#$iwc

Despite worries about rally participation, the micro-cap segment of the market is hitting all-time highs.

Right on cue, the stock market has bounced back sharply from its test of the early-February initial correction lows. In spite of the strong rebound in prices, however, there has been a vocal (and familiar) chorus of skepticism regarding the “quality” of the rally. One source of protestation pertains to the level of “participation” in the rally. In other words, some market observers are making the argument that the recent rally is occurring on the backs of a relatively few numbers of stocks, e.g., FANG and the like. We’re not sure how valid that argument is.

Exhibit A in the counter-argument can be seen in today’s Chart Of The Day. As shown here, it reveals that, despite the hand-wringing over “weak participation”, the micro-cap segment of the market (as represented by the iShares Micro-Cap ETF, IWC) has actually already rebounded off its correction lows back into all-time high territory.

Now, just because the micro-caps are back at all-time highs and demonstrating a good deal of “green” on a daily basis, it doesn’t necessarily mean the rally is widespread. However, normally the concern over participation comes when large-cap stocks are contributing an undue weight to a rally while the smaller-caps, i.e., the broad market is lagging. Clearly that is not the case at the moment with micro-caps back at all-time highs and small and mid-caps also out-performing off of the correction lows.

So, in our view, while there might be legitimate reasons for concern in the stock market at the moment, weak participation does not appear to be a valid one.

If you’re interested in the “all-access” version of our charts and research, please check out our new site, The Lyons Share. You can follow our investment process and posture every day — including insights into what we’re looking to buy and sell and when. Thanks for reading!

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

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

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

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

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

The spreads for value and momentum are greater than twice the spread in Large Stocks. The Value spread in Micro suggests one could go long a portfolio of the cheapest stocks and short the most expensive to earn an eye-popping 28.2% annualized return. Practically, this would be virtually impossible due to the operational challenges and costs of managing the short side of a micro cap portfolio. This real world complexity necessitates a focus on not owning the lowest ranked names—as opposed to shorting, and owning the highest ranked names.

The table below continues our previous analysis of adjusting the microcap universe for quality by eliminating poorly ranked names. To that high quality group of stocks, the two rightmost columns display the results from only owning names falling in the highest ranked decile by Momentum and Value, respectively.

As was the case with quality adjustments, a focus on momentum improves return by 3.6% annualized with 10% lower volatility than the quality adjusted group. The addition of value is even more compelling. A focus on value improves return by 6.1% annualized with 17% lower volatility than the quality adjusted group.

Structural features underpin the persistence of factors in micro cap

While I wish I was the only one aware of the massive spreads available in the micro cap space, the reality is that this information is well known. On a recent Masters in Business podcast, Ed Thorp remarked that "Any edge in the market is limited, small, temporary, and quickly captured by the smartest, or best informed, investors."

It is curious that investors have not arbitraged this clear edge. In practice, real world implementation costs quickly erode theoretical alpha if not managed precisely. Thorp also commented "Every stock market system with an edge is necessarily limited in the amount of money it can use and still produce extra returns." Along these lines, there are three inherent structural constraints to scale that hamper professional money managers, thus, protecting the persistence of alpha for dedicated investors at appropriate scale.

Supply of Transactable Stock

Liquidity can be thought of along a spectrum that ranges from the most liquid U.S. Treasury securities (T-bills) to illiquid private businesses (Private Equity). Moving to the illiquid end of the spectrum, the cost of implementation increases, which magnifies the importance of expertise when transacting in scale. The primary considerations as it relates to implementation on the liquidity spectrum are free float and dollar volume of transactions.

Float is the number of shares that are freely available to trade. While a mega cap firm like Apple has a free float of 96% of its shares outstanding, micro cap stocks tend to have the lowest free float as a percentage of the total shares of any market cap range. As of year-end 2016, their average free float was just 72% of shares outstanding. Because of their stage in the business life cycle, micro caps commonly feature large ownership by founders and insiders, and relative to large stocks, could be considered closely held. This feature is important because it reduces the available supply of stock to transact in by 28%. Given Apple’s 96% free float, $737 of its $767 billion in market cap is freely tradeable. Within the micro cap universe of $50-$200 million, just $72 billion of the $100 billion is freely tradeable. This curtails the size of any individual actor in the space, including large institutional investors and product providers.

Volume of Transactable Stock

Dollar volume gives a sense of transaction velocity, and an investor’s ability to enter and exit the market at will. The chart below details total dollar volumes, adjusted for inflation, for large, small, and micro stocks over the last 20 years. The difference in dollar volume is astounding. Dollar volume in large and small stocks is 245x and 43x greater, respectively, than micro cap. The relatively low $420 million volume for micro cap suggests that an active manager employing strategies similar to the ones discussed in this paper would find it rather difficult to oversee assets of significant size, while still being able to transact.[1]

Transaction Costs

While free float and volume constrain the ability to oversee a large amount of assets in the space, implementation costs erode theoretical factor spreads. At scale, these costs can be material. Real world costs have always been, and will likely continue to be, a barrier to entry at scale in less efficient spaces.

The three costs of implementation investors must grapple with are commissions, market impact, and bid-ask spreads. Fortunately, commissions have a relatively low impact on cost given the highly competitive nature of the brokerage business. Most institutional transactions occur at pennies per share (generally not relevant unless transacting in penny stocks). Commissions are the only true explicit cost. The more relevant and hidden share of costs are market impact and bid-ask spreads. Market impact is effectively how much you move the market when transacting at a certain size.

The chart below organizes the U.S. market into liquidity groups sorted from most to least dollar volume to assess the market impact and bid-ask spread of a hypothetical $10 million trade to get exposure to each liquidity group. Overlaid on the chart is the measure of dollar volume across the market. The horizontal axis is the average market cap for each liquidity bucket. From this, one can infer that dollar volume and market cap are highly positively correlated, while cost and dollar volume are clearly inversely correlated. Said another way, the smaller the stock, the lower the dollar volume, the more expensive to trade.

A $10 million trade could be implemented in the most liquid group of U.S. stocks for approximately 5 bps. Sophisticated trading techniques would likely neutralize this impact altogether as smart traders act as liquidity providers when establishing positions. This is made considerably easier with an average $480 million average volume in the most liquid stocks with which to work the trade. Capacity in this part of the market is virtually unlimited. On the other end of the spectrum, stocks in the least liquid bucket bear an all-in cost estimate of 220bps, a 44x increase in cost on 99.97% lower dollar volume with which to trade. Again, sophisticated trading techniques could minimize, but in this case not eliminate, relevant costs. Capacity in this corner of the market is low, but alpha potential remains massive net of transaction costs.

Supply, volume, and cost act as significant barriers to scale in micro cap. Not only do they require a specialized set of skills to implement portfolios in an efficient manner, but they require restraint on the part of money managers as it relates to asset gathering.

Scale Destroys Alpha, Alpha is Expensive to Realize

Objectively, the capacity of a given strategy is a function of supply, volume, and cost of implementation. Subjectively, and most importantly, capacity is determined by the investment manager’s desire for assets under management. Increasing strategy capacity can often lead to conflicts of interest between the business necessity for fee generation and the client necessity for alpha generation. There is a dichotomy in the fact that less liquid micro cap stocks require greater skill in implementation, while also requiring restraint in scale. From a product management perspective, the space is anathema to large money management organizations because asset-based fees on low capacity strategies struggle to support the costs of dedicated teams and infrastructure.

It is not uncommon for micro and small cap managers to creep up the market cap spectrum in order to realize greater capacity. Moving up-market results in smaller factor spreads, and therefore, reduced opportunity for alpha generation. Another alternative is bearing greater market impact costs through larger trade sizes. Both are unappealing options. Pushing the limits of scale could easily detract hundreds of basis points of return. Static, however, are manager fees, which capture a greater proportion of alpha even as the effectiveness of factors are diluted.

Look beyond highly competitive markets for factor exposure

We’ve been conditioned for decades to believe that obvious anomalies will be arbitraged away. Business schools teach the fundamental principles of the efficient market hypothesis even though it clearly does not reflect reality. Most investors readily agree that alpha is scarce. It is hard to find, highly sought after, and requires skill to extract.

Based on this premise and the recent horrendous performance of active managers, many investors establish their beachhead in the most competitive portions of the equity market, large cap, where alpha is scarcest.

I’ll call this the institutional perspective. Though we often mock the Hollywood scene, we are just as guilty of star-gazing. Institutions follow their peers like hawks, and research has shown that herding does occur amongst sophisticated investor asset allocations. For a multi-billion dollar plan, sheer size prevents them from accessing the micro cap. A $5 billion plan would probably need to make a $100 million allocation to micro cap to make a difference to overall plan returns. That’s a large allocation to a constrained space. Going larger, a $30 billion plan? Forget about it! So, instead they pay massive fees for coveted, concentrated access to illiquid private equity markets where their edge cannot be arbitraged away—as easily. But, should smaller investors follow suit?

While large allocators face structural constraints, all else equal, this behavior doesn’t make sense for smaller investors. Just as business schools teach the intricacies of the efficient market hypothesis, students cross the courtyard for their next round of classes in…marketing strategy, corporate finance, competitive strategy, game theory, entrepreneurship…all geared toward identifying and exploiting strategic advantage in business. Investors should start building allocations where competition is low and alpha is less scarce—micro cap. Why not approach allocations from the non-institutional perspective?

At a time when the proliferation of factor investing is being driven by asset gatherers in highly-competitive spaces, my guess is that discerning investors find the research on factors in micro cap quite enticing. In this series on micro cap, we began by reviewing the Russell definition of micro cap, finding that the majority (88%) of what Russell considers micro cap to actually be small cap. The inferior construction methodology of the index—simple market cap weighting—omits critical considerations for quality and the cost of implementation in micro cap. The lackluster results of index returns fail to offer a compelling narrative for micro cap allocations. We then explored the composition of the micro cap universe to shed light on why it is a less competitive and lower quality space. A revolving door of new ventures and fallen angels flank a core group of steady state firms, which cause significant variability in the measurement of underlying stock fundamentals—often leading investors to write off the space as a junk yard littered with poor quality stocks. We then homed in on pure micro cap stocks that offer the potential for risk-adjusted return on par with large stocks through a framework for quality assessment. We noted the significantly greater spreads for the multi-factor stock selection themes of value, momentum, earnings quality, financial strength, and earnings growth in micro cap as compared to large and small stocks. We closed with an argument for the persistence of alpha generation in micro cap based on the structural barriers of supply, volume, and implementation costs to scale.

By breaking away from the institutional paradigm that is heavily aligned with the most competitive portions of the market, avoiding low quality, controlling implementation costs, and focusing in on stocks with strong momentum and value characteristics, I believe investors can realize substantial alpha in this capacity-constrained

In the previous post in this microcap series, I established that the fundamental drivers of micro cap businesses are widely varied, at least in part, due to their state of being—new venture, steady state, and fallen angel. This poses a challenge for stock pickers. It creates a lot of noise in the data, as we saw in the previous post, and requires expertise in many different types of situations—venture, growth, distressed, etc. One could argue that stock picking in microcap requires a broader analytic skill set than for more stable large stocks. This post attempts to cut through some of the noise inherent in micro caps to level the playing field.

Let’s take a step back to build intuition for stock selection regardless of where a company falls on the business life cycle. In our research, we have found several quality metrics to be indicative of good businesses. Generally, businesses should be profitable, growing at a reasonable pace, and appropriately capitalized. Individually, these metrics are effective, but when used together thematically, they provide a powerful framework for eliminating poor quality stocks. The table below compares several characteristics for Large and Mirocap stocks.

In each case, a simple average of characteristics for Micro cap stocks betrays the universe’s lower quality nature relative to Large Stocks. One would assume from looking at the Microcap Stocks column that these businesses are rapidly growing their asset base (Change in Net Operating Assets), not particularly profitable (ROIC), taking on tremendous debt (1-Year Debt Change), and generating negative free cash flow (Free Cash Flow-to-Enterprise Value). All of these would seemingly signal starvation for cash, a particularly bad thing for small businesses.

Change in Net Operating Assets (NOA) measures the growth in assets required to run the business. If a small consumer products company, for example, hit the jackpot with a new contract at a huge retailer and then had to ramp up production to fulfill the order, this metric would increase. Sales growth requires large investment for raw materials, inventory, delivery of finished goods, and equipment for ongoing production. The challenge with growth is that it requires huge cash outlays. This cash is all outlaid before revenue occurs. Dramatic growth in operating assets can be indicative of stress, as it leaves the business in a tenuous cash position. This state of affairs appears to be the norm for micro cap stocks with an average change in NOA of 44.3%—close to twice the rate for Large Stocks.

Few small firms have enough internal capital to fund such large investments. They then turn to capital providers to fund growth—equity offerings or taking on debt. Keep in mind that many micro cap stocks have no analyst coverage, so the ability to tap equity capital markets is limited and expensive. Debt becomes the default source of capital. The average 1-Year Change in Debt for the universe is 32.6%, and debt-to-equity is on par with Large Stocks. The ROIC of just 13.2% indicates that capital, of which debt is a part, is not being as efficiently invested as with Large Stocks. A free cash flow yield of -4.5% suggests economic value is being destroyed, rather than created.

Each of these characteristics are components of multi-factor themes that can be used to assess the quality of a firm: Earnings Quality (NOA), Financial Strength (D/E, Change in Debt), and Earnings Growth (ROIC). To level the playing field for comparison to Large Stocks, we can rank stocks in the micro cap universe based on these themes and eliminate the lowest ranking decile. Firms falling into these poorly-ranked groups tend to be poorly capitalized and have low profitability and weak earnings quality.

By adjusting the micro cap universe, the overall metrics dramatically improve, and in some cases, are actually better than Large Stocks. Quality Adjusted Microcap Stocks reveal much more moderate growth rates in NOA. An average 13.7% is indicative of businesses that are more likely to handle organic business growth without needing to seek substantial funding from debt or equity issuance. The improvement in the 1-Year Debt Change metric after adjusting for quality supports this logic. A large 32.6% increase in debt decreases to just 12.1%—lower than the average for Large Stocks.

Clearly, the universe quality metrics have improved, but how does this translate into investor returns? It turns out that elimination of poor quality boosts the return of our universe by 5.3% annualized with a 0.7% reduction in annual volatility (table below).

Incorporating quality criteria to eliminate stocks from consideration has a dramatic impact on micro cap stocks. Performing a quality assessment highlights the importance of a less appreciated aspect of factor investing. While many researchers focus on the outperformance associated with factors, the avoidance of groups of stocks can be just as positive a contributor to investor returns. After controlling for quality, the risk-adjusted returns available are in-line with large stocks. In the first post of this series, I mentioned that the historical return and risk of the Russell Microcap® Index did not merit an allocation according to mean-variance optimization. This simple quality screen alters the space’s characteristics to such an extent that it becomes a viable source of differentiated return for investors.

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

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

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

Unique aspects of the micro cap universe

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

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

Notice the significantly fatter tails for micro cap relative to large stocks. If growth in sales is the most basic assessment of the state of a firm, this suggests much greater dispersion in the underlying metrics of micro caps. The popular rhetoric is often that small and micro cap stocks are junkier than their large cap counterparts. While this is true on average, a wide dispersion in fundamental metrics obscures many phenomenal businesses in meaningless averages.

A deeper dive reveals a disparate group of constantly evolving (and devolving) businesses

Investors have widely accepted that there exist many different types of private equity—angel investing, venture, early stage, late stage, mezzanine, LBO’s, distressed. Interestingly, in the private space, these labels represent the need of the firm receiving the investment. Just as there are many sub-classes of venture capital and private equity, such is the case with micro cap stocks, but for whatever reason, we do not view these businesses with the same categorical lens as we do private investments.

The micro cap universe can be divided into three broad categories: New Ventures that have become revenue generating within the last three years, distressed Fallen Angels that have descended into the micro cap universe from small cap—and sometimes large cap—and those in a Steady State that have been micro caps for at least three years.

From 1982-2016, new ventures represented 25% of the micro cap universe, while 16% were fallen angels, and 59% were steady state. Effectively, 41% of the universe is in some sort of transition—from startup to established firm, or from established firm to potential liquidation. When you think about micro cap, think of a revolving door where firms are constantly entering and leaving for different reasons.

This simplistic perspective on the universe is relevant because it sheds light on the strong inherent biases that skew the underlying fundamental characteristics. Below is the same distribution of sales growth for micro cap broken down by these three categories.[2] These disparate groups possess fundamentally different metrics that when averaged together obscure a lot of noise in Micro cap stocks.

New Ventures, with their small sales bases are highly skewed towards positive sales growth. Unsurprisingly, new ventures tend to be comprised of Information Technology and Health Care stocks—most notably biotech, software and pharmaceuticals. Currently, these industries represent a rather large 20% of the micro cap universe. The average annualized return of this group from 1982-2016 is 4.7%, woefully short of the micro cap universe average of 8.9%. Adding insult to injury, annualized volatility for this group is 27.8%. This likely has to do with the nature of outcomes in the space. Biotech firms generally succeed or fail in what amounts to binary outcomes—leaving investors with staggering gains or maximum losses.

Steady State firms are more centered in the distribution, but still positively skewed. At 59% of the overall universe, a good proportion of steady state firms are Commercial Banks and Thrifts. These two industries represent 20% of the universe currently. Banks are the least volatile micro cap industry and one of the top performers. The remainder of firms in this category tend to be widely dispersed across industries. Steady state firms are the best performing of the three categories with an annualized return of 10.1% and volatility of 22.8%.

Fallen Angels skew significantly in the negative growth direction. This group is a smattering of firms across industries. Currently, the oil & gas industry has the highest representation in this category. It tends to offer representation of groups of stocks that suffered in the previous cyclical business downturn. This group delivered an annualized return of 8.0% from 1982-2016 with volatility of 27.4%.

Our task as factor investors is to develop empirical criteria that enable us to cut through the noise to separate the good from the bad within the space. Given the perspective above, we know that there are reasonable fundamental explanations for the “junk-ish” nature of micro cap stocks. Quite simply, a lot of micro cap stocks possess poor business characteristics, whether that be weak cash flow generation, too much leverage, or dwindling and unprofitable revenues. By categorically identifying and removing firms with poor characteristics, we can improve the investor’s base rate for success.

For the third installment on micro cap investing, I’ll suggest some screening criteria that will aid in parsing out some of the “junkiness” of microcaps. Surprisingly, eliminating low quality, puts risk-adjusted returns for micro caps on par with large stocks.

 [1] This would be analogous to the approximately 2,600th to 4,000th stock using Russell’s ordinal market cap ranking methodology.

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.

One of the few indices yet to break out, the NYSE Composite is threatening its all-time highs.

One of the characteristics of the “Trump Rally” has been its breadth of participation. Sure, there have been a few sectors that have lagged badly. However, from a market cap standpoint, most indices, from micro-caps to mega-caps, have scored new all-time highs. It isn’t unanimous, though. A few broad market gauges have not quite made it to new high ground. The Value Line Geometric Composite is one that we mentioned last month. The NYSE Composite is another.

As the chart shows, the NYSE topped in May 2015 at the 11,240 level. After a tumultuous 19 months, the index finally returned to that level in December. And after a couple weeks of a pullback, it is back testing that level again, closing yesterday at 11,246.

A couple observations: First, we do not ever want to anticipate a breakout. That is, don’t buy something with the assumption that it will break out in case the resistance is too much to overcome. Think about the whole “Dow 20,000″ focus that seemed like an inevitability. Sure, it may still happen but the Dow has spent 4 weeks within inches of the level without yet attaining it. Rest assured that if a security or index does finally break out, there will be plenty of time and profits to reap should it indeed prove to be a successful breakout.

On the other hand, there is reason to be optimistic that the NYSE will indeed breakout. That optimism may partially be fueled by a potential cup-&-handle formation on the NYSE chart. As we’ve discussed on several occasions, this is considered to be a bullish pattern. What does it look like and why is it bullish? The pattern involves 2 parts, generally showing the following characteristics:

The Cup (May 2015-December 2016): This phase includes an initial high on the left side of a chart followed by a relatively long, often-rounded retrenchment before a return to the initial high.

The Handle (December 2016-January 2017): This phase involves a shorter, shallower dip in the security and subsequent recovery to the prior highs.

The bullish theory is predicated on the idea that after taking a long time for a stock to return to its initial high during the “cup” phase, the “handle” phase is much briefer and shallower. This theoretically indicates an increased eagerness on the part of investors to buy since they did not allow it to pull back nearly as long or as deep as occurred in the cup phase. Regardless of the theory, the chart pattern has often been effective in forecasting an eventual breakout and advance above the former highs.

Now, many technicians may take exception to the fact that the “handle” in this case is too short and too shallow in proportion to the cup. That is a reasonable protestation on technical grounds. However, the spirit behind the pattern’s typical bullishness remains valid, in our view, and it suggests an eventual breakout.

The post-election “Trump Rally” does not need any more confirmation for purposes of its “validation”. The emphatic new highs in many segments of the market, from small-caps to large-caps, speak for themselves. However, if the NYSE Composite is indeed able to break out to new all-time highs, it would be another feather in the cap for this market. And as with the Value Line Composite, it would certainly mean more than Dow 20,000.

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More from Dana Lyons, JLFMI and My401kPro.

Despite glowing breadth statistics during the recent rally, the micro-cap space is one area that hasn’t kept pace.

When considering the “quality” of the post-February stock rally, one of the biggest positives has been the excellent breadth. It remains to be seen whether it will provide the springboard for a longer-term advance -- or if it was merely a display of mean-reversion, given the broad market’s gross under-performance during the 6 months prior. However, no one can reasonably complain about a lack of participation. Of some concern, though, there is one area that has struggled to keep up with the broad rally: micro-caps.

Comprising some of the smallest of the listed companies in the U.S. market, micro-caps have notably lagged their peers of late, even the traditional small-caps. Yes, the group, as measured by the iShares Russell Micro-Cap ETF (ticker, IWC), has rallied roughly 13% from its February low to its recent rally high, almost exactly in line with the rally in the SPDR S&P 500 Large-Cap ETF (ticker, SPY). However, given the significantly higher beta of micro-cap stocks, the bounce certainly should have well exceeded that of the SPY.

Quantitatively, consider what that 13% move represents. For the SPY, the 13% equates to a 73% retracement of the decline from last May to February, and a 78% retracement of the decline since November. The same 13% rally in the IWC only retraced 32% of its decline since June and 44% of the decline since December. That is not keeping pace.

Another way to measure micro-cap performance is simply via a performance ratio versus the SPY. When the IWC:SPY ratio is rising, micro-caps are out-performing. When the line is dropping, micro-caps are under-performing. After peaking in early 2014, the ratio has dropped considerably. And after hitting a lower high in June, the IWC:SPY ratio dropped precipitously, indicating the severe under-performance of the micro-caps. By December, it had hit a new low since 2009.

After dropping into the low in February, the ratio bounced a bit in the early stages of the recent rally. However, unlike other broad small-cap and mid-cap averages that saw their post-February strength persist, the micro-cap rally has petered out. In fact, the lagging in micro-cap stocks has been so egregious that the IWC:SPY has already found itself back at a 7-year low.

So what’s the big deal if micro-caps are under-performing? Well for one, it presents a bit of counter-evidence to the “strong breadth thrust” case. Furthermore, the relative performance of micro-caps, like any high-beta sector, can serve as an indication of the willingness of investors to take on risk. As the chart shows, the IWC:SPY ratio generally trended upward during the favorable markets from the 2009 low into 2011 and from the 2011 low into 2014. Conversely, the ratio has traditionally fallen during “risk-off” periods in the market, most notably from 2007-2009.

The point is that, at least based on the relative performance of micro-caps, the investment landscape may not be as optimistic as the strong breadth and momentum since February might suggest. Yes, it is only a small segment of the equity market. But if micro-caps can’t get off the mat here, it may be an indication that investors are not willing to fully take on risk yet -- putting any hopes of a durable rally on hold.

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Muhammad Ali photo from Daily Mirror.

More from Dana Lyons, JLFMI and My401kPro.

Each week we read dozens of transcripts from earnings calls and presentations as part of our investment process. Below is a weekly post which typically contains some of the most important quotes about the economy and industry trends from those transcripts.  Click here to receive these posts weekly via email.

This Week's Post: A View of the World From Microcap Companies

This week's post is a little different from usual because we spent this week at the LD Micro conference in Los Angeles. LD Micro is an bi-annual conference that is put together by Chris Lahiji and his team. He brings together a couple hundred companies with average market caps around $50m.  They do a great job.

Although we usually focus on larger companies, the LD Micro conference is always an enlightening few days. I think there is a general perception that if you're a microcap company you've done something wrong, but there are still some very interesting stories and high quality management teams here each year. For instance, this week I met with a former CEO of Anadarko and a former Senior Manager from Abbot Labs. Each was running a company with a market cap lower than $30m.

There are certainly snake oil salesmen in the mix, but there are also people running these companies who have been extremely successful. The CEOs are often unpolished, but they are also scrappy, practical and often survivors. Many are multi-multi millionaires who have built their fortunes by traveling a road that was off the beaten track and hustling. Sometimes I get the sense that some of these CEOs are among the most gifted pure-businessmen that I encounter.

That said, I want to make it very clear that we are in no way shape or form recommending an investment in any of the companies that are mentioned below. We took most of these meetings at random and make no representations as to the quality of any of these companies in particular.

With that disclaimer out of the way, this week we take a peak inside Microcap land. It's quite a trip.

The Macro Outlook: What is it like to be a Microcap company?

It's tough to be a microcap company today

"Being a microcap is tough. There's a perception that being OTC is not where up and coming companies are." --Greg Cash, CEO BioSig (Medical Device)

Companies have to contend with a deeply ingrained stigma

"I think that bulletin board stocks are unfairly maligned. The accounting requirements are exactly the same" --Harold Montgomery, CEO Calpian (Payment Processing in India)

There aren't a lot of investors interested in companies this size

"$2-10 million is a tough nut to crack. It's a tough amount of money to raise. There aren't a lot of investors looking to write that size check. You're too big for private investors and too small for most institutions. It's no man's land" --Michael Oliver, CEO SpectraScience (Medical Device)

A lot of management teams voiced frustration with how government regulation has made it more difficult for microcaps

"Over-regulation has destroyed the microcap market. They've put all the small brokers out of business. They say it's to protect the small investor, but then look what they allow, crowdfunding? Give me a break. It's laughable, but it's not funny." --Harvey Bibicoff, Investor BG Staffing (Staffing Company)

Others recognized that this is just a part of life

"Regulations are a barrier to competition and they are a bigger barrier to smaller competition. But it's like fish swim in the water. It's part of who you are so you deal with it." Michael Oliver, CEO SpectraScience (Medical Device)

So the question is, why be a public company at this size?

This is definitely the harder way to go, but many see it as the right thing to do to protect shareholder value

"There's no doubt that this is the harder way to go, but it's what's right for the company, patients and shareholders" --Greg Cash, CEO BioSig (Medical Device)

"Maybe if I were 30 years old and needed the money to support my family I would raise money from a VC. I can see that. But if you want to do what's right for the company and employees, and you're comfortable in your personal finances, then this is the way to do it." --Andy Khanna, CEO Sonasoft (Email Archiving)

Most said that VC and PE funds want to take too much control over the company

"I knew this was going to be a multi year effort and we would have lost control if we had been funded by a VC. In order to have the time necessary and keep the founders in control, being a public company was the best option." --Bill Caragol, CEO PositiveID Corporation (Biotech)

"I've worked with Private Equity partners in the past, we know them well, but ultimately it came down to the fact that they just want to take too much of the company." --John Seitz, CEO GulfSlope Energy (Oil Exploration and Production)

International:

Sam Wu, CFO of a US listed Chinese company, told me that the reason so many Chinese companies are listed in the US is that it gives them credibility at home

"being publicly listed in the United States creates credibility at home in China. The government trusts us more because we are a US listed company. It shows that we have strong financial backing and can finish a job with quality" --Sam Wu, CFO Yu Long Eco-Materials (Chinese Construction Materials Company)

Financials:

Richard Prati is a former investment banker.  He is now CEO of a medical device company. He talked about the differences between his old job and his new one.

"Wall Street has changed a lot, regulation has changed it. It's not as entrepreneurial as it used to be. It's not as fun. People are just focused on keeping their jobs, not trying to figure out how to build a company...in this, I get to wake up every morning asking how do I make the patient and customer's life better" --Richard Prati, CEO Life Care Medical Devices (Private Medical Device co)

Gene Cartwright was a top manager at Abbott Labs and then GE. He moved to a struggling Microcap because he saw an opportunity. He shared some lessons that he's learned about managing the finances of a microcap company.

"Never do a floating deal. You're better off giving up something significant early on for a fixed price. And cut your burn rate--even further than you think you can. You'll always be ok." --Gene Cartwright, CEO Guided Therapeutics (Medical Diagnostics)

Domenic Penna worked for Diageo and then then moved to Teva Pharmaceuticals before ending up at a small Pharmaceutical company in Canada. He talked about the importance of analytical thinking.

"The difference between being a good accountant and a good analyst is that an analyst can see a story through the data. I always say, don't give me data, give me information. Unless you can bridge the gap, you'll be stuck as an accountant." --Domenic Penna, CFO IntelliPharmaceutics (Pharmaceutical)

Consumer:

Leonard Mazur was responsible for a number of big consumer brands at Cooper in the 1980s. He helped build Oral B from $1m in sales to the largest toothbrush brand in the US. He shared his insights on marketing.

"It's critical when you're in a very competitive market, you have to be unique, you have to do something that makes people remember you. You've got to do something that gives you recognition and do it in a way that's never been done before." --Leonard Mazur, President Citius Pharma (Phamaceuticals)

Technology:

Peter Bloch is an "Eric Schmidt" figure to two bright young mechanical engineers in Toronto who are building a mechanical exoskeleton to help paraplegics walk again. He talked about the potential for robotics in Medicine.

"I believe that these products haven't even begun to realize their potential in the market...engineering is important, but penetration is going to come from strong data" --Peter Bloch, CEO Bionik Labs (Medical Robotics)

Andy Khanna brings an old school mentality to a cloud based software company.  He talked about how they optimize the value of their engineering budget by hiring software engineers overseas

"We hire software engineers overseas, because you can't find a software engineer in the US for less than $150k and you can't afford that unless you're financed by a VC. And then what ends up happening is management ends up owning 1% of the stock. From a quality standpoint we find that coding/testing is actually better overseas than here. What is lacking are design capabilities, so we do design here and then take it to where the skill-set is available." --Andy Khanna, CEO SonaSoft (Email Archiving)

Healthcare:

There are a LOT of med-tech companies in the microcap space

Daron Evans and Jeff Baxter are two business focused CEOs with long term industry experience. Both stressed looking for base-hits rather than home runs as a med-tech investor.

"When you're looking at a small company in the healthcare space, focus on whether you have a clear line of sight to a cash flow generating company. Focus on evolution, not revolution." --Daron Evans, CEO Nephros (Medical Device)

"Focusing on unmet clinical needs, that's BS, that's not for small and mid-cap companies. You need to be pushing against an open door." --Jeff Baxter, CEO VBI Vaccines (Biotech)

Doug Janzen also stressed going after base hits, but provided some pointers for investors who feel compelled to search for home runs

"Focus on products, things that you can touch. A scientist with an enzyme, that's a concept, not a product. If you're going to invest in biotech, look for products that have a huge benefit, not just some incremental improvement. Also, if someone's in a sexy area of science, things will tend to roll down hill" --Doug Janzen, Co-Founder Aequus Pharmaceuticals (Pharmaceuticals)

Biotech companies have extremely long development cycles with uncertain outcomes. I asked Emanuel Bjorne for insight on what it's like day-to-day to devote one's life to a dream

"If you're in clinical development, the work can be exciting every day. If you're in pre-clinical development, it can be a bit like fighting a desert war" --Emanuel Bjorne, Corporate Development Director Hansa Medical (Biotech)

If you want to succeed as a biotech startup you have to be extremely disciplined about controlling expenses

"The key to success in biotech is to get really bright people together and make sure they have moderate, but not excessive resources. Biotech has to be lean, mean and rigorously focused. You have to bring scientific expertise together with good business expertise. Scientists will figure out a way to spend money if you let them." --Jeff Baxter, CEO VBI Vaccines (Biotech)

Ultimately, everything comes down to the phase III trial

"The last trial is Phase III, this is to be or not to be. You know Hamlet? It's like that." --Rob Babecoff, CEO BiondVax (Biotech)

These management teams have everything riding on a highly uncertain outcome

"We have all our chips on the table. We're all in." --Jerome Jabbour, Chief Business Officer Matinas Biopharma (Biotech)

Not everyone is going to make it

"There is going to be some failure, there has to be some failure. That's the history of science." --Albert Scardino, Chairman ImmunoVaccine (Biotech)

Materials, Industrials, Energy:

John Seitz, who is the former CEO of Anadarko, shared his secret to success in oil exploration. The key is good people.

"The formula for success in oil exploration isn't terribly complicated: Pick a basin where oil has been found, acquire all the data (seismic and well), put a highly experienced team to work on it and give them the time and support they need. In other words, get out of the way and it just works." --John Seitz, CEO GulfSlope Energy (Oil Exploration and Production)

One CEO I spoke to talked about how the US should think more about the importance of manufacturing

"People are very interested in software today, but as my old boss used to say, it's not a real business unless you ship things out the back door. I think it would serve the US well to think about that more often." --Tom Steipp, CEO Liquidmetal Technologies (Injection molded metal)

Miscellaneous Nuggets of Wisdom:

Ironclad's CEO sells a lot of gloves to oil and gas industry workers.  He reminded me that the strongest relationships can be built when customers are hurting.

"At this point in the cycle, that's the time when you make friends" --Jeff Cordes, CEO Ironclad Performance Wear (Work Gloves)

Antonio Tremenino is a passionate Nicaraguan-born businessman. He shared insights on investing and on life.

"In moments of crisis and moments of success you need two things: stay healthy and stay focused" --Antonio Tremenino, Co-Founder ROI Land Investments (Land Development)

A. Paul Gill went from a government worker to mining tycoon when he made a 9000% return buying a discarded copper mine from Rio Tinto in the late 90s. He had some uplifting advice.

"Don't let anyone tell you it can't be done. It can be done. Buy low, build high" --A. Paul Gill, CEO Lomiko Metals (Graphite mining and processing)

Albert Scardino was a Pulitzer Prize winning journalist who made 22x his money investing in Canadian broadcasting rights and then even more in mining. He shared what he looks for in investments.  It comes down to people.

"I look for people, for people I can trust and work with. I don't have a financial background, but I've found I can never get as much out of the financial statements as I can out of the people. I find that if you have the right people, you don't have to worry as much because you trust them and can take them at their word." --Albert Scardino, Chairman ImmunoVaccine (Biotech)