There are approximately 9,000 publicly traded securities in the United States. When a majority of U.S. investors hear the term "stock market," they immediately think of the Dow Jones Industrial Average, the S&P 500, or NASDAQ. There is, however, a segment of the U.S. equity market with which many people are not familiar and have absolutely no investment exposure. Companies within this segment are typically overlooked and under-researched in the marketplace because they do not generate investment banking or brokerage commission revenues for Wall Street firms. Even those who have heard of this exciting sub asset class have significant misperceptions about the companies that reside there. I refer, of course, to the micro cap equity universe, which we at Mesirow Financial define as companies between $20 and $500 million in market capitalization. Today, this investable universe includes some familiar names such as Standard Parking (STAN), Coachmen Industries (COA), Ashworth (ASHW), and The Sharper Image (SHRP), but also includes many lesser-known yet high-quality companies such as American Shared Hospital Services (AMS), the leading provider of non-invasive Gamma Knife brain surgery services in the U.S.

Micro cap stocks, as the name implies, lie at the smallest end of the capitalization spectrum. Micro cap equities, as measured by the Russell Microcap Index, have significantly outperformed both the S&P 500 large cap and Russell 2000 small cap indices over the past five years.*

This heightened performance does not come without a price, that being specifically liquidity and financial risk. Liquidity risk, the risk that an investor cannot sell a security quickly enough to prevent or minimize a loss, can be mitigated through proper portfolio management techniques. Financial risk, the risk that a company will not have enough cash flow to meet financial obligations, is a serious risk in the micro cap arena. That said, utilizing a strict, deep value investment process can significantly reduce a micro cap portfolio's financial risk profile. Micro cap value companies sell at attractive valuation levels as defined by low P/E ratios, low price to tangible book ratios, low price to cash flow ratios, low price to sales ratios, and surprisingly, many pay a dividend. In addition, these micro cap value companies often are industry leaders in a niche-product area, have relatively high insider ownership, and have lower debt to total capitalization ratios because they do not have access to the capital markets like larger capitalized companies.

Finally, one of the greatest benefits of investing in the micro cap value arena is that it can provide significant diversification to your existing portfolio. Micro cap value equity portfolios typically have very low correlations with all other U.S. equity classes (some as low as 0.65 versus the S&P 500), as well as international equity and fixed income; thus, it brings something very different to your overall portfolio.

Obviously, you should not invest all your assets into micro cap equities, but it is certainly appropriate to allocate a portion, especially over the long run. Moreover, investing in value-oriented micro cap equities can give you exposure to this attractive space, while mitigating some of the major risks inherent in the sector.

This article originally appeared in the Spring 2006 edition of the Investment Management Newsletter. Click here to access the current and all past issues of that publication.

 

* Source: Zephyr StyleAdvisor

Nothing contained herein constitutes an offer to sell nor a solicitation of an offer to buy an interest in any Mesirow Financial Investment vehicle(s). Any offer can only be made through the appropriate Offering Memorandum.

The Memorandum contains important information concerning risk factors and other material aspects of the investment and should be read carefully before an investment decision is made. It should not be assumed that any recommendations incorporated herein will be profitable or will equal past performance.

Securities offered through Mesirow Financial, Inc., Member NYSE, SIPC.