The idea that smaller companies can potentially generate bigger rewards is an old one, although it’s forever new in creating hope.
In 1981, Rolf Banz formally introduced the concept of a small-cap risk premium into the academic literature. For the 43 years through 1974, small cap performance left large cap stocks in the dust, his study found.
The news probably wasn’t surprising to financial economists. Modern portfolio theory, forged in the 1950s and 1960s, teaches that higher returns are a function of higher risk, and by that simplified reasoning the higher performance identified by Banz looks like compensation for higher risk.
In the years after Banz’s paper, small cap research has became increasingly sophisticated, as well as controversial. As evidence, one need only review the debates that are still raging in the wake of the Fama and French research that identifies small-cap and value risk factors as fundamental drivers of equity returns generally.
Certainly there’s plenty of risk in small cap stocks. On that, we can all agree. There’s even more risk in the micro-cap equity realm, which includes the smallest of the small. Does the higher risk translate into even higher returns? Perhaps, although this world isn’t for the financially squeamish. But if you can stand the heat, and you have an eye for value, there may be opportunity at the low end of the capitalization scale.
Exactly how much opportunity is debatable. In search of more context, Jon Heller recently created an index that tracks a basket of the “deep value” spectrum of micro-cap value stocks: the Cheap Stocks 21 Net/Net Index. It’s far too early to make definitive judgments on such a short track record, but that doesn’t stop us from looking.
If you’re curious, pay a visit to Heller’s blog, Cheap Stocks,where he comments on value investing far and wide. Yet for all his enthusiasm for poring over thinly traded microcaps in search of value, he’s also mindful of the dangers. As he wrote last week, there’s no shortage of hazards lurking in the murky waters of deep value microcap investing. That may be why the rewards can be so extraordinary. Nonetheless, the traps “are especially prevalent in the land of net/nets (companies trading below net current asset value) where we expend a great deal of research effort,” Heller warns.
Heller, by the way, is an analyst by training. Holding both a CFA and an MBA, he’s president of Newtown, Pa.-based KEJ Financial Advisors, LLC, his recently launched fee-only financial planning firm. Previously, he spent 17 years looking at the numbers for Bloomberg, L.P., in various positions, including overseeing the firm’s equity research department for several years. He’s also worked at SEI Investments. This reporter had the good fortune to witness Heller’s impressive analytical skills up close, when our paths crossed at Bloomberg. For all his abilities at reading balance sheets, deciphering income statements, and otherwise looking for financial pearls among swine, he has also has a healthy respect for portfolio diversification and the power of multi-asset class portfolios. In short, Heller is that rare breed who knows how to navigate the micro and macro waters when it comes to investing strategies and financial analysis.
As such, we were intrigued when we learned that our old pal has been dabbling in an indexing project targeting micro caps that look undervalued. Relatively little is known about how this group acts as an asset class, if we can call it that. That makes Heller’s forays, tentative and experimental though they are at this point, worthy of closer inspection. Inspired to learn more, we recently conducted an email interview with Heller on his new index. Here’s an excerpt: