"Microcaps represent a formidable crack in the so-called 'efficient market theory' "- Michael Corbett, Perritt Capital Management
[The Institute for Innovation Development - as part of our ongoing series of interviews exploring unique or innovative viewpoints from active asset managers - recently talked with Michael Corbett, CEO and CIO at Perritt Capital Management, an independent investment advisory firm and manager of 3 mutual funds with a 25 year commitment and focus on microcap equity management. We asked Michael to share his firm’s singular vantage point and research on the unique nature of the microcap asset class.]
Hortz: As a leading expert on microcap equities, what do you see as the most interesting and compelling nature of this universe of companies?
Corbett: While not all microcap equities result in making more than 10 times your money, the microcap universe is one of the best places to find those type of opportunities. Microcap equities are the least researched publicly invested securities. Due to their under-researched and under-followed nature, they tend to be inefficiently priced, which can offer great upside potential for investors. Microcaps represent a formidable crack in the so-called “efficient market theory”. Furthermore, with the entire microcap segment being very small at less than $400 billion (45% of the market value of Apple) and a median capitalization of about $400 million, many large institutional investors, as well as equity analysts, tend to shy away from this sector. These 2 factors very easily distort the risk/return characteristics of individual stocks in this area that can be exploited by active managers who know how to uncover well run companies through intensive independent research and deep knowledge of this space. Research we have done on the microcap area have also determined that portfolios of microcap stocks have a high probability of producing a significant positive alpha.
Hortz: What have you learned about company managements that choose being a microcap public company versus staying private?
Corbett: Believe it or not, there are many publicly traded microcap companies that should be private. We have met several management teams that were convinced many years ago to become a public company, but have executed poorly. Our experience leads us to avoid these management teams. This main fact is why we believe it is imperative to use an active management approach in the microcap space and it requires a reliance on non-traditional investment idea mining. We purchase companies strictly at potentially attractive valuations and strongly believe that great companies are great investments only at great prices. This long-term perspective drives our investment professionals to evaluate management teams in a way that we believe will potentially provide our shareholders the most gain.
Hortz: What is the case for microcap equities as a proxy for private equity?
Corbett: Microcap equities tend to act similarly to private equity, primarily due to their under-researched and illiquid nature. Performance trends in the same direction and they enjoy similar periods of difficulty and success. Management of microcap equity portfolios usually have lower fees and the liquidity is better than that of private equity.
Hortz: Your research in the microcap space makes the case of microcap investing being an intrinsically active versus passive investing approach. Can you further explain that for us?
Corbett: We believe the microcap asset class is better suited for active management. Most of the reason is related to the fact that there are many mismanaged companies in the space and, contrary to popular opinion, not all small companies depend on debt financing. Hence, an index product would capture all companies, including the lower quality companies. An active, ongoing due diligence process helps us to avoid these riskier companies.
Hortz: How do you see that microcap equities can be best deployed for maximum portfolio construction and management benefit?
Corbett: An investor receives enhanced risk-adjusted returns, augmented diversification through non-correlated performance, and delivers many of the benefits of private equity and venture capital within a liquid vehicle, all by allocating a small percentage of microcap stocks to their portfolio. Our research has shown that returns are enhanced and volatility reduced when a small-cap allocation is complemented with a microcap allocation. We have a variety of investors that allocate between 3% to as much as 20% of their portfolio to microcap equities.
Hortz: You have both a microcap fund and an ultra-microcap fund. Please describe the difference in companies and the nature of the two portfolios?
Corbett: Our flagship fund is the Perritt MicroCap Opportunities Fund (PRCGX), which invests in companies that have market capitalization between $50 million and $500 million. Our Perritt Ultra MicroCap Fund (PREOX) invests in even smaller companies that have market capitalization between $10 and $300 million, but most of the companies have market caps below $100 million. These can include early stage companies and those with relative obscurity in the investing world. Our investment process is the same for both funds emphasizing profitable companies with high growth potential and strong returns on capital.
Hortz: As a pioneer in this area of investing, any interesting stories or observations on this space?
Corbett: Microcap companies come into this space in many forms. You may think an Initial Public Offering (IPO) may be the most obvious, but that is the least likely entrance. Some enter to the space through a spinoff, reverse merger or some of which we call “fallen angels.” It is also important to note that since 1992, 60% of all public M&A transactions occurred at the microcap level. The microcap space is ever changing, and it is important to monitor all the roads to and throughout the microcap world.
Hortz: What about the few indices that have been built to capture the microcap space? Did they get it right? Are they truly representative of the space?
Corbett: Microcap companies are the true small companies in the marketplace. Some firms even consider the space un-investable. Frank Russell & Company, however, did launch a micro-cap index in 2005. The Russell Microcap Index is a reasonable proxy due to the size of the companies in the index. However, nearly half of the companies in the index are not profitable, which does concern us about the quality of the index.
Hortz: What do you see as further development and future of this investment area? Microcap ETF’s and other vehicles coming our way?
Corbett: There are nearly 50% less publicly traded microcap stocks today versus nearly 20 years ago. We believe this decline is starting to reverse in the past year, which should be a net positive for investors. In terms of microcap ETF’s, there are very few available to investors, but one of which is the iShares Russell Microcap Index (IWC). As mentioned in earlier answers, I would be a little hesitant to recommend this investment vehicle due to the low quality of many representative companies in the index.
Hortz: On another note, out of curiosity, I see that you hired Sondhelm Partners to help you acquire a few other small funds. Why are you buying versus building new funds and what do you look for in an acquisition?
Corbett: We hired Sondhelm Partners to explore alternatives for our business, but primarily to purchase assets of other funds. The desire is to acquire another mutual fund, and merge the assets into one of our other funds. We are still open to all opportunities.
Hortz: In closing, what best advice can you offer financial advisors on how to best work with microcaps in their portfolios and in discussions with their clients?
Corbett: Microcap stocks offer a great diversification benefit. A diversified portfolio of microcap stocks tends to have very low correlation to that of the broad equity markets and a modest allocation may make a significant improvement in an investor’s overall risk-adjusted return. Please feel free to use the information from our research reports on this asset class in your discussions.
This article previously appeared in Financial Advisor Magazine Online.
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