The post-covid market downturn saw a wave of new and younger investors enter global equity markets. While the silent majority are remaining within the bounds of large, stable companies and broadly diversified funds, a vocal minority are trying their luck in the smallest, darkest ends of the market. Visit any Reddit board and you'll find investors discussing the prospects of small mining stocks or chasing short-lived momentum stocks.

While there's certainly nothing wrong with investing in micro-cap companies, the risks are real in one of the least researched segments of the market. The stocks are too small, new or speculative to be on the radar of most researchers. There are considerable challenges in understanding, monitoring and accounting for the risks these companies pose in the early stages of development.

In this article we'll draw the curtain back on micro-caps, their allure and their risks.  

What are micro-caps?

What constitutes a micro-cap stock will vary between markets. Safe to say that it is the smallest end of the market by market capitalisation.

In Australia, Morningstar defines the micro-cap segment as comprising the bottom 3% of the Australian market by capitalisation, or companies with a market cap up to AU$300 million. The largest 70% are classified as large-cap; the next 20% are mid-cap and small-cap make up 7%.

ASX-Listed Companies Categorised, Equity Style - Market Cap Weighted


Source: Morningstar

In general, a micro-cap fund manager will invest a large proportion of their portfolio at the very small end of the market.

Ownership zone and market cap breakdown - Perennial Value Microcap Opportunities

Portfolio as at 30/06/2021


Source: Morningstar

The appeal

Obscurity is the main attraction in the micro-cap space. Micro-caps are an under-researched segment of the market. These stocks are either too small, too new, or indeed too speculative to be on the radar of many stockbrokers or institutional investors. Skilled micro-cap investors try to identify the undiscovered gems with the potential to grow earnings and migrate upwards towards the Small Ordinaries, or beyond. These companies tend to grab fewer headlines and garner less interest and research, allowing investors to “find some gems” for cheap.

For example, ASX-listed buy-now pay-later provider Afterpay (APT) has grown from relative obscurity to a solid S&P/ASX 50 company. Growth on AU$10,000 invested in 2017 is an incredible AU$384, 888 – or 3,848%.

APT | Price Chart Since Listing


Source: Morningstar

Successfully uncovering these opportunities early on takes considerable time and effort. As Morningstar analysts explain:

"Micro-caps with nascent business models often have scant financial histories and unproven management, and they operate in rapidly evolving industries. While the rewards can be significant, the research effort to understand, monitor, and account for the risks is commensurate."

"The biggest risks lie around management, cash flow, and liquidity. Early-stage micro-caps with immature business models can be cash hungry, and reliant on regular capital raisings to fund growth."

In the event of a correction, analysts note that equity market liquidity can dry up quickly, leaving micro-caps vulnerable. In simple terms, this refers to how quickly shares can be bought or sold without impacting the price.

"For investors, the lack of liquidity can also mean difficulty exiting positions during times of market stress. During the financial crisis, small and micro-cap stocks suffered badly as cheap credit became scarce, liquidity dried up and losses were amplified, particularly during the global financial crisis."

While short term-gains can be considerable, investors must be prepared to weather extreme levels of volatility – or wild swings in the share price. Along with greater growth prospects, there is also a greater chance of failure. It's as profitable to avoid the failures as it is to pick the successes.

The ASX microcap index has underperformed its larger-cap peers over 10-years

S&P/ASX Indexes


S&P/ASX Indexes - Annual Returns

Source: Morningstar

Micro-cap funds

In Australia, microcap strategies once occupied a niche area of the market, but in recent years managers have rushed offerings to investors. Morningstar analysts believe the trend is driven by several factors including:

  1. No capacity in the managers’ existing small-cap strategies
  2. High micro-cap fees
  3. Synergies between micro-cap and small cap strategies

But should investors take them up? Morningstar fund analysts caution that while micro-caps have been a highly lucrative place for investors in the current market, the outsized returns on offer carry considerable risks.

Capacity also becomes an issue with small and micro-cap funds. "As funds gather assets and grow, their ability to move nimbly in and out of meaningful positions without adversely affecting the stock price becomes difficult," analysts say.

Morningstar recommends approaching strategies with care, and at most, considering a satellite allocation within a broadly diversified portfolio. Here, you might categorise 80 per cent of your overall portfolio as the "core" and the remaining 20 per cent as the "satellite". The satellite portion of the portfolio is where to express your tactical views on the market.

Get active

Morningstar analysts recommend active strategies over passive index funds in this space noting that ETFs are not suitable for every asset class. Former passive strategies strategist Samuel Lee says:

  • ETFs work best when their underlying holdings trade in efficient, deep, and liquid markets. The micro-cap market is none of those. Micro-caps can go for days, weeks, or months without trading a single share. When they mechanically buy and sell even small share lots into a relatively illiquid market, they can affect prices. Market impact costs undoubtedly play a significant role in diminishing micro-cap ETF performance.
  • Front running also hurts micro-cap ETFs. Indexes are "stupid" in that they broadcast far in advance when and what they're going to buy and sell. Clever traders can trade shares in anticipation of these changes and pocket profits at the expense of indexed money. Front runners barely budge large-cap indexes such as the S&P 500 because arbitrageurs do a good job keeping stocks in line with fair value, but they can really hurt micro-cap indexers.

A 2020 report from Morningstar analysts found that over the past decade, most active small cap Australian equity managers have handily beaten small-cap indexes.

Here are the top performing Australian equity small cap funds  - 10-Yrs Annualised

Percentage of the portfolio in micro-caps > 5%

Top performing micro-cap funds

Source: Morningstar