INSIGHT The case for micro caps In recent years, equity investors have shown increasing interest in companies at the bottom of the size (capitalisation) spectrum, commonly referred to as micro cap stocks. In this article, we examine the reasons for this increase in interest and highlight some of the investment characteristics of micro caps. We define the selection criteria used by FTSE Russell to admit micro cap stocks to our equity benchmarks, before reviewing the new Micro Cap Index, which incorporates micro cap stocks from the world s developed and emerging markets. And we place the Micro Cap Index in the context of a seamless global equity benchmark, the Total Cap Index. Why micro caps? According to data from evestment LLC1, assets invested in active US and non-us micro cap equity strategies increased by 17.8 percent in the year to end-2017 and by 40 percent over two years. Institutional interest in micro cap investment is on the rise for several reasons. Among these are the following: Early-stage investment opportunities Micro cap stocks those at the bottom end of the size (capitalisation) spectrum often represent companies at an early stage of their development. By investing in such companies soon after their formation, investors can benefit from a later expansion of earnings and earnings multiples. A research deficit As well as being under-owned by institutional investors, micro cap stocks tend to be relatively under-researched by investment bank and other equity analysts, creating opportunities for investors in search of high-quality, fast-growing companies. In Figure 1, we show the median institutional ownership and median number of analyst estimates for micro caps in the US equity market, the world s largest by market capitalisation, as measured by the Russell US equity indexes. The median institutional ownership of a stock in the Russell 1000 Index of large cap stocks was 88 percent at end-2017, compared with a median institutional ownership of 27 percent for a stock in the Russell Microcap Index. And while the median Russell 1000 stock had research coverage from 16 analysts at the same date, the median Russell Microcap Index stock had only one research analyst. Cited in Microcaps becoming a popular source in hunt for alpha, Pensions & Investments, March 19 2018. 1 CONTINUED OVER PAGE ftserussell.com NOVEMBER 2018 1
The Russell US Equity Indexes The Russell US indexes, from mega cap to microcap, serve as leading benchmarks for institutional investors in US equities. The indexes include the following: Russell 1000 : the largest 1000 US stocks by market capitalisation Russell 2000 : the next 2000 US stocks by market capitalisation Russell 3000 : the Russell 1000 plus the Russell 2000 Russell Microcap : companies 2001-4000 in a ranking of the top 4000 US stocks by market capitalisation Figure 1: Micro caps are under-owned and under-researched Percent 100 80 60 40 20 88 Median institutional ownership 76 0 Russell 1000 Russell 2000 49 Russell Microcap 27 Russell Microcap ex-russell 2000 18 16 14 12 10 8 6 4 2 0 Median number of analyst estimates 16 Russell 1000 Source: IBES, FactSet Research Systems. Data as at December 2017. A liquid, transparent alternative to private equity 5 Russell 2000 2 Russell Microcap 1 Russell Microcap ex-russell 2000 An investment in listed micro cap stocks offer access to early-stage companies but without the illiquidity, lack of transparency and high fees characteristic of private equity funds, which often focus on companies of similar size. Access to the size premium In 1993, Fama and French 2 provided evidence that a risk factor related to firms size helps explain variations in stock returns, and that smaller-sized companies have historically offered a return premium over time. Many other studies have provided similar empirical results. Micro cap stocks offer access to this size premium. Low correlations to larger stocks Micro caps tend to have lower correlations to stocks at the opposite end of the company size spectrum than large- or mid-cap stocks. This creates a diversification opportunity for investors with a high allocation to bigger companies. In Figure 2 we show the 5-year historical correlation of US equity size segments, as represented by indexes from within the Russell US equity index family, to the Russell Microcap Index. The US equity market is chosen for this comparison as it has the largest number of microcap stocks available from within the Equity Index Series (FTSE GEIS). Figure 2: 5-year correlation of US equity size segments (to Russell Microcap Index) 5-year correlation to Russell Microcap 1.25 1.00 0.75 0.50 0.25 0.00 Russell Top 50 (Mega Cap) Russell Top 200 (Mega Cap) Russell 1000 (Large Cap) Source: FTSE Russell, data as at March 30, 2018. A more diverse opportunity set Russell Midcap (Mid Cap) Russell 2500 (SMID Cap) Russell 2000 (Small Cap) Moving down the capitalisation spectrum increases substantially the equity opportunity set available to investors. In the case of the FTSE GEIS, FTSE Russell s benchmark of the global equity markets, including the top 99 percent of stocks by market capitalisation rather than the top 98 percent for each FTSE GEIS region (i.e., adding micro caps to the benchmark) has the effect of more than doubling the number of index constituents. 2 http://rady.ucsd.edu/faculty/directory/valkanov/pub/classes/mfe/docs/fama_french_jfe_1993.pdf 2
Defining micro caps In general terms, micro caps are those equity securities that fall below the minimum size requirements necessary to be considered a large-, mid- or small-capitalisation stock, but which are still considered eligible for inclusion in a global equity benchmark. However, the users of such benchmarks are likely to pay particular attention to the potential investability constraints posed by companies of small absolute size. Therefore, a formal definition of micro caps must take into account the shares secondary market liquidity, as well as other potential restrictions to access, such as free float and foreign ownership limits. In the FTSE GEIS, FTSE Russell defines micro caps as follows: Figure 3: Determining eligibility Country classification Non-standard securities are ineligible Minimum voting rights, investability and foreign ownership limits apply Minimum size requirement Companies must pass a minimum liquidity screens A micro-cap must be assigned to a country classified by FTSE Russell as developed, advanced emerging or secondary emerging. Investment trusts, limited liability partnerships and companies (LLPs/LLCs), convertible preference and loan stocks are excluded. Eligible securities from developed markets must have at least 5 percent of a company s voting rights in the hands of unrestricted shareholders (in emerging markets, no such restriction applies). Index weightings are adjusted for free float and (where appropriate) foreign ownership limits. For companies already in the FTSE GEIS, a US$20m minimum market capitalisation limit applies, assessed at the semi-annual index review. For companies outside the FTSE GEIS, a US$25m minimum market capitalisation limit applies. For companies already in the FTSE GEIS, the daily turnover of shares (calculated after any free float adjustment) must exceed 0.02 percent, based on the median daily trading volume per month in 8 out of 12 months prior to the full market review. For companies outside the FTSE GEIS, this figure must exceed 0.025 percent. 3
Introducing the Micro Cap Index The Micro Cap Index, launched in 2018, provides deep representation of the smallest segment of the global investable equity market, rounding out global small cap and total cap allocations as international markets continue to grow and evolve. The Micro Cap Index can be understood as an extension of the coverage of the FTSE GEIS to include companies at the bottom end of the market capitalisation scale, subject to the minimum investability requirements outlined in the previous section (see Figure 3). The new index therefore complements the existing All Cap Index, which includes large-, mid- and small-capitalisation stocks from developed and emerging markets. The c. 7,700 constituents of the All Cap Index combine with the c. 8,000 constituents of the new Micro Cap Index to form the FTSE Global Total Cap Index representing 99 percent of the world s investable market capitalisation, based on the seven geographical regions used in the construction of the FTSE GEIS. Figure 4: How the Micro Cap Index expands the Equity Index Series Largest stock Target coverage of the global investable universe based on total market cap ~70% ~90% ~98% Smallest stock 100% Total Cap Index DM & EM Large + Mid + Small + Micro ~15,800 All Cap Index DM & EM Large + Mid + Small ~7,900 Micro Cap Index DM & EM Micro ~8,000 FTSE All- World Index DM & EM Large + Mid ~3,200 Small Cap Index DM & EM Small ~4,700 Large Cap Index DM & EM Large ~1,500 Mid Cap Index DM & EM Mid ~1,700 Small/Micro Cap Index DM & EM Small + Micro ~12,600 Source: FTSE Russell, data as at March 30, 2018. Constituent counts shown reflect rounding. For further information, refer to the FTSE GEIS ground rules. Viewed from a historical perspective, the creation of the Micro Cap Index is part of an ongoing trend towards deeper, more granular coverage by FTSE Russell of the world s equity markets. The forerunner of the FTSE GEIS, the FT-Actuaries World index, was set up in 1986 and aimed at coverage of around 70 percent of the market capitalisation of its 23 constituent countries. The FTSE All-World Index, created in 2000, added 20 emerging market countries and extended target market capitalisation coverage from 70 to 90 percent. The FTSE GEIS, created in 2003, added small-cap stocks to the existing membership of large- and mid-cap stocks, extending the global equity CONTINUED OVER PAGE 4
index s coverage even further. With the latest expansion of the index s coverage to the top 99 percent of the world s stocks (by market capitalisation), this process is nearly complete 3. In Figure 5, we show how FTSE Russell now represents the global equity opportunity set, whether by capitalisation band or market development status. The seamless coverage of the world s share markets provides a range of complementary benchmarks for use by professional investors. Figure 5: FTSE Russell s representation of the global equity markets Small Cap $6.0 trillion net market cap 4,678 stocks Micro Cap $1.2 trillion net market cap 7,971 stocks FTSE Developed Total Cap $47.2 trillion net market cap 11,334 large, mid, small & micro cap stocks Total Cap $52.7 trillion net market cap 15,832 large, mid, small & micro cap stocks FTSE All-World $45.5 trillion net market cap 3,183 large & mid cap stocks All Cap $51.5 trillion net market cap 7,861 large, mid & small cap stocks FTSE Emerging Total Cap Advanced and Secondary $5.6 trillion net market cap 4,498 large, mid, small & micro cap stocks FTSE Frontier $134.2 billion net market cap 369 large, mid & small cap stocks MICRO CAP SMALLCAP MID CAP LARGE CAP FRONTIER SECONDARY EMERGING ADVANCED EMERGING DEVELOPED Source: FTSE Russell, data as at March 30, 2018. Regional and industry coverage The regional coverage of the Micro Cap Index is shown in Figure 6. North American stocks represented 45 percent of the index at end-march 2018, followed by Asia Pacific ex Japan (28 percent), Developed Europe (17 percent) and Japan (6 percent). Of the US$1,226bn in the net market capitalisation of the index, US$1,023bn was represented by developed market micro caps and US$203m by emerging market micro caps. The total number of constituents in the index was 7,971, with 5,624 coming from developed markets and 2,347 from emerging markets. 3 See Indexing the World, available at http://www.ftserussell.com/sites/default/files/support_ document/indexing_the_world_extended_geis.pdf, for more on the historical development of global equity indexes. CONTINUED OVER PAGE 5
Health care INSIGHT Figure 6: Micro Cap Index regional coverage Attributes Micro Cap Net MCap (USDm) Developed Emerging Advanced Emerging Secondary Emerging Number of countries Developed Emerging Advanced Emerging Secondary Emerging Number of constituents Developed Emerging Advanced Emerging Secondary Emerging 1,225,930 1,022,874 203,056 112,956 90,100 46 24 22 10 12 7,971 5,624 2,347 1,374 973 Middle East & Africa 2% Developed Europe 17% Japan 6% Asia pacific ex Japan 28% Latin America 0.7% Emerging Europe 0.5% North America 45% Source: FTSE Russell, data as at March 30, 2018. Figures shown are for net market capitalisation (i.e., after adjustment for investability). For more details on investability weightings, refer to FTSE GEIS ground rules, Section 6.2. The industry weights of the Micro Cap Index, as at end-march 2018, are shown in the graphic below, which also shows the industry weights of the FTSE All-World Index (which contains large-, and mid-caps) and the Small Cap Index at the same date. By comparison with the FTSE All-World Index, the Micro Cap Index apportioned larger aggregate weights to stocks from the industrials, health care and basic materials sectors. In financials, technology, oil and gas, utilities and telecoms, the Micro Cap Index had smaller aggregate weights than the FTSE All World Index. Figure 7: Micro Cap Index industry weights 25% 20% 15% 10% 5% 0% Industrials Financials Consumer Goods Technology Consumer services Basic Materials Oil & Gas Utilities Telecommunications Weight in Index (%) Micro Cap Index Small Cap Index FTSE All-World Index Source: FTSE Russell, data as at March 30, 2018. 6
Spotlight on Australia As at end-march 2018, Australian micro caps represented 2.8 percent of the FTSE Global Micro Cap Index, with 386 constituents included. This meant the country had the eighth largest share in the index, following the US, South Korea, Canada, Japan, Taiwan, the UK and India. There were also 26 New Zealand entries in the index at the same date, with a collective market capitalisation of 0.3 percent. In June 2018, basic materials stocks achieved a greater collective weight amongst Australian micro caps than amongst the large, mid and small cap segments of the FTSE Australia Index (see Figure 8). This is unsurprising, given that Australia is a resource-focused economy. The next largest ICB industry weightings amongst Australian micro caps were in financials and consumer goods. However, the collective index weight of financials among Australian large caps was significantly higher than amongst micro caps again, an unsurprising result, given the tendency amongst financial services companies to achieve large scale. Figure 8: ICB industry weights in the Australian equity market by capitalisation band 100% 90% 80% 70% 60% 50% Utilities Telecommunications Technology Oil & Gas 40% Industrials 30% 20% Health Care Financials Consumer Services 10% Consumer Goods 0% Large Mid Small Micro Basic Materials Source: FTSE Russell, data as at June 29, 2018, based on net market capitalisation figures. Meeting investor demand FTSE Russell s introduction of the new Micro Cap Index helps meet investors requirements for an accurate, representative benchmark of the performance of some of the smallest listed companies worldwide. The index has been developed to meet the standards of the Equity Index Series, involving rigorous tests for nationality, security type, free float and foreign ownership limits and minimum levels of secondary market liquidity. The new index fits seamlessly into FTSE Russell s family of global equity benchmarks, enabling investors to assess micro caps in a consistent and objective way. The Micro Cap Index helps deliver an expanded global equity universe, providing additional opportunities for alpha generation and diversification. More information on the Micro Cap Index Series 7
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