Quantitative Microcap Value

(Zen Buddha Silence by Marilyn Barbone)

(Image:  Zen Buddha Silence by Marilyn Barbone.)

November 19, 2017

Warren Buffett:

Investing is simple but not easy.

(Photo by USA International Trade Administration)

There are four simple but important facts that virtually every investor should bear in mind when choosing an investment strategy:

  • A low-cost S&P 500 index fund is likely to outperform at least 90-95% of all investors, net of costs, over 4-5 decades.  For the vast majority of investors, an index fund is the best option.  That’s why Warren Buffett consistently suggests index funds not only to small investors, but also to mega-rich individuals, institutions, and pension funds.
  • You can do a bit better than an index fund over time if you adopt a quantitative value approach.  Properly implemented, this is like a value index and should do at least 1-2% better per year, net of costs, than an S&P 500 index fund.  However, quantitative value sometimes trails the market for years in a row.  If you can’t stick with it during such a period, then it’s better to invest in an S&P 500 index fund.
  • If you’re pondering quantitative value investing, you should also consider quantitative microcap value.  That’s what the Boole Microcap Fund does.  By screening for cheap micro caps with improving fundamentals, you can reasonably expect to outperform the S&P 500 by roughly 7% (+/- 3%) per year on average.  (Compared to the S&P 500, this microcap strategy could do 4% better per year, 10% better, or anything in-between.  There’s a high degree of randomness in investing.  The important thing is to stick with it for at least 5-10 years.)
  • Determining which strategy, or mix of strategies, is best for you requires humility.  The trouble is that, generally, we’re overconfident.  If asked, most of us believe we’re above average across a variety of dimensions such as looks, smarts, driving skill, academic ability, future well-being, and even luck.  (Men suffer from overconfidence more than women, perhaps in part because overconfidence was useful for hunting.)  We also suffer from other cognitive biases, all of which are the result of evolution.

On the topic of overconfidence, Buffett’s partner Charlie Munger likes this quote from Demosthenes:

Nothing is easier than self-deceit.  For what each man wishes, that also he believes to be true.

(Charlie Munger at the 2010 Berkshire Hathaway shareholders meeting.  Photo by Nick Webb)

Let’s consider each point in a bit more detail.



Would you like to do better than approximately 90-95% of all investors, net of costs, over the next 4-5 decades?  It is surprisingly simple to achieve this result:  invest in a low-cost broad market index fund.  That’s why Warren Buffett, arguably the best investor ever, consistently recommends such an index fund to small investors and also to mega-rich individuals, institutions, and pension funds.

If your investment time horizon is measured in decades, a low-cost index fund is the obvious choice.  Passive investors on the whole will match the market.  Therefore, active investors will also match the market, before costs.  After costs, active investors (on the whole) will trail the market by 2-3% per year.  (John Bogle has done a terrific job telling this simple truth for a long time.)

  • 2-3% per year really adds up over the course of decades.  For example, if the average active approach returns 6.5% per year (net of costs) over the next 30 years, then $1 million will become $6.61 million.  If an S&P 500 index fund returns 9% per year (net) over the next 30 years, the same $1 million will become $13.27 million, twice as much.  (Moreover, the index fund is well-diversified across 500 American businesses.)

Even over the course of one decade, a low-cost broad market index fund can produce excellent results.  Warren Buffett’s 10-year bet against Protégé Partners demonstrates clearly that a simple index fund can beat the vast majority of all investors: http://boolefund.com/warren-buffett-jack-bogle/

After nine years, a group of a few hundred hedge funds – managed by intelligent, honest people who are highly incentivized to maximize their performance – is up a bit over 22%, net of costs.  Buffett’s investment in a Vanguard S&P 500 index fund is up 85.4%, net of costs.  That’s 7.1% per year for the index fund versus 2.2% per year for highly intelligent hedge fund (and fund of hedge fund) managers.

This illustrates how investing is simple but not easy.  Even if you restrict your examination to the most intelligent 10% of all investors, the long-term results are the same:  the vast majority of these investors will trail an S&P 500 index fund, net of costs, over time.

In the 2016 Berkshire Hathaway Letter to Shareholders, Buffett writes that, in his own lifetime, he identified – early on – ten investors he thought would beat the market over the long term.  Buffett was right about these ten.  But that’s only ten out of hundreds, or even thousands, of similarly intelligent investors.  Buffett:

There are no doubt many hundreds of people – perhaps thousands – whom I have never met and whose abilities would equal those of the people I’ve identified.  The job, after all, is not impossible.  The problem simply is that the great majority of managers who attempt to over-perform will fail. 

See: http://berkshirehathaway.com/letters/2016ltr.pdf

In a nutshell, you can do better than about 90-95% of all investors over 4-5 decades by investing in an S&P 500 index fund.  This is purely a function of costs, which average 2-3% per year for active approaches.  Therefore, for the vast majority of investors, whether large or small, you should follow Warren Buffett’s advice:  simply invest in American business by investing in a low-cost broad market index fund.

(BNSF, owned by Berkshire Hathaway.  Photo by Winnie Chao.)



A seminal paper on quantitative deep value investing is by Josef Lakonishok, Andrei Shleifer, and Robert Vishny (1994), “Contrarian Investment, Extrapolation, and Risk.”  Link: http://scholar.harvard.edu/files/shleifer/files/contrarianinvestment.pdf

LSV (Lakonishok, Schleifer, and Vishny) were so convinced by their research that they launched LSV Asset Management, which currently manages $105 billion.  LSV’s quantitative deep value strategies have beaten their respective benchmark indices by at least 1-2% per year over time.



(Illustration by Madmaxer.)

Check out this summary of the CRSP Decile-Based Size and Return Data from 1927 to 2015:

Decile Market Cap-Weighted Returns Equal Weighted Returns Number of Firms (year-end 2015) Mean Firm Size (in millions)
1 9.29% 9.20% 173 84,864
2 10.46% 10.42% 178 16,806
3 11.08% 10.87% 180 8,661
4 11.32% 11.10% 221 4,969
5 12.00% 11.92% 205 3,151
6 11.58% 11.40% 224 2,176
7 11.92% 11.87% 300 1,427
8 12.00% 12.27% 367 868
9 11.40% 12.39% 464 429
10 12.50% 17.48% 1,298 107
9+10 11.85% 16.14% 1,762 192

(You can find the data for various deciles here:  http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html)

The smallest two deciles – 9+10 – comprise microcap stocks, which typically are stocks with market caps below $500 million.  What stands out is the equal weighted returns of the 9th and 10th size deciles from 1927 to 2015:

Microcap equal weighted returns = 16.14% per year

Large-cap equal weighted returns = ~11% per year

In practice, microcap annual returns will be 1-2% lower because of the difficulty (due to illiquidity) of entering and exiting positions.  So we should say that an equal weighted microcap approach has returned 14% per year from 1927 to 2015.  Still, 3% more per year than large caps really adds up over the course of decades.

  • Most professional investors ignore micro caps as too small for their portfolios.  This causes many micro caps to get very cheap.  And that’s why an equal weighted strategy – applied to micro caps – tends to work well.

Value Screen: +2-3%

By adding a value screen – e.g., low EV/EBIT or low P/E – to a microcap strategy, it is possible to add 2-3% per year.  To maximize the odds of achieving this additional margin of outperformance, you should adopt a quantitative approach.

Improving Fundamentals: +2-3%

You can further boost performance by screening for improving fundamentals.  One excellent way to do this is using the Piotroski F_Score, which works best for cheap micro caps.  See:  http://boolefund.com/joseph-piotroski-value-investing/

Bottom Line

In sum, over the course of several decades, a quantitative value strategy – applied to cheap microcap stocks with improving fundamentals – has high odds of returning at least 7% (+/- 3%) more per year than a low-cost S&P 500 index fund.



(Illustration by Alain Lacroix.)

Human intuition often works remarkably well.  But when a good decision requires careful reasoning – using logic, math, or statistics – our intuition causes systematic errors.  I wrote about cognitive biases here: http://boolefund.com/cognitive-biases/

Munger’s treatment of misjudgment is more comprehensive: http://boolefund.com/the-psychology-of-misjudgment/



An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees.  The Boole Fund has low fees. 


If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com




Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

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