VALUE: After Hours (S07 E29): Why Micro-Caps Are Attractive

During their recent episode, Taylor, Carlisle, and Jason Hirschman discussed Why Micro-Caps Are Attractive. Here’s an excerpt from the episode:

Tobias: I think that’s a pretty good answer. I like that approach to its sizing helps you deal with that sort of risk. Talk to us a little bit about micro-caps. What’s the attraction there?

Jason: That’s the attraction there. [Jake laughs] That’s the question that every–

Tobias: I run a micro-cap fund too, guys. I’m not–

Jason: Yeah, I understand.

Tobias: So, I’m really asking you like, why should– [crosstalk] [laughs]

Jason: What is the attraction? Let me come up with something here. Damn it.

Tobias: Help me out.

Jake: Yeah.

Jason: Help me out. When in doubt, always Charlie Munger something. So, let me invert the question-

Tobias: I love it.

Jake: Yeah.

Jason: -and say, what hasn’t changed in the micro-cap world over the past 10 years, and then I’ll talk a little bit about what has changed in the micro-cap world according to me.

Jake: That’s even better.

Jason: So, I think the micro-cap world, I think particularly in the United States and Canada still resembles Thomas Hobbes’ famous line like, “Nasty, brutish and short,” right?

[laughter]

Jake: Yeah.

Jason: So, here’s some simple data from a screening and data tool that we use, like portfolio one, two, three. For the last fiscal year, I think there are about maybe 361 out of 500 S&P 500 companies that generate a return on equity of 10% or better. For micro-caps between $10 million and $400 million US dollars market capitalizations with their primary exchange in the USA or Canada, only 526 out of 3,154 generated an ROE of 10% or more. So, that’s 16.6% of companies. And frankly, those figures make micro-caps look good. There are 29 S&P 500 companies with negative common equity, but generated by positive net income. So, you’ll find companies like AutoZone or Lowe’s among them.

Jake: Yeah. Tons of buyback.

Jason: Bought backs. So much common stock over the years, the shareholder equity is negative and their ROE is basically infinite. But there’s companies like Pfizer, which maybe they earned a little bit less than a 10% ROE in 2024, but because of my sizable goodwill and intangibles on their balance sheet.

Now, among the 526 USA and Canadian market caps with ROE yields above 10, you’ll find 55 names with a positive ROE and a negative common equity. These are not auto sells. They are not auto sells. You’re seeing a perennially money losing company with negative shareholder equity with one year of positive accounting profit.

For example, there’s Victor Mining Group with a $50 million market cap and made $101,000 in net income in 2024 after years of losses and has a negative shareholder equity of negative $1.2 million. And for the record, I do not own any shares like Victor Mining Industry Group. I said, “Please don’t go out there and say Eight Track likes it.” You know? No. [Jake chuckles]

Okay. So, by the way, the ROE figures are not much improvable in larger micro-caps. But to be fair, these figures are used in reported earnings, which may or may not be helpful for some micro-caps and small caps. We’ll talk about that a little later. So, the ROE’s aren’t great. What’s also challenging is persistence. Even back then or now, a lot of micro-caps disappoint a good percentage of their investors who quite frankly expected more and faster than what they’re receiving.

Ian talked about this too a little bit, like micro-caps often string together a few quarters of top line growth, a few quarters of operating margin improvement. They race ahead, they hit the next pothole, and they bend an alloy wheel [Tobias laughs] and there they sit. So, they’re very well suited for six months to two year holding periods. And to be fair, at the right price, you can make good money buying a money losing unknown company that graduates to break even or profit mediocrity. You can make 3, 5, 10 times your money in some cases buying something that turns into a 10% ROE company. But to make that 10 times, I think you really probably had to exit when expectations were greater than a long-term 10% ROE biz. You’re taking advantage of that over exuberant expectation.

I think in some ways the fact many USA and Canadian micro-caps are so poorly suited for longer term investors. So, often given to fits and starts, so little populated with long-term winners, this actually creates an opportunity for investors like me. The greatest returning micro-caps over the long haul are rarely owned by those who originally owned their shares, because it takes different skills to know which micro-cap is worth suffering for.

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VALUE: After Hours (S07 E29): Why Micro-Caps Are Attractive

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