Examining the Environment for Microcap Stocks

The smallest companies in the market may be overlooked by many investors, but can offer big potential. Here, we posed some questions about micro-capitalization (microcap) stocks to Franklin Mutual Series Portfolio Manager Oliver Wong, who explains how they have fared recently and where he’s finding opportunities.

Microcap companies have had a significant run recently, why do you believe this segment is still attractive?

Microcap stocks tend to perform well in an expansionary environment due to their high sensitivity to the domestic economy. Comments from both the US Federal Reserve and Treasury clearly indicate that interest rates will remain low for the foreseeable future, which should further fuel the economic recovery from COVID-19.

However, valuations can appear optically high for some microcap stocks as investors anticipate a degree of fundamental recovery for these stocks. Therefore, we believe active management is the best way to participate in microcap stocks in today’s environment via exposure to those select names that appear best positioned to benefit from a continued rebound in the economy.

What’s so interesting about microcap stocks in your view—and how do you define them?

As of their latest reconstitution in May 2020, all securities within the Russell MicroCap Index* were below $1 billion in market capitalization.1 We believe this niche asset class deserves a role in many equity investors’ portfolios for two main reasons.

First, US microcap stocks, as measured by the Russell Microcap Index, have provided strong absolute returns since 2000, outperforming their large-cap peers in the Russell 1000 Index.2

Second, microcap stocks tend to be an under-researched area, which increases the odds of discovering attractive investment opportunities. This is because larger-cap stocks dominate the overwhelming majority of US equity trading. As a result, the brokerage firms orient their research capabilities in that direction, leaving the microcap space largely unattended.

As active microcap managers, we scour this vast investment universe of under-researched stocks looking for good companies that have been ignored, overlooked or temporarily beaten up. We believe the fact that most institutional money managers aren’t even looking in the microcap space allows us to find stocks that offer superior performance potential over the long term.