September 2009

MICRO CAPS: small can be beautiful

Value is coming back to micro caps, including some of the sector’s fallen angels, says Robert Marren of Nicholas Applegate...
sprinkles.jpg The market meltdown of 2008 destroyed value across all market capitalisations, and especially in the micro-cap sector. But the result today is that we find ourselves facing some amazing opportunities in micro-caps.

Rather like the post-tech bubble of 2003, when technology stocks were trading well below cash on the balance sheet because investors were so frightened of uncertainty, we now see a similar level of opportunity for micro-cap investors.

The micro-cap universe has always been populated by a combination of undiscovered gems, but the interesting new addition to the mix is a number of fallen angels. Stocks that previously traded in small and mid-cap portfolios fell 50-60% into the micro-cap category, virtually overnight. These stocks were caught up in the overall market correction and reacted disproportionately to relatively minor changes in fundamentals, such as a modest decrease in growth rate or an up-tick in refinancing risk, but have resulted in some great opportunities to buy well-known, well-managed companies in the micro-cap space.

As ever, the trick is to identify the right stocks. Given the dramatic impact of higher oil prices and the weaker housing market on consumer spending in 2008, it made sense then to reduce the consumer discretionary weighting, and move into companies that were either neutral toward, or even benefiting from, the slowing economy. For example, a car repair chain fits the theme of fixing the car you own, rather than buying a new one.

The best opportunities are emerging in materials, industrials and energy, which have already discounted the economic slowdown. Some offer extremely attractive possibilities, with strong fundamentals that we believe will benefit as energy and materials prices firm on rising demand, particularly in China.

Healthcare stocks have traditionally provided a safe haven in recessions, but less so this time around – largely due to political uncertainty around President Obama’s plans for healthcare reform. Biotech, however, has been an interesting micro-cap story this year, with several bio-tech stocks experiencing wild share price swings. Some have appreciated up to 1000%, largely related to FDA approvals and clinical trial results.

There are, of course, unique risks and challenges in the micro-cap space, including low trading volumes and high event risk. It’s therefore important to have a diversified portfolio, so that no one stock has a significant impact on overall portfolio performance. Sparse analyst coverage can also be a double-edged sword. Micro-cap analysts tend to work for regional boutique firms so they have a much smaller platform with which to distribute their research. There is a relatively limited group of institutional micro-cap  products, less than one tenth the number of small-cap products. So discovering a micro-cap stock before small-cap investors do can offer an opportunity for multiple expansion, although the flip-side can be true, if the stock experiences a negative surprise!

Overall, the larger institutions primarily use micro-cap as an additional component to their small-cap allocations. They may have multiple small-cap mandates and add a micro-cap manager to the roster. Often small-cap managers own similar stocks, so micro-cap managers may offer a very different return pattern from the small-cap managers. Micro caps may diverge from small caps for extended time periods. For the past five years, they have trailed small caps, but over time, micro caps have proven to provide the highest returns in the small-cap family because of the high level of inefficiencies in the asset class. This leads investors, including high-net-worth individuals or endowments, to the alpha opportunities. Ultimately, this is more important than where the asset class fits in the style box. Size, as they say, is not important.

©2009 funds europe

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