Missing the IPOs? Give Microcaps a try

Photo courtesy of Andreas Poike on Flickr

Photo courtesy of Andreas Poike on Flickr

Rob Swystun, Pristine Advisers

Are you lamenting the lack of IPOs this year? The last few years have seen a rise in IPOs, including some really flashy ones. If you’re hankering to cash in on some small companies that display innovation, imagination and energy, then US News and World Report’s Joanne Cleaver suggests giving micro-cap funds a try.

Micro-cap funds are, of course, funds that hold investments in companies with market capitalization of $500 million to $1 billion (not to be confused with penny stocks, which don’t generally show up in indexes). They require a steady hand and a clearly defined exit strategy to reap returns, but it is possible.

Most microcaps are American, Cleaver says, but, contrary to popular belief, they’re not all startups. In fact, they’re not even mostly startups.

Chief investment officer of North Star Investment Management Corp. Eric Kuby says the majority of microcaps are stable companies that have been around for decades that have — as Cleaver puts it — steady but unsexy growth.

Microcap funds also aren’t the landing place for new IPOs, as the cost of going public has risen dramatically over the past several years due to Sarbanes-Oxley and many fast-growing, small companies deliberatly delay their IPOs until they can justify the expense. This cost can be in the millions of dollars and by the time many of these rapid growing companies are ready for their IPO, they’ve already grown out of microcap territory, explains Michael Corbett, president of Perritt Capital Management in Chicago.

“[The cost of an IPO] is a big percentage of your cash flow,” Corbett says. “That’s why companies are staying private longer.”

The opposite of predictable

The only thing you can really count on with microcaps is their unpredictability. This stems from the fact that, unlike large companies that have diverse product lines that appeal to a wide array of customers, microcaps are niche companies that have a limited customer base.

This means the performance of microcap funds are, for the most part, unrelated to overall market trends and often do not track with indexes of larger companies. Rather, microcap managers are keeping their eyes out for small companies that could potentially be big hits if they are acquired by a larger company.

“The illiquidity gives you an upside,” Corbett says. “If something really good happens, the upside is enormous.”

Cleavers says one company that’s in the right place at the right time can drive results for an entire microcap fund.

The fees

Cleaver likens the management of microcaps to managing a basket full of puppies, something that takes patience and time. This extra care pushes up the fees for microcaps, usually in the 1.2 – 1.7% range. Kuby looks for an expense ratio of less than 1.5%.

“Fees are going to be higher, but the performance is generally net of fees so you can compare performance for funds,” he says.

Managing microcaps involves one-on-one relationships, analysis and management. Indexing and automation don’t work well due to the wide variety of specialized holdings.

“There’s no automatic pilot,” Kuby says. “There’s a gigantic universe of companies that are very, very different – every industry group, every type of company, some that are fast growing, some that aren’t.”

While tons of analysts cover each major publicly held company, almost none cover each micro-cap company. Getting enough information to make intelligent decisions is a big part of the cost.

One way to incorporate microcaps into a portfolio, Christopher D. Tessin, managing partner of Acuitas Investments in Seattle, says, is to “go passive in large cap, and actively managed with small cap.”

There are a couple of key situations that microcap fund managers look out for that promise good value in a company.

  • Corbett says he looks for “broken IPOs,” which he describes as companies whose IPOs “stalled at the gate, usually related to the valuation being too high when they went public. There’s excitement, euphoria and the newness of it all, and then they go public and poof.”
  • Corbett also says restaurant chains can be lucrative, as they are especially vulnerable to post-IPO deflation. Noodles & Co. and Potbelly Corp. are two restaurant chains Corbett cites that had people excited at first, but … “Then, after they reported their numbers, the market said, ‘that’s not exciting. It’s just lunch.'”

Corbett’s last bit of advice is to invest in relatively small micro-cap funds because large funds can become unwieldy and erode returns.

“The maximum capacity for a microcap would be about $500 million in a single fund,” he says. “How much capacity does the manager have to run the product?”

If you’re missing those big-name IPOs, give microcaps a try. You might just get into a fund with that right-place-right-time little company.

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