The MicroCap Advantage

Ian Cassel Blog, Educational Leave a Comment

In 2010, Dr. Gerald Perritt, Founder of microcap fund bellwether, Perritt Capital Management wrote the following piece, “The MicroCap Advantage”.  Dr. Gerald Perritt has since sold Perritt Capital Management to Michael Corbett whom I interviewed recently. In “The MicroCap Advantage” posted below, Perritt makes his point that extraordinary returns have historically been found in the microcap arena.  

The MicroCap Advantage

By Dr. Gerald Perritt

Ever since stock markets were created, investors have been devising schemes to enable them to beat the market’s average return. Some invest in large companies, some invest in small companies, and others ignore company size and invest in companies of any size as long as they have potential to produce market-topping returns. Some investors buy-and- hold while others trade frenetically. Some invest in high multiple growth stocks while others prefer to shop among companies whose stocks have recently been beaten down. Then there are the technical analysts and those who analyze only economic fundamentals. Some investors assemble portfolios from “the top down” while others prefer a “bottom up” approach.

Academics have long admonished investors for spending so much time trying to predict the future. They point to the plethora of studies that indicate the stock market is a reasonably efficient mechanism. In an efficient market, the best guess at tomorrow’s stock price is today’s price. The existence of numerous buyers and sellers and the near instantaneous flow of new information cause securities to be priced according to their inherent risk. Most academics will tell you the only way to produce market-topping long-term investment returns is to build and maintain a highly diversified portfolio that contains more systematic risk than the stock market as a whole. In short, what investors ultimately get from their equity portfolios is paid for by the risks they take.

The Small Firm Effect

The first formidable crack in the so-called efficient market theory appeared in the late 1970s when a University of Chicago doctoral student discovered a strategy that has produced superior investment returns for more than 80 years. Superior meaning that this strategy has historically produced greater returns than dictated by portfolio risk. This strategy has come to be known as “the small firm effect.”

Simply put, the small firm effect is the tendency of the common stocks of small firms to outperform the common stocks of large firms given the same level of risk. In an efficient market, the expected rate of return from any portfolio is directly related to its non- diversifiable risk. The greater the level of non-diversifiable risk, the greater the expected rate of return. Contemporary research, however, indicates that this has not been the case for well-diversified portfolios consisting of small firm common stocks.

The small firm effect was first measured in 1978 by Rolf Banz while completing his doctoral dissertation at the University of Chicago. Banz ranked NYSE-listed stocks by market capitalization and formed five portfolios containing the largest to smallest stocks listed on the Exchange. These portfolios were held for five years and then the stocks were re-ranked and new portfolios were formed. He repeated the process throughout the period 1925 through 1975. Next, he measured the monthly returns of each portfolio and applied a least squares regression analysis to those returns to obtain each portfolio’s beta (measure of relative systematic risk) and alpha (the portfolio’s average monthly risk- adjusted return). He expected portfolios with larger amounts of systematic risk to produce larger investment returns than portfolios with smaller amounts of systematic risk. What he found was a return anomaly that has yet to be fully explained.

Over the 50-year period studied, the first four portfolios (those containing all but the smallest NYSE firms) provided investors with investment…..

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