Practical analysis for investment professionals
08 October 2018

Factor Investing in Micro and Small Caps

Treasure Hunting in the Wild West of Equity Markets

FAANG stocks like Apple (AAPL) are covered by dozens of highly trained financial analysts. Galaxy Gaming (GLXZ), on the other hand, is followed by exactly zero analysts.

Galaxy Gaming who?

Galaxy Gaming, which produces table games and betting platforms for the casino industry, has a market capitalization of $50 million and trades over the counter (OTC). Unfortunately for such companies, analyst coverage of US stocks has been steadily decreasing since the 2000s due to tighter Wall Street regulations, among other factors.

But the lack of analyst coverage might offer alpha-generating opportunities. Could the less-covered areas of the equity markets be worth an extra look?

Although analyzing thousands of micro- and small-cap stocks by hand is not a sensible strategy, investors can apply systematic frameworks to uncover hidden gems. So does factor investing in micro- and small-cap stocks in the United States offer any additional alpha?


To find out, we divided the US equity market into three segments based on market capitalization. Together these three segments approximate the Russell 3000 universe:

  • Micro caps include about 800 stocks, each with $100 million to $500 million in market capitalization.
  • Small caps feature about 400 stocks with $500 million to $1 billion in market capitalization.
  • Mid and large caps have market capitalizations in excess of $1 billion and number about 1,800 stocks in total.

We created market cap-weighted and equal-weighted indices as well as three equal-weighted factor portfolios composed of the top 10% of stocks ranked by each factor. We define Value as a combination of price-to-book and price-to-earnings multiples and Quality as a combination of return-on-equity and debt-over-equity. Momentum is measured by the performance over the last 12 months, excluding the most recent month.

The indices are rebalanced quarterly and the factor portfolios monthly.

Transaction costs are 1% for micro caps, 0.5% for small caps, and 0.1% for mid and large caps. Since shorting micro- and small-cap stocks is expensive and frequently impossible, we focused on long-only portfolios.

Factor Investing in Micro Cap

The small-cap companies generally come in two varieties: a small number of firms that recently went public and a large cohort whose businesses are in decline.

The characteristics of the universe are reflected by the performance of the Quality portfolio, which successfully reduces exposure to less healthy companies by focusing on profitable and lowly levered stocks. Cheap companies also outperformed the indices, while the Momentum portfolio underperformed post-2009, reflecting the severe Momentum crash that followed the financial crisis.

Micro Cap Factor Performance

Source: FactorResearch

Factor Investing in Small Caps

Small caps generated more attractive returns than micro caps from 2000 to 2018. Only the Value portfolio outperformed the indices, with most of the outperformance coming between 2000 and 2003, when the tech bubble imploded. Cheap stocks were unpopular during the tech bubble but rebounded significantly thereafter.

Small Caps Factor Investing

Source: FactorResearch

Factor Investing in Mid and Large Caps

The mid-and large-cap universe is composed of mostly successful companies. As with micro and small caps, only cheap companies outperformed the indices. It is worth noting that the factor performance across market caps is relatively homogenous, which partially depends on the starting point of the analysis.

Mid and Large Cap Factor Investing

Source: FactorResearch

Comparison across Market-Cap Segments

Analyzing the returns across the different market-cap segments yields the following takeaways:

  • Index returns were highest for mid and large caps when weighted equally (EW), but highest for small caps when weighted by market cap (MW).
  • Micro caps did not generate attractive returns at the index level regardless of the weighting methodology.
  • CAGRS from the Value factor portfolio increased linearly with market capitalization. This is likely because the Value rebound after the tech bubble was stronger in mid and large caps.
  • The Quality factor is most effective in micro caps, successfully screening out the deteriorating businesses.
  • Momentum was impacted by the Momentum crash of 2009 across market cap segments.

CAGRS: Comparison of Micro, Small, and Mid and Large Caps, 2000 to 2018

CAGRS: Comparison of Micro, Small, and Mid and Large Caps, 2000 to 2018

Source: FactorResearch

Returns can be normalized by transforming them into risk-return ratios. This demonstrates factor investing works just as well with mid and large caps as it does with small stocks.

Other researchers have shown that small caps generate the largest factor returns. Why do our results differ? Probably because we have different definitions of the market-cap segments, lookback periods, and transaction cost assumptions.

Risk-Return Ratios: Comparison of Micro, Small, and Mid and Large Caps, 2000 to 2018

Risk-Return Ratios: Comparison of Micro, Small, and Mid and Large Caps, 2000 to 2018

Source: FactorResearch

Further Thoughts

Fortunately for most investors, our results demonstrate that factor returns are not exclusive to smaller companies.

So as alluring as they may be, US micro-caps — the Galaxy Gamings of the world — can safely be ignored.

For more insights from Nicolas Rabener and the Factor Research team, sign up for their email newsletter.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer

Image credit: © Getty Images/CSA-Archive

About the Author(s)
Nicolas Rabener

Nicolas Rabener is the managing director of Finominal, which provides quantitative solutions for factor investing. Previously he founded Jackdaw Capital, a quantitative investment manager focused on equity market neutral strategies. Previously, Rabener worked at GIC (Government of Singapore Investment Corporation) focused on real estate across asset classes. He started his career working for Citigroup in investment banking in London and New York. Rabener holds an MS in management from HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100km Ultramarathon, Mont Blanc, Mount Kilimanjaro).

5 thoughts on “Factor Investing in Micro and Small Caps”

  1. Felix Lenk says:

    Thanks for this critical view! Can the author please add information (i) if transaction costs are assumed to be incurred twice every month, i.e. is it selling AND buying, and (ii) is the conclusion (“micro-caps can safely be ignored”) still true if portfolios are rebalanced annually?

    To me it seems as if transaction costs really create a lot of noise so that the true strategy returns cannot be seen.

    1. Nicolas Rabener says:

      Hi Felix, regarding your questions:

      1) Costs are incurred for each transaction, i.e. when buying and selling.
      2) If we rebalance on an annual basis, the conclusion does not change. The microcap index returns will improve, but Momentum requires frequent turnover and becomes worse if not rebalanced frequently.

      The reason for the different transaction costs is to show a more realistic view of investing across market caps. Indeed most researchers exclude transaction costs, but it is pointless from our perspective if the results are attractive in theory and not applicable to reality.

  2. As somebody who spends most of his time looking at micro and small caps, I have to differ with the view that micro caps come in two varieties: a small number of firms that recently went public and a large cohort whose businesses are in decline.

    Most of the best micro cap opportunities are companies that have been listed for years and are hitting their strides. IPOs might be great for a stag profit but often run into a range of problems in the first few years of being listed. Often board and management struggle to adapt to public market demands. Sometimes the IPOs are over-hyped. Sometimes pro forma financials used for IPOs are over stated or just plain misleading.

    1. Nicolas Rabener says:

      Hi Martin, thank you for sharing your perspective. We were somewhat surprised that micro caps did not generate higher returns, even if with higher volatility.

      We can also use external data to come to a similar conclusion as with our own data – eg the iShares Russell Microcap Index (IWC) generated lower returns with higher volatility than the S&P 500 since its inception in 2005. Do you have any views on this?

      1. Martin Pretty says:

        Hi Nicolas, I think the paper done by AQR staffers kind of hits the point: when wading through small and micro caps, you need to “control your junk”!

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