By Yale Bock, CFA, President, Y H & C Investments
The small and microcap public equity sector might be a better fit for many family offices and small institutions than alternative investments like venture capital, private equity, private real estate, music royalties, private land, private credit, or public debt.
Let’s start by understanding the challenges of active investing. According to a study by Hendrik Bessembinder of the W.P. Carey School of Business at Arizona State University, from 1990-2020, 2.4% of all the companies in the stock market accounted for 75.7 trillion dollars of the wealth created.[1] Essentially, one out of 40 companies do the heavy lifting of generating great returns. In the small and micro-cap area, which we define as anything with less than two billion dollars of market capitalization, the probability of finding one of these heavy lifters is even smaller. We know we are up against a difficult task.
Even with a minimal probability of success, investors come to the microcap area because it may be possible to find mispriced situations where the returns can be substantial. Institutional investors may want to look at investments in the space as similar to venture capital where power laws dictate one massive winner pays for many others that offer substandard returns. There are several reasons why institutional investors might find the small and microcap area more appealing than venture capital.
First, small and microcap companies typically trade for lower valuations than many venture capital-backed entities. This is an excellent time to look at the small and microcap because valuations remain at trough levels when historically they trade at premiums to large cap entities. (See Wellington Management’s April 2024 paper on this topic).
You also have a wide variety of companies to choose from, since small and microcaps make up approximately 15-20% of the total number of listed companies, many of which have more developed businesses than a majority of venture capital-backed companies.
Generally speaking, only the top venture capital firms deliver excellent performance to investors. Access to the top firms is difficult, if not impossible, to obtain for most investors. Exposure to big winners in the small and microcap segment may offer a similar and potentially better alternative.
With respect to other alternative asset classes, a similar argument is applicable. Private equity is often the territory of prior relationships. Private real estate is a specialized field where real estate professionals dominate the landscape. Credit investing and music royalties are large industries where the biggest enterprises get first priority on the best opportunities, similar to venture capital. For a family office or institution without those established relationships and networks, access becomes a difficult challenge to overcome. The large number of opportunities in the small and microcap area certainly should be something to consider as an alternative.
If I have piqued your interest, where might you turn for more information? If you are willing to go it alone, the Russell 2000 and Russell 1000 indexes are a place to start your research. If you are more aggressive and willing to delve into microcaps, the LD Micro and Planet Microcap conferences and websites, run by Chris Lahiji and Robert Kraft, offer great ways to become offer great ways to become familiar with the sector.
There are many excellent investors in the space who can help guide you and offer advice as well. Remember, every large business begins as a small business!
If you have any questions about the small or microcap space or the article, please reach out to information@y-hc.com and I will be happy to help.
Thanks for your valuable time.
