Microcap Funds Are Super-Cheap. Why They Could Deliver Big Returns in 2024.

Yet the smallest microcap stocks, which should benefit most from a sunnier economy, are still remarkably cheap. Consider
Bridgeway Ultra-Small Company Market.
The fund, which is basically an index fund with some minor tweaks, invests in the smallest 10% of companies in the U.S. market. As such, its portfolio stocks have a minuscule $144 million average market capitalization, compared with $2.2 billion for the
iShares Russell 2000
exchange-traded fund and $234 billion for the
SPDR S&P 500
ETF. That micro-focus has led the fund to underperform, with a 4.4% five-year annualized return versus the Russell 2000 and S&P 500 ETFs’ 6.9% and 13.7% respective ones.

Consequently, the average ultrasmall stock in the Bridgeway fund has a 1.0 price-to-book-value ratio versus the Russell 2000’s 1.6 and the
S&P 500’s
3.6, according to Morningstar. While microcaps normally trade at a valuation discount to high-quality large-caps, the current discount is much wider than usual. According to Bridgeway’s data, dating back to 1978, the smallest stocks would have a 2.1 price/book ratio currently to trade at their historical median discount relative to the S&P 500, requiring an almost 100% gain to close the gap.

But everything about stock investing tends to be amplified the smaller one goes down the capitalization ladder—volatility, returns, and the effect of investment factors that financial academics have identified as leading to market outperformance. “The value [factor] may work in the large-cap space, but it works much, much better in small-caps, and even better when you get into the microcap space,” says Andrew Berkin, Bridgeway Capital Management’s head of research. “It’s the same thing with momentum and other factors.”

Because factor investing is the province of active management, traditional index funds are less effective in microcaps. One can see the active edge at Bridgeway itself. The shop’s actively managed
Bridgeway Small-Cap Value
has beaten 92% of its Small Value fund category peers in the past 10 years. About 56% of the fund’s portfolio is in microcap stocks, according to Morningstar.

There are some excellent active microcap funds.
Wasatch Micro Cap Value
has been managed by Brian Bythrow since 2003. It has beaten 93% of its fund peers in the past 15 years with a strong 15.2% annualized returns, versus 14.0% for the S&P 500. (Bythrow isn’t a deep-value manager but a growth-at-a-reasonable-price one, so Morningstar categorizes his fund as Small Growth.)

Bythrow sees a lot of what he jokingly refers to as “micro craps” in the fund’s Russell Microcap Index benchmark. “There’s hundreds of public banks, and a lot of them are just not very exciting,” he says. “Also, 20% of the index is money-losing biotech [companies].”

He seeks companies with strong insider ownership, clean balance sheets, reasonable valuations and defendable niche businesses that won’t be clobbered by larger competitors. While he’s not a fan of banks generally, he likes
Esquire Financial Holdings
because of its unique niche. “Esquire makes loans to law firms,” he says. “What makes it interesting is there’s no competition, so they can earn outsize margins.”

Similarly, Bythrow likes
HCI Group,
a Florida property-and-casualty insurer, as most of its competitors recently have left Florida. Meanwhile, a new state law to prevent fraudulent homeowner’s insurance claims recently passed. HCI’s “been able to raise prices pretty dramatically,” he says. “So the combo of fewer claims and higher prices is the perfect tailwind for dramatic earnings improvement.” Also, HCI has “sophisticated algorithms” to help it price its insurance based on hurricane risk.

On the more traditional value side,
Aegis Value
and
Franklin MicroCap Value
are both excellent choices. Franklin’s fund has a low 1.0 price-book ratio and is concentrated in high-quality value stocks. Aegis employs a deep value strategy, with a price-book ratio of just 0.8. Aegis has stronger returns lately but tends to be more volatile than Franklin on both the upside and the down.

Franklin manager Oliver Wong tends to hold microcaps for a long time to unlock their value and to avoid liquidity issues trading tiny stocks. Despite a recent selloff in eye-care pharmaceutical company
Harrow,
he has been adding to his position. Though Harrow’s management just launched a promising new eye-care drug, Wall Street has been impatient with its recent growth rate, Wong says: “Management has reiterated that growth is going to be spread out over many years, not quarters.”

For more of a growth tilt, check out
Oberweis Micro-Cap
or
Paradigm Micro-Cap,
which both have long-tenured managers and bested their peers. There is also
DFA US Micro Cap,
the oldest available microcap fund, launched in 1981. It has a cheap 0.40% expense ratio, but you need a financial advisor to buy it.

As long as the economy is doing well, these funds should follow suit.

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