The notion that smaller companies can yield greater returns is a time-tested principle that continually inspires hope among investors. In 1981, Rolf Banz formally introduced the concept of a small-cap risk premium to academic literature. His research revealed that, between 1939 and 1974, small-cap stocks significantly outperformed large-cap ones, a finding that likely did not surprise financial economists. According to Banz’s study, this performance can be interpreted through the lens of modern portfolio theory, developed in the 1950s and 1960s, which posits that higher returns come with higher risks. Thus, the impressive returns identified by Banz can be seen as compensation for the associated risks.
In the years following Banz’s groundbreaking paper, research on small-cap stocks has evolved, becoming both more sophisticated and contentious. The debates that have emerged, particularly surrounding Fama and French’s research on small-cap and value risk factors as essential drivers of equity returns, are still ongoing.
Small-cap stocks inherently come with risks that are widely acknowledged. For even greater risks, one can look into the micro-cap sector, which encompasses the smallest companies in the market. While the potential for higher returns exists, investing in this arena is not for the faint-hearted. However, if you can tolerate the volatility and possess a keen eye for value, opportunities may abound at the lower end of the capitalization spectrum.
The extent of these opportunities remains a topic of debate. Recently, Jon Heller developed an index that tracks a selection of “deep value” micro-cap stocks, named the Cheap Stocks 21 Net/Net Index. Despite its nascent track record, it prompts intriguing considerations about the landscape of micro-cap investing.
If you’re interested in delving deeper, check out Heller’s blog, Cheap Stocks, where he explores various aspects of value investing. While Heller passionately investigates underappreciated micro-cap stocks, he’s also acutely aware of the risks involved. As he noted last week, the world of deep value micro-cap investing is fraught with uncertainties. These complexities may explain why the potential rewards can be substantial. However, Heller warns that pitfalls are particularly common among net/net stocks (companies trading below their net current asset value), often necessitating extensive research.
Heller is an analyst by profession and holds both a CFA designation and an MBA. He is the president of KEJ Financial Advisors, LLC, a fee-only financial planning firm based in Newtown, Pennsylvania. Previously, he spent 17 years analyzing financial data at Bloomberg, L.P., overseeing the company’s equity research department for several years and holding various other roles, including positions at SEI Investments. I had the privilege of observing Heller’s impressive analytical skills firsthand during our time at Bloomberg. Despite his talent for scrutinizing financial documents and hunting for valuable investments, he maintains a strong appreciation for portfolio diversification and the advantages of multi-asset class strategies. In essence, Heller embodies a rare talent, navigating the complexities of both micro and macro investing strategies.
Therefore, it was exciting to learn that our former colleague has ventured into an indexing project focused on undervalued micro-cap stocks. Given the relative scarcity of information regarding this asset class, Heller’s experimental efforts deserve closer examination. Eager to understand more, we conducted an email interview with Heller about his new index. Below is an excerpt from our conversation:
