A nano-sized cyber buy

September 23, 2015 01:00 PM

Microcap stocks are one of the few asset classes where the average investor, through disciplined research, can compete with institutional traders. Retail traders can find relatively small companies (sub $500 million market cap) that eventually grow into multi-billion dollar companies. 

In late 1978, research from University of Chicago doctoral student Rolf Banz showed that small company stocks had outperformed large company stocks during most of the 20th century. Of course, smaller company stocks typically outperform larger stocks because they contain more risk. However, Banz’s research showed that this tendency went beyond what could be accounted for by increased risk. This outperformance tendency became known as “the small firm effect.”

During the next decade, a number of mutual fund companies launched funds aimed at capturing the extra returns offered by small firms. Although successful in attracting assets, mutual fund managers quickly found that the limited liquidity of smaller stocks precluded investment in them. To maintain fully invested portfolios, managers increased the size of the companies included in their portfolios. As a result, the average market capitalization of these funds began to exceed the original threshold used by Banz to define the universe.

To account for the disparity a new category was born: Microcap. Generally, microcap funds were defined as those with portfolios with average market capitalizations below $300 million; companies valued at $300 million to $1.5 billion would be considered small caps. Today, microcap funds typically include stocks with market capitalizations below $500 million.

The separation of microcap and small cap funds by tracking services was necessary because of the wide risk/return differential of the two sectors. Funds that invest in microcap companies were not comparable to those that invest in small caps. Even so, both microcap and small cap funds compared their results to the Russell 2000 Index.

The Chartered Financial Accountant Institute states that investment portfolio benchmarks “[should] embody the opportunity set of investments in an asset class.” Basically, to properly measure portfolio manager performance, you should compare their returns to an appropriate benchmark. This task became impossible in the 1990s and early 2000s for microcap funds because there was no appropriate index.

In the mid 2000s, several firms, including Frank Russell & Co., launched microcap indexes. The Russell Microcap Index launched in June 2005. 

The Russell Microcap Index generally is made up of the 1,000 smallest companies within the Russell 2000 along with another 1,000 companies. But because there are not always an additional 1,000 public microcaps available, the index has floated between 1,600 to 1,700 stocks. 

Because of its rebalancing structure, several multi-billion dollar companies stay in the Russell Microcap Index. The lower turnover ratio has increased the indexes’ concentration within financial services and healthcare, primarily biotechnology. 

A stronger company in the increasingly important cyber security industry is Zix Corp. (ZIXI), which provides e-mail encryption and data loss prevention. Perritt Capital Management first purchased shares a year ago when ZIXI’s market cap was less than $200 million. Today, the company’s market capitalization is more than $300 million. 

We find ZIXI attractive because of its strong customer retention and market share gains, which was further validated by the recently announced partnership with Cisco (CSCO). ZIXI has consistently grown revenue at or near double digit rates, and we expect this trend to continue. Along with above-average valuations of more than four times revenue and 20 times future earnings, ZIXI remains attractive due to its high recurring revenue and consistency in generating cash and returning it to shareholders.

About the Author

Michael J Corbett is CEO, CIO and Portfolio Manager for all equity portfolios with Perritt Capital Management, Inc. Perritt first employed Mr. Corbett in 1990 as a research analyst, and became lead portfolio manager of all micro-cap portfolios in 1999.