MICRO-CAP STOCKS: AN OVERLOOKED AND INEFFICIENT ASSET CLASS

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1 MICRO-CAP STOCKS: AN OVERLOOKED AND INEFFICIENT ASSET CLASS SEPTEMBER 2015 WE BELIEVE MICRO-CAP STOCKS, BOTH IN THE U.S. AND GLOBALLY, ARE AN ATTRACTIVE INVESTMENT OPPORTUNITY. They represent one of the least efficient sectors of equity markets, with low analyst coverage and wide spreads in valuation. At approximately 20,000 stocks in developed markets worldwide, this is an investment universe that offers potentially fertile ground for active stock selection. Participating in micro-caps is not without challenges. Liquidity, trading costs, and individual company risk are all factors to seriously consider. However, quantitative investment processes are well positioned to mitigate such problems and can offer investors exposure to a wide range of attractive small companies in markets worldwide. WHAT ARE MICRO-CAP STOCKS? Micro-cap describes the segment of the smallest investable stocks. While exact definitions vary, a representative market cap range would be $50 million to $500 million. This capitalization band contains about 20,000 stocks in developed markets worldwide. Of these, we estimate that approximately 1,840 in the U.S. and 5,900 outside of the U.S. are institutionally investable. By count, micro-cap dominates global stock markets, representing about 56% of Acadian s developed market investable universe. Micro-caps sometimes suffer from the perception that they are either sketchy start-ups or established companies on a downward trajectory. In fact, we estimate that stocks in the Micro Cap Index have traded for about 19 years on average (21 years for micro-caps outside the U.S.). 1 In terms of perceived junkiness, it is true that the micro-cap universe does contain a higher proportion of low-quality companies. However, there is great dispersion of quality within micro-caps, and many companies show excellent quality characteristics. This, combined with the large size of the investment universe, offers strong support for active management. Another attractive feature of micro-cap companies is their ownership structure. Micro-caps offer a natural bridge between public and private markets, both domestically and internationally. As shown in Figure 1, the percent of market cap held by insiders and private investors steadily increases from large-cap stocks to small-cap stocks to micro-caps. For these smaller companies, management has skin in the game. Many investors believe that these ownership characteristics drive a greater focus on shareholder returns. For these reasons, micro-caps are often put forth as an attractive, liquid alternative to private equity. Over time, micro-caps have had similar risk and return characteristics to small-caps at the index level. 2 The real potential in this asset class lies in its greatly enhanced potential for active stock selection. FIGURE 1 Ownership by insiders and private investors 3 PERCENTAGE OF INDEX BY CAP 20% 15% 10% 5% 0% MSCI World ex USA MSCI World ex USA Micro Cap Small Cap Large Cap MSCI World ex USA 1 This estimate is based on a composite of data items from Factset, Bloomberg, and S&P Capital IQ. 2 See Appendix for micro-cap index risk and returns. 3 Sources: S&P Capital IQ, MSCI, Acadian. Copyright MSCI All rights reserved. 1

2 THE CASE FOR ACTIVE MICRO-CAP INVESTING BREADTH Micro-caps have a number of distinctive qualities that make the asset class ideal for active management. The first is the exceptional size of the universe. The micro-cap universe, comprised of 7,700 institutionally investable stocks, has roughly double the number of investable stocks as the small-cap universe and close to five times the number of investable large-caps. The Fundamental Law of Active Management (IR skill * square root of breadth) highlights the value of a large opportunity set. The greater the breadth, the more potential for a skilled manager to generate superior risk-adjusted active returns. 4 Of all equity asset classes, micro-caps offer the most opportunities at bat. INEFFICIENCY Given the vast size of the investment universe, many micro-cap stocks are underfollowed or ignored by analysts. While the average number of analysts covering a stock in MSCI World is 17, and the average number covering a stock in MSCI World Small Cap is 7, the average analyst coverage for a company in the corresponding micro-cap universe is 2. We estimate that 58% of the companies in MSCI World Micro Cap have no analyst coverage at all. 5 The lack of coverage makes sense, given the limited scope of most fundamental research organizations. It is simply too expensive to extend an investment universe that far. We believe the benefit for active managers who have the ability to cover a broad universe is that mispricings among micro-caps are more persistent. Given the relatively sparse information environment, we would expect to find evidence of mispricing in the micro-cap universe. And we do in fact see this. Taking valuation as an example, we see wider spreads across the micro-cap universe compared to larger stocks. As Figure 2 shows, the dispersion of value grows larger as stock size decreases. This suggests that the micro-cap arena does indeed offer greater potential to uncover undervalued stock opportunities. FIGURE 2 Dispersion of Value factor by market cap, DISPERSION (%) U.S. World ex-u.s Micro Small Large Sources: Axioma, Acadian micro-cap universe of securities. For illustrative purposes only. Past results are not indicative of future results. Every investment program has an opportunity for loss as well as profit. 4 Grinold, Richard, The Fundamental Law of Active Management, The Journal of Portfolio Management, Vol. 15, No. 3 (Spring 1989): This is the average number of analyst forecasts for companies in each cap range, as tracked by Acadian currently using a proprietary database drawn from multiple data sources including IBES. 2

3 A NOTE ON MICRO-CAP INDICES There are a number of issues to consider when choosing a micro-cap benchmark index. As of now, there are four major micro-cap indices the Russell Microcap Index, the MSCI World Micro Cap Index, the Wilshire US Micro-Cap Index, and the Dow Jones Select MicroCap Index. While some are constructed as standalone universes, others don t include a hard cutoff to ensure a true concentration of stocks below $ million in market cap, and so they may have overlap with the purveyor s small-cap index. Overlap with a small-cap universe may increase liquidity, but may also dilute the benefits of a micro-cap allocation. In addition, not all micro-cap indices are global. Of the indices above, only MSCI and S&P offer fully developed non-u.s. index coverage in addition to U.S. coverage. THE QUANTITATIVE VALUE PROPOSITION Given the unique characteristics of micro-caps, not every investment approach is going to be successful in effectively managing these assets. As noted above, there is sparse fundamental research on the scope of the micro-cap universe. This makes micro-caps a natural fit for a quantitative approach, which can access data and leverage the insights of analysis across many thousands of stocks. In addition, micro-caps can pose challenges with regard to effective trading. They are less liquid than other equity asset classes and have correspondingly high transaction costs. The average bid-ask spread for micro-caps is close to four times as large as for small-cap stocks (2.14% versus 0.55%, according to Acadian s trading data). Trading in this arena requires a deep information set and precise techniques for assessing potential alpha in light of trading costs. A successful manager will be able to estimate the cost not just of gaining exposure to an attractive holding, but also of eventually unwinding it. The good news is that total daily trade volume for global micro-caps is close to $14 billion, versus $30 billion for small-caps. 6 That is large enough to accommodate institutional-sized trading, as long as there is a strong focus on transaction cost control. ACADIAN S APPROACH TO MICRO-CAP Micro-cap is a natural extension of Acadian s long history as an early mover in underexplored areas of the investment universe, from our pioneering non-u.s. small-cap strategies in the 1980s, to emerging markets, frontier markets, and EM small-cap. We believe our investment process brings clarity, consistency, and objectivity to micro-cap investing, shedding light on what many still think of as an opaque and risky area. Acadian has maintained a global micro-cap universe since the late 1980s and currently covers the full global universe of micro-cap stocks. We incorporate over 50 data sources into our investment process to render a continually updated view on even the smallest stocks. Our process carefully tracks transaction costs and incorporates this information into trading decisions. The Acadian trading team has been managing the complexities of trading small, less liquid global stocks for three decades. Our approach to portfolio construction uses a transaction cost model that can be customized to the higher and steeply escalating costs associated with trading in the micro-cap universe. Acadian s structured process thrives on inefficiency, and we can see the heightened return potential of micro-cap stocks in our own forecast data and hypothetical results. 7 Figure 3 compares hypothetical universe-relative returns by Acadian alpha forecasts across different capitalization ranges. We break the alpha forecasts into quintiles, with the return to our highestforecasted stocks on the left, and the return to our lowest forecasted stocks on the right. 6 Source: Acadian 7 There is no assurance these forecasts can be achieved. Hypothetical results are not indicative of actual future results. 3

4 FIGURE 3 Average one-month relative return by alpha forecast quintile within developed market stocks RETURN (%) 2.0 Acadian Micro-Cap Acadian Small-Cap Acadian Large-Cap High Q2 Q3 Q4 Low Source: Acadian Asset Management LLC. For illustrative purposes only. This is meant to be an educational illustrative example and is not intended to represent investment returns generated by an actual portfolio. They do not represent actual trading or an actual account, but were achieved by means of using the Acadian large-, small- and micro-cap universe of securities. Average universe-relative one-month return by alpha forecast quintile. Period is June 2005 May Micro-cap defined as stocks with cap <$500M, small-cap as stocks with cap between $500M and $5B, and large-cap as stocks with cap >$5B. The universe is defined as non-u.s. developed world stocks. Alpha forecast quintiles are equal cap-weighted. Results do not reflect transaction costs, other implementation costs, and do not reflect advisory fees or their potential impact. Hypothetical results are not indicative of actual future results. Every investment program has the opportunity for loss as well as profit. Forecasts are based on proprietary models. There can be no assurance forecasts will be achieved. It is clear from this data that the return potential from our process grows larger as we move into less efficient areas of the market, with micro-caps offering the most attractive environment for stock selection. Micro-cap is, in fact, the ideal playing field for a high conviction quantitative manager. We define high conviction as the ability to build portfolios with high alpha potential through 1) concentrated exposure to the most favorable factors, 2) controlled avoidance of unfavorable factors, and 3) optimal implementation through sophisticated portfolio construction and transaction cost modeling. The micro-cap universe offers one of the fullest opportunity sets for this type of investment approach. In short, we see great potential in the micro-cap asset class, which, in our view, offers a number of underutilized benefits to investors. It also offers one of the best ways currently available to leverage the strengths of a broad, disciplined, quantitative investment process. 4

5 APPENDIX MICRO-CAP INDEX RISK AND RETURNS Micro-Cap Small-Cap December June 2015 Return 7.9% 9.3% 6.2% Standard Deviation 21.6% 20.8% 16.3% Sharpe Ratio Beta Year Return 17.0% 18.5% 16.8% Standard Deviation 12.5% 11.0% 8.4% Sharpe Ratio Beta Year Return 16.5% 17.7% 16.8% Standard Deviation 16.1% 15.7% 12.0% Sharpe Ratio Beta MSCI World ex-u.s. Micro-Cap MSCI World ex-u.s. Small-Cap MSCI World ex-u.s. December June 2015 Return 2.8% 2.5% -0.1% Standard Deviation 21.6% 21.6% 19.9% Sharpe Ratio Beta Year Return 13.5% 13.6% 11.1% Standard Deviation 11.2% 10.7% 10.3% Sharpe Ratio Beta Year Return 11.3% 11.1% 9.0% Standard Deviation 15.6% 16.0% 15.4% Sharpe Ratio Beta Sources: MSCI, Acadian Asset Management LLC. For illustrative purposes only. It is not possible to invest directly in any index. Past performance is not indicative of future results. Every investment program has an opportunity for loss as well as profit. Index Source: MSCI Copyright MSCI All Rights Reserved. Unpublished. PROPRIETARY TO MSCI. 5

6 Acadian provides this material as a general overview of the firm, our processes and our investment capabilities. It has been provided for informational purposes only. It does not constitute or form part of any offer to issue or sell, or any solicitation of any offer to subscribe or to purchase, shares, units or other interests in investments that may be referred to herein and must not be construed as investment or financial product advice. Acadian has not considered any reader s financial situation, objective or needs in providing the relevant information. The value of investments may fall as well as rise and you may not get back your original investment. Past performance is not necessarily a guide to future performance or returns. Acadian has taken all reasonable care to ensure that the information contained in this material is accurate at the time of its distribution, no representation or warranty, express or implied, is made as to the accuracy, reliability or completeness of such information. This material contains privileged and confidential information and is intended only for the recipient/s. Any distribution, reproduction or other use of this presentation by recipients is strictly prohibited. If you are not the intended recipient and this presentation has been sent or passed on to you in error, please contact us immediately. Confidentiality and privilege are not lost by this presentation having been sent or passed on to you in error. Acadian s quantitative investment process is supported by extensive proprietary computer code. Acadian s researchers, software developers, and IT teams follow a structured design, development, testing, change control, and review processes during the development of its systems and the implementation within our investment process. These controls and their effectiveness are subject to regular internal reviews, at least annual independent review by our SSAE 16 auditor. However, despite these extensive controls it is possible that errors may occur in coding and within the investment process, as is the case with any complex software or data-driven model, and no guarantee or warranty can be provided that any quantitative investment model is completely free of errors. Any such errors could have a GENERAL LEGAL DISCLAIMER negative impact on investment results. We have in place control systems and processes which are intended to identify in a timely manner any such errors which would have a material impact on the investment process. Acadian Asset Management LLC has wholly owned affiliates located in London, Singapore, Sydney, and Tokyo. Pursuant to the terms of service level agreements with each affiliate, employees of Acadian Asset Management LLC may provide certain services on behalf of each affiliate and employees of each affiliate may provide certain administrative services, including marketing and client service, on behalf of Acadian Asset Management LLC. Acadian Asset Management LLC is registered as an investment adviser with the U.S. Securities and Exchange Commission. Registration of an investment adviser does not imply any level of skill or training. Acadian Asset Management (Japan) is a Financial Instrument Operator (Discretionary Investment Management Business). Register Number Director- General Kanto Local Financial Bureau (Kinsho) Number Member of Japan Investment Advisers Association. Acadian Asset Management (Singapore) Pte Ltd, (Registration Number: D) is licensed by the Monetary Authority of Singapore. Acadian Asset Management (Australia) Limited (ABN ) is the holder of Australian financial services license number ( AFSL ). Under the terms of its AFSL, Acadian Asset Management (Australia) Limited is limited to providing the financial services under its license to wholesale clients only. This marketing material is not to be provided to retail clients. Acadian Asset Management (UK) Limited is authorized and regulated by the Financial Conduct Authority ( the FCA ) and is a limited liability company incorporated in England and Wales with company number Acadian Asset Management (UK) Limited will only make this material available to Professional Clients and Eligible Counterparties as defined by the FCA under the Markets in Financial Instruments Directive. 6