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I’ve recently been exploring the world of micro cap stock investing. You don’t hear much about this space except from the occasional banner ad promising a 10,000% return in a week by buying penny stocks. So I think micro cap gets a bad wrap. The truth is that you don’t hear about micro caps because the large fund and ETF providers generally shy away from the space. At just around $100 billion in total market cap, as opposed to over $20 Trillion for the rest of the market, it truly is a tiny corner of eclectic firms. Liquidity is low and transaction costs are high at scale. These things are anathema to product providers that are constantly seeking the next blockbuster hit ETF that can accommodate tens of billions in assets.

This is the first in a series on micro caps. When I began working at Western Asset in 2008, my then boss had me spend my first week studying the core bond benchmark, the Lehman (now Barclays) Aggregate–how it was constructed, what sectors existed, rules for inclusion, etc. As an active manager, we got paid to beat the benchmark, so understanding our bogey’s behavior was critically important. For the first installment, I dive into the Russell Microcap Index to understand it’s construction and behavior. The second part will leave the benchmark behind and think more fundamentally about what drives the opportunity set of microcap stocks. The thirdpart in the series will apply some fundamental criteria (factors) to control for the universe’s biases to drive (hopefully) outperformance. The final installment is a discussion of the real world application of the theory discussed in the first three installments, and an argument for the persistence of alpha in the space.

Enjoy, comment, send me feedback and questions!

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Micro cap stocks represent a fraction of the total U.S. market—literally less than 1% of total capitalization. These stocks are under-covered, unloved, and under-owned. Since the late 1990’s, micro cap’s share of the total U.S. equity market has been cut in half—though it was small to begin with. A key culprit, the proliferation of passive and “Smart Beta” investment products has resulted in disproportionate flows into the large cap space, and therefore, away from small and micro cap stocks. Below is a chart of the share for large (market cap above average) and small (market cap below average) for the U.S. market. Large is dominating. This is the wealth effect in stocks. The big keep getting bigger.

Though there are many unique considerations as it relates to liquidity and tradability at the smaller end of the market, as factor investors who constantly seek ways to tilt the probabilities of investment success the investor’s favor, we simply can’t look away from the opportunity that capacity constrained corners of the market—like micro cap—provide.

What is micro cap?

Russell defines the micro cap space using an ordinal ranking methodology. Whereas the Russell 1000® consists of the 1000 largest stocks in the U.S., the Russell 2000® contains those ranking from 1001 to 3000. The Russell Microcap® Index overlaps with the Russell 2000® in that it includes the 2,001st to 4,000th ranked stock. Russell has conveniently created some overlap to prevent index churn—buying and selling constituents frequently crossing over between index thresholds—because there tends to be a lot of movement in the ranking of stocks at the lower end of the market cap spectrum.

Since these indexes are market cap-weighted, owning the Russell Microcap index is nothing more than owning a small tail of the Russell 2000® plus a minor allocation to even smaller names. 88% of the Russell Microcap® Index overlaps with the Russell 2000®. The correlation of return between the two indexes is 0.96.  (Yet, the relevant iShares Russell ETF (IWC) carries an expense ratio of 0.60%, 3x the fee of its Russell 2000 counterpart (IWD) costing just 0.20%.)

A similar picture emerges when reviewing the share of dollar volume in each index. The table below summarizes the allocation of the total U.S. market based on capitalization and dollar volume across the indexes.

Notice that average dollar volume declines exponentially as you move away from large cap. Also, the small unique portion of the Russell Microcap® index (3,001-4,000), highlighted in green, represents half the dollar volume weight as it does the market cap weight. Low volumes in this corner of the market can lead to significant transaction costs if not managed appropriately. This suggests that the cost of exposure to that small tail is very expensive, and likely a drag on performance of the index. (We’ll review implementation costs in the fourth installment of this series.) Based on our own analysis, we found that applying a liquidity floor of $100 thousand-dollar average daily volume, inflation-adjusted, improved the index return by an annualized 0.8% from 1982-2016. That’s a huge gain over 35 years.

In current form, the index performance statistics for micro cap certainly do not drive a compelling narrative for adding an allocation to portfolios. The risk-return trade-off is poor enough that commonly used covariance optimization techniques in an institutional asset allocation study would suggest a 0% weighing to micro cap. In fact, most would suggest little or no weight to the small cap Russell 2000® as well. Given these results, its little wonder large cap stocks are all the rage.

The bull market in U.S. equities has narrowed over the past 6 months as strength has become concentrated in large cap stocks. Recently, strength has narrowed even among those large caps.

One common theme in these pages (and others) over the past 6 months has been the narrowing of participation in the equity bull market. That is, the rally has persisted among the major averages, but fewer and fewer stocks are rallying alongside. This dynamic is possible, of course, due to the uneven weighting of most stock indexes. The largest stocks, either by market cap or by price, have the greatest impact on the performance of the indexes. And those big-cap stocks have shown little propensity thus far to slow down. However, just recently, we are seeing the narrowing of the rally even among these large cap stocks.

We touched on this trend earlier this month, pointing out that the “Equal-Weight” version of the Russell 1000 Large-Cap Index had been lagging behind the “market cap-weighted” version since this past May. That is evidence that even the average large-cap stock has failed to keep up with biggest of those stocks. Further, we illustrated in a chart that while the Russell 1000 cap-weighted Index was back near its May levels, the Equal-Weight Index, i.e., the average stock, had not only lagged, but was down some 6% over that time.

Today’s Chart Of The Day takes that contrast even further by looking at the relative ratio between the Russell 1000 Equal-Weight Index and the cap-weighted version. As of Friday, that ratio had dropped to its lowest level since the inception of the Russell 1000 Equal-Weight Index 

Granted, the Equal-Weight Index has only  been around for 5 years. It would have been interesting to note its relative behavior around the top in 2007, and especially during the “great divergence” between 1998 and 2000. Nevertheless, we must read the recent developments in a negative light as the fewer number of stocks that are rallying, the less robust and resilient the rally is likely to be. Sure, it may have little to no impact on those areas that are still working right now. However, when those areas do begin to succumb to selling pressure, there will be precious little left to support the broader market.

There is no telling when the ultimate top in the major stock averages will be. However, participation in the rally is getting narrower and narrower -- even among the bull market’s former leaders.

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“Road narrows ...” photo by Jeremy Segrott.

More from Dana Lyons, JLFMI and My401kPro.

Participation among all stocks in the recent stock rally, as measured by an equal-weight index, has been relatively weak -- as it has been since last spring.

In several posts last week, we looked at the developing weakness among “equal-weight” indexes versus their comparable cap-weighted versions. As the name implies, an equal-weight index applies an equal weighting to all of the components in the index, regardless of price or market cap. Taking this more democratic view of the index makes it easier to assess how strong the broader group of stocks really is, as opposed to a weighted index which may be supported by a relatively small number of its biggest constituents. This weakening among the equal-weight indexes showed marked acceleration over the past few weeks. But is it possible that the cap-weighted indexes were merely catching up to their equal-weight counterparts?

We offer as evidence of this variant view, the performance of the Equal-Weight Russell 1000 Large-Cap Index versus the traditional, cap-weighted Russell 1000 as the market was emerging from its late September lows. As this chart shows, in the initial rally off the lows, the Equal-Weight Russell 1000 handily beat its cap-weighted counterpart, as well as both the Russell 1000 Growth and Russell 1000 Value. This demonstrates that it was not just the style of stocks accounting for the leadership, it was the breadth of stocks. The equal weighting of the smaller components in the index allowed for the out-performance of the cap-weighted Russell 1000 Index.

On October 9, following the first 2 weeks of the bounce, the Equal-Weight Russell 1000 was between 1% and 2% ahead of each of the other indexes. At that point the other indexes certainly had some “catching up” to do.

From October 9 to October 21, that’s exactly what the other indexes did. During that period, the Equal-Weight Russell 1000 drifted slightly lower as the others drifted slightly higher. As of October 21, each of the indexes’ bounce gains were within 0.2% of +7%. Thus, the other indexes had caught up to the Equal-Weight. At that point, a reasonable argument could have been made for the “catch-up” hypothesis. In other words, the under-performance of the Equal-Weight Index was simple mean-reversion versus its initial out-performance.

However, the continued relative under-performance since October 21 undercuts that argument. Since the other Russell 1000 Indexes caught up to the Equal-Weight Index, they have continued to drift higher. Meanwhile, the Equal-Weight Russell 1000 has continued to drift sideways. As of Friday, October 30, about 1 month following the September market low, the other Russell 1000 Indexes had garnered a bounce advantage of between 1% and 2%. The tables have been turned.

Zooming out a bit, we find probably a more compelling case against the “catch-up” argument. See, this under-performance by various equal-weight indexes (i.e., the broad market) goes back further than a few weeks. As we touched on in last week’s posts, among the consumer discretionary and energy sectors, the ratio between the equal-weight and cap-weight indexes has fallen to 2009 levels. And even among the S&P 500 stocks, the equal-weight index is at relative 3-year lows versus the cap-weighted index. This is not just a recent phenomenon.

We can see this in the Russell 1000 Equal-Weight Index as well. Looking back to the Index’s top in May (which was the top in many other indexes as well), it has clearly been under-performing its cap-weighted peers for 5 months now. 

Thus, the under-performance of the Equal-weight Russell 1000 is not just a phenomenon of the post-September rally. It has been underway for many months now. Therefore, the out-performance by cap-weighted indexes over the past few weeks can hardly be considered a mean-reversion following the initial relative leadership by the equal-weight indexes directly off of the lows. If anything, the strong equal-weight bounce off the lows was the mean-reversion.

The larger point is that this relative under-performance of equal-weight indexes is a trend we observe across numerous sectors and market segments, not just the Russell 1000. And we have observed it for 5 months now. Therefore, in our view, this issue should not simply be viewed in the context of judging the quality of the bounce off of the September lows. It should be viewed as a larger, more significant challenge to the longer-term sustainability of the stock market rally.

For, even as the major average are once again approaching their former highs, they are doing so on the backs of a diminishing number of stocks.

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“Vintage Scales” photo by Cool Kats Photography.

More from Dana Lyons, JLFMI and My401kPro.

Large growth stocks are winning the battle this year...by a lot. The Russell 1000 Value Index is down -7.3%, while its Russell 1000 Growth Index counterpart is up +2.6%. That's a return differential of 9.9%! Like any other investment, its important to understand what drives returns of these respective indexes. Classically, the distinction between a growth stock and a value stock is based on the relationship between a company's book value and its market price. Book value represents the difference between a company's assets and its liabilities. Think of it as the net worth of a firm.

One would think that buying stocks that are inexpensive relative to book value (low price to book ratio) would outperform. But, sometimes expensive prices relative to book value (high price to book ratio) are warranted if an investor believes that the stock has out-sized potential in the growth of its business. Historically, stocks that are cheap relative to their book value outperform, but this year is an exception. The chart below divides the large cap investment landscape into expensive (growth) and cheap (value) stocks by price to book in a similar methodology as the Russell indexes. You can see that on average growth stocks have delivered a 4.5% return while value stocks have delivered a -11.5% return. What gives?

Below are the five "reasons" why growth is beating value.

These 5 tech heayweights (treating Google Class A and C as one) have done exceptionally well this year. That's the good news, if you have owned them. The bad news is that caution is required. Any new money going into these stocks should be done with a healthy does of skepticism. We all love the latest and greatest technologies, but sometimes good companies don't make good investments. Investing is all about the price you pay, and these companies are more expensive than a McLaren F1. Using a combined ranking based on earnings, sales and cash flows, these stocks are on average more expensive than 90% of large stocks in the U.S. Stocks that fall into the most expensive 10% by valuation historically go on to underperform the market by -6.4% per year.

Not only are they expensive, but some of the firms are massively diluting shareholders through enormous stock option packages to executives and employees. Facebook (FB), for example has diluted shareholders to the tune of 9% of its market value over the previous 12 months. This trend is rampant among social media darlings. Twitter (TWTR) issued $170 million in 3Q 2014, 47% of its market value at the time. Be wary of companies lining their pockets with shareholder dollars.

So why are these companies so appealing? In a word... growth. In a low growth world, which we have experienced since the credit crisis, rapidly growing industries are enticing. The possibilities for blue skies are endless if these firms can just figure out how to turn all those ad sales into earnings, which by the way, they have not yet.

But all good things come to an end. While these tech darlings have rocketed up on average 42.9% year to date, the rest of the growth index has declined on average -0.9% over the same period. Growth has been leading value for several years and the cycle may be beginning to turn. The chart below shows rolling 3 year returns from 1975 through 2015. The blue represents periods when value stocks outperform. The red represents periods when growth stocks outperform. Just as stocks and bonds come in and out of favor, such is the same with value and growth stocks.

Management of large U.S. firms decided long ago to outsource the growth of their sales, earnings and cash flows to foreign markets. Last year, nearly half of S&P 500 revenues came from overseas. The portion of S&P 500 profits from foreign sources has been growing at twice the rate of profits from domestic sources since 2000. Multi-nationals currently have a few trends working against them that make small cap stocks interesting.

First, the massive appreciation of the U.S. dollar over the last year will slowly chip away at the earnings for large firms in the coming quarters. As I have written previously, the 23.3% strengthening of the dollar is almost unprecedented historically. Small stocks typically have domestic-oriented businesses that are not directly impacted by currency fluctuations.

Second, from a longer term perspective, large multi-national firms are now in the unenviable position of needing to find new sources for earnings growth on a massive scale. Think, for example, of Wal-Mart. The company generates $485 billion per year in sales. To increase sales over the next year in-line with the recent 3.7% GDP print, the company would need to generate new revenues of almost $18 billion per year!

In some cases, large companies have capitulated, instead preferring to repurchase their own stock as opposed to growing the business organically. This can occur when companies struggle to find new opportunities for expansion. My colleague, Patrick O'Shaughnessy, noted in a recent piece that as of 6/30/2015 nearly half a trillion dollars was spent on corporate buybacks over the trailing twelve months. He finds though that the majority of buyback programs are small relative to company size--typically a sign of low management conviction in the program. Because small cap companies are attempting to grow their revenues and earnings from a much smaller base, they can engage in lucrative projects that would not meet the requirements for scale of large firms.

Third, low interest rates have boosted current profit margins of large companies to levels not seen since the 1960's. As the Fed tightens monetary policy, look for the profit margins of debt dependent companies to shrink. QE benefited large cap companies by lowering the cost of debt for the strongest players. QE is really just the apex of a multi-decade debt binge that began with the infamous leveraged buy-out (LBO) boom in the 1980's--the RJR Nabisco deal being one of the most notorious. Since the mid 1980's, large companies have used a much larger portion of debt in their capital structures. Today, the small cap market is about 20% less levered with a debt to equity ratio of about 1.0.

Small cap firms, because of their risk profiles, do not have ready access to secondary debt capital markets. Their debt issues would be too small and too risky. So, they are forced to access financing through stock issuance and bank loans. Given post crisis bank capital requirements, banks have been less willing to lend. With QE over in the U.S., large firms struggling to find avenues for global growth, and the prospects of increased interest rates, small cap firms appear to be relatively well positioned in the coming years. In future posts, I will talk about some characteristics of small cap stocks that historically lead to outperformance.

In the past few months, we learned that 4th quarter S&P 500 earnings declined 14%, their worst year-over-year decline of the expansion.

With growth harder to come by, investors have been actively bidding up growth names wherever they can find them.

The Russell 1000 Growth Index (IWF) has outperformed the Russell 1000 Value Index (IWD) by over 5% thus far in 2015. We have seen similar outperformance in small cap growth (IWO) over small cap value (IWN).

Looking at the difference in sector weighting between Russell 1000 value and growth indices, we can see that growth has benefited from the outperformance in Tech and Consumer Discretionary with an overweight in those sectors. Growth has also been aided from an underweight in Financials, Energy, and Utilities as those sectors have declined thus far in 2015.

Sector performance in the first quarter has largely followed revenue growth, with Tech, Consumer Discretionary, and Health Care posting above-average revenue growth while Financials, Utilities, and Energy have shown below-average growth.

With the release of 1st quarter earnings in a few weeks, it will be interesting to see if the outperformance of growth over value persists. If growth remains scarce, we could see a continued widening in this relationship. On the other hand, if growth comes in stronger than expected, particularly in the “value” overweight sectors such as Financials and Energy, we will likely see a convergence in performance.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO, CMT

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of two award-winning research papers in 2014 on Intermarket Analysis and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors, an institutional investment research firm. Previously, Mr. Bilello held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms, giving him unique insights into portfolio construction and asset allocation.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

We are about a month away from this bullmarket turning seven years old making it the 4th longest bull marketsince 1928. Fortunately, age alone doesn’t end bull markets. But, as a bull matures certain things tend to happen - volatility sets in, market breadth starts to narrow, defensive names may outperform economically sensitive ones and being selective becomes critical.

I’ve noted many times recently that I believe this bull market has some room to run - and I still think that’s the case. But, I also think investors would be wise to consider rebalancing portfolios to categories of stocks that tend to do well in aging bull markets. One of those categories is dividend-paying stocks.

Dividend-Paying Stocks May Temper Downside Volatility

A high dividend-yielding strategy can help reduce near-term downside volatility and provide downside protection when the broader market is posting cyclical losses. Dividend stocks have historically held up better in bear markets than low-or-no dividend paying stocks as a sizable portion of high dividend paying stocks’ return is in the form of cash (which is insulated from downturns).  

To be fair, it is right to concede that a high dividend equity portfolio may underperform during strong growth markets. But, in terms of this particular bull market cycle, those years may be behind us already. Moving forward, we could see a greater degree of choppiness and eventually (though I do not think this year) the bull market will become a bear. During that transition, whenever it occurs, a portfolio of high dividend paying stocks can potentially produce attractive total returns and lower levels of volatility compared to a portfolio of low-or-no dividend stocks.

How to Build an Effective Dividend Strategy

With the Dividend Strategy at Zacks Investment Management, we choose stocks from the Russell 1000 Value universe and use a proprietary model to screen names for potential entry. We analyze dividend yield, seek names with potential for price appreciation and look for attractive beta relative to the market.

The result is a portfolio of 50 to 100 stocks. We’ve been fortunate to have strong absolute and relative performance with the Dividend Strategy since inception. From April 2004 – December 2014, the Zacks Dividend Strategy has delivered net cumulative returns of +133.56%, compared to the +128.75% return of the Russell 1000 Value.

What I think stands out most in those years was the Zacks Dividend Strategy performance in 2008. This year was the year of the Great Recession and quite difficult for most equity investors. In that year, the S&P 500 lost -37% and the Russell 1000 Value lost -36.85%.  Comparatively, during this challenging time, Zacks Dividend Strategy fell -27.78% on the year. Our outperformance in that bear market year underscores the value of a well-executed dividend strategy in a down cycle.  Certainly, the hope is that investors will not have to experience gut-wrenching times like this, however the situation illustrates the benefit of a well-managed portfolio.

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Past performance is no guarantee of future results. Inherent in any investment is the potential for loss.

Zacks Investment Management, Inc. is a wholly-owned subsidiary of Zacks Investment Research. Zacks Investment Management is an independent Registered Investment Advisory firm and acts an investment manager for individuals and institutions. Zacks Investment Research is a provider of earnings data and other financial data to institutions and to individuals.

A reader asks:

Now that factor funds keep getting launched, do you think that will ultimately spell doom for any potential future out-performance?

This is a great question. Investing in factors, tilts, anomalies or whatever you want to call them is definitely becoming more mainstream because the academic research is now well-known. ETFs and mutual funds make it easier than ever to invest in specific risk factors including momentum, value, size and quality. But, as this reader so astutely points out, it’s possible that we could see an overcrowding in these risk factors, disrupting future performance.

In his book Rational Expectations, William Bernstein touched on this issue with an interesting analogy:

Over thirty years ago, my wife and I came upon a shop in Paris that made the most exquisite umbrellas we had ever seen. Although their products weren’t cheap, they were still within our budget. In the following few years we bought several, which we treasure to this day. Each time we returned to the umbrella store, we found it ever more crowded with shoppers from around the world. Its prices grew correspondingly out of reach, particularly after the elderly sisters who ran the store passed it on to their tonier niece.

Similarly, now that everyone knows about and can visit the “equity umbrella shop,” stock prices have risen and lower expected returns have resulted. This likely goes double for “tilted portfolios,” the term used for small-cap and value-oriented stocks.

It used to be nearly impossible for individual investors to invest in something like a small cap value or momentum strategy because the costs were simply too high or the strategies too complex to build on your own. But the fact that they’re now so easily obtained through ETFs in a tax efficient manner at much lower expense ratios offers something of a margin of safety. You can invest in these different factors at a fraction of the cost than the past, so even if the future premiums are compressed compared to historical averages, the lower costs could mean no meaningful difference in performance on a net basis.

I also think that the ease of access means that there will be plenty of weak hands piling into these factors hoping to hit immediate pay dirt. When volatility spikes or there’s a period of relative underperformance, these investors will quickly hit the exits. The biggest gains will only be made by strong hands that can live with higher tracking error.

No factor or strategy works every year. The cycles can be extremely uneven. The reason these factors have worked in the first place is because there are plenty of times when they don’t work. Take a look at the following chart from Euclidean Technologies that shows a simple value strategy (buying the cheapest stocks by EBIT) against the S&P 500 going back to the 1970s:

You can see the value outperformance up top, but look at the relative underperformance in the lower chart. There have been periods where value underperformed the market by anywhere from 30-50%. How many investors will have the discipline to stick with a strategy when it underperforms by that much for a lengthy period of time? I think the majority of the gains to any factor in the future will be made by those investors that have the intestinal fortitude to stick with them and even rebalance into periods of underperformance.

Plus there’s the fact that much of this knowledge has been around for quite some time now. Warren Buffett has been preaching the virtues of value investing for decades.Benjamin Graham’s books on the subject have been around since the 1930s. Everyone now knows that buying cheap or high quality stocks works if you’re patient. Most people aren’t patient. Therein lies your edge as an investor.

One of the hardest parts about investing is that no matter what it is that you buy there will almost certainly be another investor, asset class, sector, fund or security that will be outperforming you at any given point in time. Behavior is the ultimate equalizer in the markets, Most investors will always prefer to invest based on a narratives over evidence. It’s much easier for the financial industry to sell a story attached to a fee-producing product than the virtues of a long-term strategy that could take some time to play out.

The degree of tilting in any given portfolio will all depend on each individual’s theshold for short-term pain and tracking error from the overall market.

All of these views fall under the category of something I believe but can’t prove with statistics because no one really knows what the tipping point is for the different risk factors. Even if the premiums from these anomalies narrow in the future, I can think of worse ways to build a diversified portfolio than by investing based on the weight of historical evidence and common sense mixed in with the ability to look past difficult short-term periods of underperformance.

Sources: Rational Expectations: Asset Allocation for Investing Adults Why is Value Investing so Difficult (Euclidean Technologies)

Further Reading: Why Value Investing Works The Small Cap Value Cycle The Style Box of the Future

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This post from Ben Carlson (@awealthofcs) originally appeared on A Wealth of Common Sense.