iShares Microcap ETF (IWC) – A Benchmark that is Not Very Microcap
The IWC underweights the highest performing group, microcaps that are profitable & growing earnings.
5 min read
A quantitative look at the popular factor ROIC and how it relates to microcaps
Return on Invested Capital (ROIC) is one of more popular investing factors. Michael Mauboussin and others have written extensively about this metric, so I won’t repeat it here, but rather we’ll look at ROIC as it applies to microcaps, and some other unique quantitative factors that potentially complement this factor.
The basic theory is if ROIC is in excess of a firm’s cost of capital, then value is being created. If the cost of capital exceeds the ROIC, then value is being destroyed.
Cost of capital can be a hotly debated topic, as it is so subjective, particularly cost of equity.
In our approach, we’re not so interested in cost of capital, but we’ll look at ROIC from four angles:
There are many variations of ROIC, but its basic equation is:
or simply NOPAT / IC
With different variations for both the numerator and denominator I typically resort to the Mauboussin versions. Intangibles have generally been accepted as another source of “capital” in recent years, however this can be difficult to quantify. There are quantitative factors that can be used to help approximate these values, but they are still quite broad. I use an approach similar to the one covered in this paper.
ROIC & Microcaps
Only ~24% of our MC-GUTS US microcap universe is NOPAT positive, compared to 93% of the S&P500.
Canada has roughly the same proportion of NOPAT/ROIC positive stocks, but much higher in Europe with more than half.
High ROIC
Do high ROIC microcaps outperform low ROIC microcaps?
Many critics of ROIC (and other factors) argue that the factor is backward looking, and doesn’t tell you anything about the future, and therefore shouldn’t provide any outperformance.
What does the data say?
If we simply rank all microcaps by trailing ROIC (higher, the better), the top ranked 10% of stocks (right decile) have returned 11.3% annualized (equal weight, quarterly rebalance, last 10 years), outperforming:
The rank chart also features a slowly descending performance of deciles (or monotonic), which is what we want to see.
See here for another post on rank charts on the MicroCapClub Community.
Here is the performance if ranking on high ROIC, including intangibles, for the same US Microcaps universe:
Nice monotonic lineup, but here the top ranked ROIC firms (including intangibles) has underperformed (3.1% annualized) the 2nd highest ranking decile.
Either way, the data shows that for microcaps, high ROIC firms have outperformed low ROIC firms, with some variation depending on which version of IC is used.
Capital Allocation Factors - Investment and Capital Management Factors
But to those critics’ point, we can look at factors that may contribute to higher ROIC in the future, and therefore may not already be incorporated into the share price.
As “invested capital” is a key part of ROIC in being the denominator, we can look at how a microcap stacks up in its capital allocation decisions, and if it has added to performance.
We’ll look at a factor group I call the “Investment” factor, that ranks stocks on the following sub-factors:
All as a proportion of the firms’ invested capital (including intangibles).
And a “capital management” factor:
Also scaled by IC (w/ intangibles).
Let’s assume each of these factors equally, and build a ranking system, i.e.
All to be ranked “higher the better”. And we will rank our US Microcap universe:
Adding the investment and capital management factors have improved performance with just ROIC alone (particularly when including intangibles).
These are a few ways to look at ROIC as it applies to microcaps. In the full post at MicroCapClub here, we also look at how ROIC can be changing thru Return on Incremental Invested Capital (ROIIC), and potential ROIC inflection points.
Ryan Telford is Head of Evidence Based Research at MicroCapClub. He uses quantitative strategies to invest in Microcaps, using his GUTS methodology, and shares his insights with the MCC community and on X. Reach out to him at MicroCapClub, or on Twitter/X, @rtelford_invest.
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The IWC underweights the highest performing group, microcaps that are profitable & growing earnings.