when the order was executed.
Delay cost occurs when the investor tries to wait for the “best price” to make a trade with someone who is monitoring the stock closely. The odds are about even that the experienced investor or trader will not get a better price. In the worst case, the order gets canceled. Opportunity cost is the extreme of the delay cost. This is the cost of missing out or just partially covering the order.
In the late 1970s, Rolf W. Banz at the University of Chicago began study-ing the returns of stocks based on their market capitalization. His research suggested that, even after adjusting for risk, small company stocks seemed to do better than the stocks of large companies. Banz and Marc R. Reinganum subsequently published papers in the March 1981 issue of the Journal of Financial Economics1, 2 that argued that those stocks in the small-est cap CRSP deciles generated returns more than 5 percent higher than returns of the larger cap stocks over the same periods. They construed this excess return as the risk premium for holding the smaller capitalized stocks. This observation was discussed among academics in the context of the Capital Asset Pricing Model (CAPM) and became known as the size effect.
The risk/return aspects of the size effect have been debated frequently over the last 20 years. There is always the question of the actual costs of buying or selling the smallest capitalized stocks. These thinly issued stocks are in relatively short supply, and an investor is always at a disadvantage when posting a buy or sell order for one of these stocks. Critics of the conclusions of the size effect postulate argue that these inherent transaction costs cancel out any supposed risk premium.
Transaction Costs
It is undisputed that the costs of transactions involving the smallest cap stocks are much higher than costs associated with the trading of the larger cap stocks. Not only market cap size but also investment manager style will impact transaction costs. Other than brokerage commissions, what other transaction costs are there? Wayne Wagner and Steven Glass of The Plexus Group, a Los Angeles research and consulting firm, identified and explained those other transaction costs in an article in The Journal of Investment Consulting3:
Market impact cost is measured by taking the difference in the quoted price of a stock when the manager placed an order and when the order was executed.
Delay cost occurs when the investor tries to wait for the “best price” to make a trade with someone who is monitoring the stock closely. The odds are about even that the experienced investor or trader will not get a better price. In the worst case, the order gets canceled. Opportunity cost is the extreme of the delay cost. This is the cost of missing out or just partially covering the order.
These costs, as they relate to market cap and style strategies, are sum-marized in Table 1 with the cost components computed in basis points (one basis point is equal to 0.01 percent). Growth style managers investing in small cap companies encounter higher transaction costs than any other investment style, and microcap growth managers face the highest costs of all. (Plexus Group has developed an inclusive transaction cost database and some internally generated benchmarks. Readers who require extensive and refined cost data should visit http://www.plexusgroup.com/ to find out how this data can be obtained.)
This table compares the average transaction costs (in basis points) incurred with respect to manager styles. Note the range of average costs across these styles. Not surprisingly, large cap value managers (who are shoppers by definition) enjoy a trading costs advantage. The higher costs incurred by large cap growth managers reflect their reactions to news and recommendations. Indexers will incur most of their costs at the trading desk. Small cap value and growth managers will always encounter higher costs because of the problems associated with lesser liquidity.
This table compares the average transaction costs (in basis points) incurred with respect to manager styles. Note the range of average costs across these styles. Not surprisingly, large cap value managers (who are shoppers by definition) enjoy a trading costs advantage. The higher costs incurred by large cap growth managers reflect their reactions to news and recommendations. Indexers will incur most of their costs at the trading desk. Small cap value and growth managers will always encounter higher costs because of the problems associated with lesser liquidity.
Survivorship Bias
In addition to the transaction cost argument, there is also a survivorship bias in the discussion of the size effect, just as there is when discussing investment manager performance. CRSP appears to ignore delisted stocks when making its calculations. The omission of the delisted stocks misstates relative performance figures.
In addition to the transaction cost argument, there is also a survivorship bias in the discussion of the size effect, just as there is when discussing investment manager performance. CRSP appears to ignore delisted stocks when making its calculations. The omission of the delisted stocks misstates relative performance figures.
REVISITING THE DIVERSIFICATION ARGUMENT
Microcap enthusiasts argue that most microcap stocks are inefficiently priced almost all the time; therefore, they reason that these stocks provide real diversification in a stock portfolio of different market caps. This pre-supposes some significant variance in market performance from the larger cap stocks. Is there any evidence of this for just microcap growth stocks? How valid is the evidence over several market cycles and macroeconomic cycles? Does past performance guarantee anything, particularly in the light of recent regulations governing financial disclosure and dictating trading procedures?
For the 30-year period ending December 30, 2000, small company stocks (CRSP deciles 6 through 10) returned 150 basis points over the stocks of the large companies (CRSP deciles 1 through 5), including reinvested dividends but not before transaction costs. One can therefore infer that the absolute returns difference could be negligible.
For the 25-year period ending December 31, 1998, CRSP 9 and 10 had an annual return of 13.8 percent. The S&P 500 Index annual return over the same period was 12.3 percent. Again, the difference was in favor of the smallest stock issues by 150 basis points, including reinvested dividends, but not before transactions costs.
Only when the comparisons are broken down into smaller time segments does the argument for cap size diversification appear to have merit (see Table 2).
Microcap enthusiasts argue that most microcap stocks are inefficiently priced almost all the time; therefore, they reason that these stocks provide real diversification in a stock portfolio of different market caps. This pre-supposes some significant variance in market performance from the larger cap stocks. Is there any evidence of this for just microcap growth stocks? How valid is the evidence over several market cycles and macroeconomic cycles? Does past performance guarantee anything, particularly in the light of recent regulations governing financial disclosure and dictating trading procedures?
For the 30-year period ending December 30, 2000, small company stocks (CRSP deciles 6 through 10) returned 150 basis points over the stocks of the large companies (CRSP deciles 1 through 5), including reinvested dividends but not before transaction costs. One can therefore infer that the absolute returns difference could be negligible.
For the 25-year period ending December 31, 1998, CRSP 9 and 10 had an annual return of 13.8 percent. The S&P 500 Index annual return over the same period was 12.3 percent. Again, the difference was in favor of the smallest stock issues by 150 basis points, including reinvested dividends, but not before transactions costs.
Only when the comparisons are broken down into smaller time segments does the argument for cap size diversification appear to have merit (see Table 2).
There is almost no research available on what caused this divergence, but some observations about the behavior of investors and the nature of microcap stocks may help explain some of the performance. Microcaps are the last stocks to move in the direction of a market cycle. They will be the last stocks to rally because investors turn to microcaps when they suspect that the higher caps are becoming overvalued. They are the last stocks to be sold in a major downturn because investors are loath to sell their less liquid stocks in the face of a buyer’s market. As Daniel P. Coker points out in his excellent book, this late-in-the-cycle downturn “ . . . is due more to avoidance than to actual selling . . .”4
Alert readers will note that the relative performance periods in
Table 2 are of unequal length. This is an attempt to smooth out those periodic “bursts” of extreme highs and lows that have occurred in the overall U.S. market from 1969 through 1999.
Some readers will want to deconstruct these performance periods to determine the existence of an alleged anomaly known as the “January Effect,” wherein small cap stocks go up every January. Don’t waste your time. If there were such a distinct pattern, it hasn’t existed for the last decade. There is no “January Effect.” None. End of discussion.
Critical readers will point out that, because of disparate market caps and share floats, it would be difficult to proportion a portfolio equally between microcaps and larger cap stocks —and impossible to shift funds from one class to another. They are correct. The strategic use of microcaps therefore is to allocate a relatively small proportion of microcap holdings within a diversified investment program. The degree of that proportion depends on each investor’s risk tolerance, and you have to remember high transaction costs when you want to rebalance. Never try to be market timer or a “style tilter.” Never.
Critical and alert readers will point out that the CRSP data is for all stocks, and there is no breakdown between value stocks and those stocks we set out to discuss: microcap growth stocks. Where are the data and the indexes with respect to investment styles? What are the best index funds if we want to use them instead of stocks in our allocation strategy?
MICROCAP SEGMENTATION AND BENCHMARKS
Microcaps command very little attention from that largest of institutional pools, public, and private defined-benefit pension plans. Consequently, con-sultants, investment managers, or brokers have not been motivated to underwrite or undertake any sustained compilation of segmented microcap benchmarks. There have been attempts by some Web sites to construct
microcap growth stock indexes. They have not been successful. Delistings and bankruptcies compounded the difficulties in developing a representative group of stocks in any meaningful and representative quantity.
Experienced microcap investors will tell you that most microcap stocks are considered growth stocks. They have discovered that the small number of value plays are really a variation on vulture investing. The other micro-cap issues either demonstrate sustained growth or they fail. So a benchmark comprised of all microcaps is a close proxy for microcap growth stocks (allowing for some survivorship bias). Does such a benchmark exist?
Less than 10 percent of the companies comprising the Russell 2,000 Index fall into the CRSP 9 and 10 deciles. The only near aggregate avail-able for benchmarking is the Dimensional Fund Advisors mutual fund, the DFA 9 to 10 Small Company Fund. This fund invests in the smallest 20 per-cent of all publicly traded stocks, approximating the stocks in the CRSP 9 to
10. The fund’s median market cap runs less than $130 million. It is not, however, a true index fund. The fund has some latitude in which stocks it buys and sells within the 9 to 10 universe. The fund is intended for major institutional investors who want an efficient means with which to capture size effect. The minimum purchase is $2 million.
There is no readily available microcap benchmark for the individual investor. This is not necessarily a disappointing state of affairs. There would be a dilemma for an investor in a benchmarked microcap fund. In a true index fund, stocks would get sold out of the portfolio once their market cap outgrew the micro stage. The fund could be subject to a lot of turnover and the related transaction costs. Most important, though, the investor would miss out on any subsequent increases in value of the stocks sold.
The alert and critical readers are now questioning the relevancy of this benchmark talk. “If the whole point of this chapter is a discussion of the relative performance and divergence between microcaps and large caps, why waste any more time talking about benchmarks that don’t exist?” They’re right again. We should discuss more pertinent systemic issues such as recent SEC regulations and their impact.
RECENT REGULATORY IMPACT
The adage about past performance is relevant to the discussions in this chapter but not just in the usual “mean reversion” context. Investment professionals now are working in an environment that has been changed fundamentally. Recent regulations are having a critical impact on the manner in which equities are traded and valued, particularly microcaps.
The adage about past performance is relevant to the discussions in this chapter but not just in the usual “mean reversion” context. Investment professionals now are working in an environment that has been changed fundamentally. Recent regulations are having a critical impact on the manner in which equities are traded and valued, particularly microcaps.
Where Are the Market Makers?
The SEC issued a new set of rules in 1997 that changed the way orders were handled by the Nasdaq systems. The rules were intended to correct some practices that were allegedly increasing investors’ trading costs. After the new rules were implemented, securities dealers who had provided the liquidity with their trading desks soon discovered that it was impossible to make any money trading the smallest of caps under the new rules. These securities dealers subsequently shut down their trading operations and ceased making “retail” markets in the Nasdaq Small Cap Issues system.
A few large (extremely well-capitalized) dealer firms had been func-tioning as warehousing wholesalers to the smaller dealers. When those deal-ers ceased making markets, the wholesalers became the only game in town. The new rules didn’t permit those few large dealers to make any money on transactions either. However, these firms may have found a better way to make money from their well-capitalized advantage: They can glean infor-mation from the flow of all those buy and sell orders that come to them.
There is now an oligopolic structure standing astride the Nasdaq Small Cap Issues system that is not providing the necessary liquidity for that system’s listed stocks. Investment bankers who underwrite IPOs that would have been listed on the Small Cap Issues system are now arranging to have those stocks listed on the AMEX. There also have been many instances wherein companies have left the Small Cap System for the AMEX.
Conventional wisdom has held that the auction markets (exchange floors) exist for seasoned (higher capitalized) issues and that negotiated markets have accommodated the smaller publicly listed issues. Such arrangements are no longer the case. Will the move toward trading qualified microcaps on the AMEX enhance their liquidity and reduce transaction costs? Will another exchange decide to challenge the AMEX microcap franchise? For investors interested in microcap growth stocks as alternative investments, these questions are relevant, pertinent, and crucial.
Regulation FD
In October 2000, the SEC instituted a new rule governing the disclosure by corporations of their operating and financial information: Regulation fair disclosure (FD). This new rule is a deliberate effort by the SEC to “level the playing field” for individuals and institutions.
Regulation FD was a response to the practice of issuers selectively sharing material, nonpublic information with certain institutional clients and analysts before disseminating their findings to the public at large. This practice was thought to put all excluded investors at a disadvantage.
The SEC issued a new set of rules in 1997 that changed the way orders were handled by the Nasdaq systems. The rules were intended to correct some practices that were allegedly increasing investors’ trading costs. After the new rules were implemented, securities dealers who had provided the liquidity with their trading desks soon discovered that it was impossible to make any money trading the smallest of caps under the new rules. These securities dealers subsequently shut down their trading operations and ceased making “retail” markets in the Nasdaq Small Cap Issues system.
A few large (extremely well-capitalized) dealer firms had been func-tioning as warehousing wholesalers to the smaller dealers. When those deal-ers ceased making markets, the wholesalers became the only game in town. The new rules didn’t permit those few large dealers to make any money on transactions either. However, these firms may have found a better way to make money from their well-capitalized advantage: They can glean infor-mation from the flow of all those buy and sell orders that come to them.
There is now an oligopolic structure standing astride the Nasdaq Small Cap Issues system that is not providing the necessary liquidity for that system’s listed stocks. Investment bankers who underwrite IPOs that would have been listed on the Small Cap Issues system are now arranging to have those stocks listed on the AMEX. There also have been many instances wherein companies have left the Small Cap System for the AMEX.
Conventional wisdom has held that the auction markets (exchange floors) exist for seasoned (higher capitalized) issues and that negotiated markets have accommodated the smaller publicly listed issues. Such arrangements are no longer the case. Will the move toward trading qualified microcaps on the AMEX enhance their liquidity and reduce transaction costs? Will another exchange decide to challenge the AMEX microcap franchise? For investors interested in microcap growth stocks as alternative investments, these questions are relevant, pertinent, and crucial.
Regulation FD
In October 2000, the SEC instituted a new rule governing the disclosure by corporations of their operating and financial information: Regulation fair disclosure (FD). This new rule is a deliberate effort by the SEC to “level the playing field” for individuals and institutions.
Regulation FD was a response to the practice of issuers selectively sharing material, nonpublic information with certain institutional clients and analysts before disseminating their findings to the public at large. This practice was thought to put all excluded investors at a disadvantage.
Regulation FD requires that, when a public company has material, non-public information to discuss in a selective forum, it must first disclose that information publicly through a news release, an 8-K filing, or simultaneously through a fully accessible, nonexclusionary Webcast or telephonic means. Not surprisingly, Regulation FD has had some unforeseen consequences with respect to fundamental research conducted by individual investors and buy-side investment managers who use a “pick-and-shovel” approach to secu-rity analysis.
When a diligent money manager or enterprising individual calls a com-pany to confirm some material information obtained through the investor’s own initiative, the company response is: “Our lawyers told us we can’t respond to your question until we disclose our complete response through a fully accessible medium. Sorry, goodbye.” From conversations with sev-eral microcap investment managers, we have confirmed that this response, or a paraphrase, is always the case. From conversations with some of the top securities lawyers in the nation, we have learned that this response is the most appropriate. No guidance from the target company, however indirect, is advisable. This prevailing condition leaves the diligent investor with two alternatives: (1) sustained queries among the target company’s suppliers, cus-tomers, distributors, and competitors or (2) “the hell with ‘em.”
The sustained queries become indirect, but identifiable, additional costs of investing —the unintended consequence of a well-intentioned mandate. The alternative response could result in an opportunity cost. The microcap market is inherently imperfect because information within this area of investment activity is not widely disseminated. Regulation FD compounds this situation. Indisputably, investor skill has become a more significant fac-tor. Tenacious research is a comparative and competitive advantage.
SECURITY ANALYSIS
Up to this point we have discussed microcap growth stocks in the context of market risk. The critical features in any portfolio are the risks specific to each of the companies whose stocks are owned. Not too long ago, vigorous debates about the valuations of emerging company stocks dominated the financial news. When reviewing the comments by market professionals and academics about this matter, one can come to either of two conclusions: (1) Each party had a responsible point of view, or (2) some of the debaters didn’t have a clue. In our opinion some of the most responsible arguments are those of Baruch Lev, who teaches at the Stern School of Business at New York University (NYU), Robert
G. Eccles of Advisory Capital Partners in Jupiter, Florida, and Andy Kessler, a partner at Velocity Capital Management in Palo Alto, California.
When a diligent money manager or enterprising individual calls a com-pany to confirm some material information obtained through the investor’s own initiative, the company response is: “Our lawyers told us we can’t respond to your question until we disclose our complete response through a fully accessible medium. Sorry, goodbye.” From conversations with sev-eral microcap investment managers, we have confirmed that this response, or a paraphrase, is always the case. From conversations with some of the top securities lawyers in the nation, we have learned that this response is the most appropriate. No guidance from the target company, however indirect, is advisable. This prevailing condition leaves the diligent investor with two alternatives: (1) sustained queries among the target company’s suppliers, cus-tomers, distributors, and competitors or (2) “the hell with ‘em.”
The sustained queries become indirect, but identifiable, additional costs of investing —the unintended consequence of a well-intentioned mandate. The alternative response could result in an opportunity cost. The microcap market is inherently imperfect because information within this area of investment activity is not widely disseminated. Regulation FD compounds this situation. Indisputably, investor skill has become a more significant fac-tor. Tenacious research is a comparative and competitive advantage.
SECURITY ANALYSIS
Up to this point we have discussed microcap growth stocks in the context of market risk. The critical features in any portfolio are the risks specific to each of the companies whose stocks are owned. Not too long ago, vigorous debates about the valuations of emerging company stocks dominated the financial news. When reviewing the comments by market professionals and academics about this matter, one can come to either of two conclusions: (1) Each party had a responsible point of view, or (2) some of the debaters didn’t have a clue. In our opinion some of the most responsible arguments are those of Baruch Lev, who teaches at the Stern School of Business at New York University (NYU), Robert
G. Eccles of Advisory Capital Partners in Jupiter, Florida, and Andy Kessler, a partner at Velocity Capital Management in Palo Alto, California.
Arguments withstanding or not, microcap investors should begin their due diligence by studying the operating, financial, and accounting measures that are the practical day-to-day concerns about the specific risks of owning microcap growth stocks. We will discuss qualitative aspects at the end of this section.
The Income Statement
The most frequently mentioned valuation measure in the popular media is earn-ings. No experienced investor accepts earnings as a “first-cut” measure of appeal, regardless of the size of the subject stock’s market cap. The experienced response is always, “How were the earnings computed?” This quality of earn-ings issue will be discussed but not in the context of earnings per share (EPS).
Earnings measured in shares outstanding of an emerging company’s stock are not relevant to meaningful analysis. An emerging company has a relatively small number of equity shares outstanding, (and an even smaller proportion in the float). So, what if an increase in the number of outstanding shares would decrease EPS? It’s the earnings and their sustainability that count. An increase in the float (such as from exercised options) will always enhance the appeal of a microcap stock due to increased liquidity, and so would an increase in the shares authorized for public trading.
There are two concerns with respect to microcap company earnings: Can an increase in earnings be sustained? How were the earnings computed? With respect to sustaining earnings, here are two typical comments from money managers about any report of a decrease in earnings by a microcap company:
1. “Don’t tell me that a microcap company can have a bad quarter once in a while and then bounce back. Phooey! When a company’s profits turn south, it takes a long time to reverse course.”
2. “An earnings surprise in a microcap stock is the beginning of a long period of underperformance —maybe the beginning of the end.”
Whether or not you subscribe to such severe interpretations, the fact that others do creates a substantial headwind for a buy decision. Hurray for you contrarians! Just don’t underestimate the effects of consensus risk. The “quality of earnings” issue is the other concern in the analysis of an emerging company. Yes, there is always the probability of some chi-canery in a company’s financial reporting, but that probability is of rela-tively small concern. Ninety-nine percent of listed emerging companies won’t engage in it for the same reasons that 99 percent of the higher cap-italized companies won’t. The consequences from having the abuses being discovered are too severe.
Time spent trying to detect crime puts the investor/analyst at a severe cost disadvantage. Just focus on the presentations in the SEC forms 10-Q and 10-K. The methods permitted for the reporting of revenues and expenses will provide challenge enough.
Revenues In July 2000, the Financial Accounting Standards Board (FASB) issued new revenue recognition rules, most notably mandating distinctions between gross and net revenues. Gross revenue is the amount invoiced. Net revenue is how much the company retains after paying a wholesaler or manufacturer for the invoiced products. The experienced investor recognizes this as a cost of goods sold (COGS) issue. Past practice for “old economy” firms was to report in their gross income computations a deduction of the direct (actual) costs of goods sold. To compute revenues otherwise would overstate them substantially. A lot of microcap companies within the high-tech sector have computed otherwise. How was this permissible?
The question of permissibility was succinctly treated in an article by Julia Lawlor in the December 4, 2000, issue of Red Herring5. Many e-merchants operate as agents, rather than principals, in a transaction. No brick-and-mortar travel agency would book as revenue the cost to its customers of the travel and lodging it reserved, just the commissions earned. Priceline.com booked as revenue the full price of the reservations it arranged for customers. Lawlor cites the Priceline.com justification: “ . . . although it doesn’t take title to the product until after the customer has made a nonrefundable purchase by credit card, it assumes the risk if the customer’s credit is bad, the charge is disputed or the supplier goes out of business . . .” The diligent investor understands that “disputed” might be the only operative word in the that rationale.
Lawlor also addresses the practices among emerging biotech firms: “ . . . Historically, biotech companies have gotten upfront fees when they have affiliated with big pharmaceutical companies for joint research and devel-opment arrangements. The fees are booked immediately as revenue, under the assumption that the payment is for research the companyhas already completed. But the SEC says the payments should be spread out over the term of the agreement.” The industry has been challenging the SEC’s view.
As Andy Kessler reminds us, chief financial officers love to tweak. They are tempted to smooth out “lumpy” revenues. Revenues actually received from a larger-than-usual sale in the last few weeks of one quarter may not be reported for that quarter but apportioned over a couple of subsequent quarters. This has probably occurred a few times among a lot of firms, big or small. If you discover that this practice is frequent and common at one of your target companies, then remove the company from further consideration. Another tactic of concern is the flip side of the booking issue: Watch that a company doesn’t report all the revenue stipulated in a long-term contract as revenue received now.
The key questions remain. Did real money come into the company as the result of a sale? Is any of that money owed to the actual selling princi-pal in the transaction? Did the company put that money into their operat-ing account at the bank? Should some of the money have gone into a reserve account?
A decrease in revenue growth can be interpreted as negatively as the previous responses to earnings decreases. A couple of quarters of increased earnings but flat revenues should be cause for concern. Any evolving company should be enjoying economies from moving further up the learning curve. What is happening to the top line? Look closely at unit volume, the aging of receivables, and the retention rate of existing customers. Determine how quickly new customers are being acquired and, more important, how much revenue is from new products or services. Research conducted by Eccles and PricewaterhouseCoopers provides evidence of a direct link between revenues from new products and market cap growth.
Rapid revenue growth is a critical element in valuing emerging companies.
The Income Statement
The most frequently mentioned valuation measure in the popular media is earn-ings. No experienced investor accepts earnings as a “first-cut” measure of appeal, regardless of the size of the subject stock’s market cap. The experienced response is always, “How were the earnings computed?” This quality of earn-ings issue will be discussed but not in the context of earnings per share (EPS).
Earnings measured in shares outstanding of an emerging company’s stock are not relevant to meaningful analysis. An emerging company has a relatively small number of equity shares outstanding, (and an even smaller proportion in the float). So, what if an increase in the number of outstanding shares would decrease EPS? It’s the earnings and their sustainability that count. An increase in the float (such as from exercised options) will always enhance the appeal of a microcap stock due to increased liquidity, and so would an increase in the shares authorized for public trading.
There are two concerns with respect to microcap company earnings: Can an increase in earnings be sustained? How were the earnings computed? With respect to sustaining earnings, here are two typical comments from money managers about any report of a decrease in earnings by a microcap company:
1. “Don’t tell me that a microcap company can have a bad quarter once in a while and then bounce back. Phooey! When a company’s profits turn south, it takes a long time to reverse course.”
2. “An earnings surprise in a microcap stock is the beginning of a long period of underperformance —maybe the beginning of the end.”
Whether or not you subscribe to such severe interpretations, the fact that others do creates a substantial headwind for a buy decision. Hurray for you contrarians! Just don’t underestimate the effects of consensus risk. The “quality of earnings” issue is the other concern in the analysis of an emerging company. Yes, there is always the probability of some chi-canery in a company’s financial reporting, but that probability is of rela-tively small concern. Ninety-nine percent of listed emerging companies won’t engage in it for the same reasons that 99 percent of the higher cap-italized companies won’t. The consequences from having the abuses being discovered are too severe.
Time spent trying to detect crime puts the investor/analyst at a severe cost disadvantage. Just focus on the presentations in the SEC forms 10-Q and 10-K. The methods permitted for the reporting of revenues and expenses will provide challenge enough.
Revenues In July 2000, the Financial Accounting Standards Board (FASB) issued new revenue recognition rules, most notably mandating distinctions between gross and net revenues. Gross revenue is the amount invoiced. Net revenue is how much the company retains after paying a wholesaler or manufacturer for the invoiced products. The experienced investor recognizes this as a cost of goods sold (COGS) issue. Past practice for “old economy” firms was to report in their gross income computations a deduction of the direct (actual) costs of goods sold. To compute revenues otherwise would overstate them substantially. A lot of microcap companies within the high-tech sector have computed otherwise. How was this permissible?
The question of permissibility was succinctly treated in an article by Julia Lawlor in the December 4, 2000, issue of Red Herring5. Many e-merchants operate as agents, rather than principals, in a transaction. No brick-and-mortar travel agency would book as revenue the cost to its customers of the travel and lodging it reserved, just the commissions earned. Priceline.com booked as revenue the full price of the reservations it arranged for customers. Lawlor cites the Priceline.com justification: “ . . . although it doesn’t take title to the product until after the customer has made a nonrefundable purchase by credit card, it assumes the risk if the customer’s credit is bad, the charge is disputed or the supplier goes out of business . . .” The diligent investor understands that “disputed” might be the only operative word in the that rationale.
Lawlor also addresses the practices among emerging biotech firms: “ . . . Historically, biotech companies have gotten upfront fees when they have affiliated with big pharmaceutical companies for joint research and devel-opment arrangements. The fees are booked immediately as revenue, under the assumption that the payment is for research the companyhas already completed. But the SEC says the payments should be spread out over the term of the agreement.” The industry has been challenging the SEC’s view.
As Andy Kessler reminds us, chief financial officers love to tweak. They are tempted to smooth out “lumpy” revenues. Revenues actually received from a larger-than-usual sale in the last few weeks of one quarter may not be reported for that quarter but apportioned over a couple of subsequent quarters. This has probably occurred a few times among a lot of firms, big or small. If you discover that this practice is frequent and common at one of your target companies, then remove the company from further consideration. Another tactic of concern is the flip side of the booking issue: Watch that a company doesn’t report all the revenue stipulated in a long-term contract as revenue received now.
The key questions remain. Did real money come into the company as the result of a sale? Is any of that money owed to the actual selling princi-pal in the transaction? Did the company put that money into their operat-ing account at the bank? Should some of the money have gone into a reserve account?
A decrease in revenue growth can be interpreted as negatively as the previous responses to earnings decreases. A couple of quarters of increased earnings but flat revenues should be cause for concern. Any evolving company should be enjoying economies from moving further up the learning curve. What is happening to the top line? Look closely at unit volume, the aging of receivables, and the retention rate of existing customers. Determine how quickly new customers are being acquired and, more important, how much revenue is from new products or services. Research conducted by Eccles and PricewaterhouseCoopers provides evidence of a direct link between revenues from new products and market cap growth.
Rapid revenue growth is a critical element in valuing emerging companies.
Expenses and Amortization The accrual questions about what should be charged as direct expenses and what should be capitalized are common to any listed company. These concerns have been around as long as there have been federal agencies. Consider how expenses are viewed from the perspective of the SEC and then from the perspective of the Internal Revenue Service.
Investors’ preoccupation with earnings has aggravated a legitimate concern. Generally accepted practices discipline the reporting process. Still, there is incongruity with respect to accruals. NYU’s Lev is continually addressing accounting incongruities in his teaching, writing, and research. His intriguing and well-reasoned insights are the subject of several articles, the best of which was written by Barron’s Jonathan R. Laing6.
Lev argues that traditional methods do not accurately account for intangibles such as research and development, innovation, brand positioning, or employee training. Lev’s point is that, like the purchase of machinery, these expenditures are investments, not expenses. Lev’s arguments should be considered when you deconstruct a company’s financial statements; however, stay focused on the tangible expenses.
Look for clear evidence of a return on specific expenses such as pro-ductivity gains relative to personnel costs and sales increases from higher marketing costs. Be concerned if there is a pattern of expenses increasing at a faster rate than revenues. One microcap investment manager remarked to us, “I’m very partial to inverted burn rates.” Before analyzing operating expenses of a microcap company, put on some kilts and pretend that you are Scotch.
The Balance Sheet
At some point in the early life of an emerging company, the balance sheet ought to reflect a march to value. A company that has operated for more than five years as a publicly traded corporation should have an overall ratio of at least 1.25:1 in the amount of assets to liabilities. Pay attention to the nature of the assets, particularly accounts receivable.
Look closely at the total capital structure and the underlying debt instruments. With respect to long-term debt, look for early call provisions and for any conversion terms.
Calculate enterprise value. It’s a reliable number to keep in your head. Most investors calculate enterprise value by adding common stock market capitalization to debt and preferred shares and subtracting cash and equivalents. This is the calculation as described at Investopedia.com. Changes in enterprise value can be a better measure of circumstances than just looking at changes in market capitalization.
The best measures remain an increase in stockholder equity and cash equivalents on hand. Where is the cash? Where did it come from? Where did it go?
MERGER AND ACQUISITION CONSIDERATIONS
There is an estimate floating around Wall Street that, for every company that goes public, six get merged. Some of those who invest in microcap stocks do so with the expectation that the returns will come from takeovers.
Experienced investors are skeptical about such prospects. What are the benefits of such an outcome: Economies of scale? Increased market share? Synergy-driven increases in revenues and decreases in overall expenses? Will the acquiring company lose its focus on the activities that drove its growth? Reemerging companies are most likely to be acquisition targets, that is, target for value plays. In our opinion, the likelihood of being acquired should not be your primary reason for buying a microcap growth stock.
BEYOND THE NUMBERS
Lev, Eccles, Carolyn Brancato of The Conference Board7, Robert H. Herz of PricewaterhouseCoopers, Harold Kahn of Scudder Kemper Investments, and the Cap Gemini Ernst and Young Center for Business Innovation8 have been at the forefront of the argument that traditional accounting doesn’t reflect adequately the real value of a publicly traded company. Eccles and Herz have coauthored a watershed book, The Value Reporting Revolution, with Herz’s PricewaterhouseCoopers colleagues E. Mary Keegan and David M. H. Phillips.
We believe there are investors who do outperform prescribed equity mar-kets’ benchmarks over the long run. We believe that this sustained success is in how these investors analyze companies. Winning investors have always looked beyond the numbers reported in those mandated financial reports. Lev, Eccles, et. al. are identifying and categorizing dozens of characteristics and performance measures that create value in an enterprise, yet may be “off the books.” Many of those characteristics and measures are appropriate to the analyses of emerging companies, and some are especially pertinent. Investors who aspire to sustained success should study the sources cited at the end of this chapter.
OUR PREJUDICES
We prefer companies in which management has a large ownership stake. We like to see our investments operating businesses with high barriers to entry. Employee turnover rates are of special interest to us. We have long memories for managers who have provided inaccurate information or who have mismanaged other enterprises.
OTHER ISSUES
Taxes
In practicality, their small floats make microcaps long-term holds. Any gains from subsequent sales within taxable portfolios will be taxed at a favorable rate. If circumstances do require you to sell these issues quickly without regard for the forces of supply and demand, you will have the benefit of substantial offsetting losses.
Custody
The custody, transfer, and shareholder-recording procedures for listed stocks in the United States are administered and regulated in the same manner, regardless of market capitalization. Because a microcap company is likely to be understaffed, it may not be dealing in a timely fashion with its custodian and transfer agent. The shareholder records may be in some disarray. Make sure that your ownership is a matter of record with all appropriate institutions and agencies.
Some Good News About Bad Guys
The stocks of the microcap companies that you own are always in relatively short supply. It is unlikely that these companies ever will be targets of a bear raid entailing short-selling tactics because the “shorts” can get killed trying to cover on a runup.
DON’T TRY THIS AT HOME
We think that microcap growth stocks are attractive, alternative vehicles. The appeal of microcap growth stocks is in their divergent performance within market cycles and in their proportionate return to the risks and costs asso-ciated with them. These returns are related to some real inefficiencies encountered in the discovery, appraisal, and trading of microcap growth stocks. Yes, we do think that this small universe of equities exists as an opportunist’s market, particularly in the altered regulatory environment.
However, an enormous amount of time is required to master the knowl-edge and techniques necessary to turn those inefficiencies into high returns. In our experience, trading skills are of equal importance with analytic and portfolio construction skills. Many times the trading skills are paramount. Wall Street jokes that microcaps trade by appointment. For that reason, we recommend searching for investment managers who have had extensive experience in this investment style. We will not, however, recommend any specific managers. We can remind readers of an approach to a manager search that is a favorite of ours. We assume that the reader —for reasons of control, costs, and tax planning —would prefer an individually managed account to a microcap growth mutual fund. We have discovered that the most experienced practitioners of this style do manage both mutual funds and individual accounts. So, you can easily find a manager in Morningstar’s small cap growth mutual fund profiles. The data provided for each fund will inform you as to which fund is truly managed as a microcap growth fund.
When Morningstar writes up a mutual fund profile, it always includes a Sharpe ratio. Any college textbook on investments will provide the reader with a refresher on the Sharpe ratio. This performance measure can be used to compare managers’ performances among their style peers and among other managers of larger cap portfolios. It is logical that the performance of a manager’s individually managed accounts should parallel that of the manager’s listed mutual fund.
Did we remember to state that past performance is not necessarily a valid indicator or guarantee of future results?
Lev, Eccles, Carolyn Brancato of The Conference Board7, Robert H. Herz of PricewaterhouseCoopers, Harold Kahn of Scudder Kemper Investments, and the Cap Gemini Ernst and Young Center for Business Innovation8 have been at the forefront of the argument that traditional accounting doesn’t reflect adequately the real value of a publicly traded company. Eccles and Herz have coauthored a watershed book, The Value Reporting Revolution, with Herz’s PricewaterhouseCoopers colleagues E. Mary Keegan and David M. H. Phillips.
We believe there are investors who do outperform prescribed equity mar-kets’ benchmarks over the long run. We believe that this sustained success is in how these investors analyze companies. Winning investors have always looked beyond the numbers reported in those mandated financial reports. Lev, Eccles, et. al. are identifying and categorizing dozens of characteristics and performance measures that create value in an enterprise, yet may be “off the books.” Many of those characteristics and measures are appropriate to the analyses of emerging companies, and some are especially pertinent. Investors who aspire to sustained success should study the sources cited at the end of this chapter.
OUR PREJUDICES
We prefer companies in which management has a large ownership stake. We like to see our investments operating businesses with high barriers to entry. Employee turnover rates are of special interest to us. We have long memories for managers who have provided inaccurate information or who have mismanaged other enterprises.
OTHER ISSUES
Taxes
In practicality, their small floats make microcaps long-term holds. Any gains from subsequent sales within taxable portfolios will be taxed at a favorable rate. If circumstances do require you to sell these issues quickly without regard for the forces of supply and demand, you will have the benefit of substantial offsetting losses.
Custody
The custody, transfer, and shareholder-recording procedures for listed stocks in the United States are administered and regulated in the same manner, regardless of market capitalization. Because a microcap company is likely to be understaffed, it may not be dealing in a timely fashion with its custodian and transfer agent. The shareholder records may be in some disarray. Make sure that your ownership is a matter of record with all appropriate institutions and agencies.
Some Good News About Bad Guys
The stocks of the microcap companies that you own are always in relatively short supply. It is unlikely that these companies ever will be targets of a bear raid entailing short-selling tactics because the “shorts” can get killed trying to cover on a runup.
DON’T TRY THIS AT HOME
We think that microcap growth stocks are attractive, alternative vehicles. The appeal of microcap growth stocks is in their divergent performance within market cycles and in their proportionate return to the risks and costs asso-ciated with them. These returns are related to some real inefficiencies encountered in the discovery, appraisal, and trading of microcap growth stocks. Yes, we do think that this small universe of equities exists as an opportunist’s market, particularly in the altered regulatory environment.
However, an enormous amount of time is required to master the knowl-edge and techniques necessary to turn those inefficiencies into high returns. In our experience, trading skills are of equal importance with analytic and portfolio construction skills. Many times the trading skills are paramount. Wall Street jokes that microcaps trade by appointment. For that reason, we recommend searching for investment managers who have had extensive experience in this investment style. We will not, however, recommend any specific managers. We can remind readers of an approach to a manager search that is a favorite of ours. We assume that the reader —for reasons of control, costs, and tax planning —would prefer an individually managed account to a microcap growth mutual fund. We have discovered that the most experienced practitioners of this style do manage both mutual funds and individual accounts. So, you can easily find a manager in Morningstar’s small cap growth mutual fund profiles. The data provided for each fund will inform you as to which fund is truly managed as a microcap growth fund.
When Morningstar writes up a mutual fund profile, it always includes a Sharpe ratio. Any college textbook on investments will provide the reader with a refresher on the Sharpe ratio. This performance measure can be used to compare managers’ performances among their style peers and among other managers of larger cap portfolios. It is logical that the performance of a manager’s individually managed accounts should parallel that of the manager’s listed mutual fund.
Did we remember to state that past performance is not necessarily a valid indicator or guarantee of future results?
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