Many high-net-worth and affluent individuals and families have begun following the lead of institutional investors – allocating part of their portfolios to alternative investments such as private equity (PE), venture capital (VC) or hedge funds. To satisfy this demand, most major PE firms and many diversified asset managers have been offering “alt” funds to retail investors for years, and view this as a high-growth category. Instead of choosing alternatives like PE, VC or hedge funds, most high-net-worth investors would be better off investing in micro-cap securities via actively traded mutual funds. Micro-cap indices have tracked the performance of PE, VC and hedge funds very closely in recent years. These investments offer the potential benefits of PE, VC and hedge funds without such drawbacks as illiquidity and questionable return calculations. Of course, micro-cap stocks should only represent a portion of a well-diversified portfolio that features an appropriate asset allocation based on the investor’s goals. “Middle-Class Millionaires” who buy into the narrative of wealth associated with alternative investments may be convinced to add PE, VC or hedge funds to their portfolios. However, those who hold less esoteric investments, such as micro-caps, may be able to tell a better performance story.
Well known asset managers have performed research concluding that actively managed, value-oriented micro-cap funds tend to outperform private equity over the long term. While micro-cap funds tend to outperform PE, they do share similar performance trends and comparable return profiles. For example, micro-cap active managers often target similar assets as financial sponsors while seeking value-oriented investments in businesses with strong fundamentals and consistent cash flow. Despite the outperformance, micro-caps are often overlooked by institutional investors, which leads to them also being overlooked by the analyst community and the media resulting in capital flows into U.S. public equities holding essentially flat since 2008 while capital flows into private equity funds have averaged around $250 billion a year since then.
At Kendall Capital, we believe that the lack of attention from institutional professionals to the micro-cap space may create an excellent investment opportunity. Less analyst coverage and transparency cause more information asymmetry among microcap companies than their larger peers. This less efficient price discovery mechanism translates into more alpha-generating potential. Our main argument for investing in microcap companies is that this unique asset class may be able to give investors a taste of PE/VC-like returns without the latter’s illiquidity and opacity.
The Kendall Capital Micro-cap Strategy invests in mutual funds that own publicly traded companies with market capitalizations less than $500 million. This strategy looks for portfolio managers of mutual funds that own rapidly growing companies with strong underlying financial quality to fund their continued growth.
Over the next 12 months we will be increasing the use of the Kendall Capital Micro-Cap strategy for the accounts we manage. As always, asset allocation to this strategy along with our other strategies need prudent consideration from many factors to meet your long-term financial goals.
