Private equity has historically been one of the most lucrative industries to be involved with, both as an investor and as a manager. For example, over the five years to the end of December 2017, data shows the highest quartile private equity manager had a five-year return of 20.4%, which is nearly three times higher than the performance for the lowest quartile manager, at 7.6%, but even this lowest quartile return is still on par with the average annual gain for the S&P 500 over the long term.
There are several common reasons cited as to why private equity tends to outperform over the long term. First, the industry tends to have a longer-term outlook than the short-term focused equity markets, which tend to concentrate on short-term quarterly performance numbers.
Five- to 10-year lockups for private equity firms allow managers to take a long-term perspective and make investments others would not necessarily complete. At the same time, private equity is well-known for being ruthless with cutting costs and laying leverage on top of leverage before selling the business in question at a premium (usually into the public markets, dumping the problems on thousands of small investors).
Private equity firms have produced outstanding returns for investors over the past few decades, but they remain inaccessible to most investors. There are also drawbacks to investing in these managers. Private equity usually commands premium fees and, as noted above, the funds are locked up for years.
But there is an alternative. Micro-cap stocks have many similar qualities to the same kind of companies the private equity industry would invest in. These companies are early stage with a long runway for growth, and owning them does not require a multi-year lock up or annual fees in the double digits.
Granted, there are some critical differences between owning a micro-cap stock and a small company that is owned by a private equity company, such as management control and better access to funding, but there are many more benefits. There should be liquidity to sell if you need to raise funds, the business should be much more transparent and cost savings from having no fees could compound significantly over time.
Micro caps outperform
According to research conducted by O'Shaughnessy Asset Management, while the top quartile of private equity managers had a five-year return of 20.4%, over the same period, the highest quartile micro-cap manager returned 30.7%. The profit earned by the bottom quartile manager was 23.2%. What is interesting about these figures is that it is easier to succeed in the micro-cap marken that it is in the private equity market.
Active stock pickers have taken a lot of criticism in recent years due to their poor investment records. Micro-cap managers don't seem to have the same problem. For the five years ending March 2014, the median microcap manager outperformed the median large-cap manager by 7.9% annualized according to O'Shaughnessy.
Of course, these are backward-looking figures and trying to identify the best managers ahead of time is always going to be difficult. Nonetheless, there's an interesting idea here. Private equity has always been lauded for its above-market returns, but it seems as if it is easy to create a similar performance in the public markets by focusing on micro-cap stocks alone.
Uncovered by Wall Street
The opportunity is in the lack of attention these companies receive. O'Shaughnessy's paper highlights that 2.1 analysts only cover the typical micro-cap stock on average and they only have an average of 50 institutional owners per company, compared to 1,740 for the largest companies.
Having said all of the above, it should be noted that micro-cap investing is by no means easy. The lack of analyst coverage means it is simple to find undervalued opportunities, but it does also mean that extra research is required for each company. Still, there's a reason why many of the world's best value investors started off in the micro-cap space; if you're willing to put in the extra work, the opportunities are indeed there.
Disclosure: The author owns no shares mentioned.
