GuoLian Minsheng Securities believes that the excess returns of micro-cap stocks mainly come from PB repair and the switch from high valuation to low valuation. The smaller the market value or the lower the valuation PB, the higher the probability of achieving excess returns in the next three months. This year, the micro-cap stock index has performed brilliantly, consistently outperforming other mainstream broad-based indices, attracting widespread market attention.
Recently, analysts Deng Yulin, Bao Chengchao, and Gong Yanran from GuoLian Minsheng Securities released a report, providing an in-depth analysis of the micro-cap stock investment strategy that has garnered significant market interest. The report indicates that the micro-cap stock index has consistently outperformed mainstream broad-based indices over the years, with its excess returns primarily stemming from PB repair and valuation switching, rather than profit-driven factors. Research shows that stocks with low PB and small market capitalization have a higher probability of achieving high returns, especially when there is ample remaining liquidity or when inflation is declining. Currently, both the crowding and valuation of micro-cap stocks are at historically high levels. Investors can start with stocks in the bottom 20% of market value, supplemented by low PB screening to enhance returns, but they should be wary of crowding risks. Historical performance data consistently show that the micro-cap stock index has been able to outperform mainstream broad-based indices in most years since 2010. Except for 2017 and 2020, the micro-cap stocks’ price changes were at the forefront in other years, and they usually achieved excess returns. Even if their unique daily rebalancing is reduced to quarterly rebalancing, micro-cap stocks can still obtain considerable returns, proving the stable and sustainable nature of their excess returns. Historical experience shows that two macro factors have a clear guiding effect on the trend of micro-cap stocks: first, when there is ample remaining liquidity, micro-cap stocks tend to perform well; second, when the inflation factor is in a downward range, especially in the middle and later stages of a recession and the early stages of recovery, micro-cap stocks usually have better gains. The logic behind this phenomenon is that a loose liquidity environment provides more financial support for small-cap stocks, and during periods of declining inflation, the market has a higher tolerance for low-valued small-cap stocks, and investors are more willing to seek undervalued investment opportunities. Valuation repair is the core driving force behind the returns of micro-cap stocks. So, what is the essence of the excess returns of micro-cap stocks? The report conducted an in-depth analysis from three dimensions. Research found that increasing the frequency of rebalancing contributes to the excess returns of micro-cap stocks, but the contribution is limited. Reducing the rebalancing frequency to monthly, the strategy returns of micro-cap stocks are even higher than daily rebalancing. This indicates that excess returns do not come from high-frequency trading arbitrage. Secondly, from the profit dimension, the returns of micro-cap stocks have a low correlation with the prosperity level. Especially since 2018, micro-cap stocks with negative net profits have contributed more to the overall returns, and the contribution trend continues to rise.Ultimately, the report reveals that the excess returns of micro-cap stocks primarily stem from the repair of Price-to-Book (PB) ratios and the shift from high valuations to low valuations. By dissecting the returns of micro-cap stocks into contributions from valuation PB, asset growth rate, and valuation PB discount, the results indicate that PB contributions and PB discount contributions are the main sources of returns.
Data validation shows that the smaller the market capitalization or the lower the valuation PB, the higher the probability of achieving excess returns in the next three months. Based on this, the report suggests that selecting individual stocks based on small market capitalization, supplemented by further screening with low PB, can better capture opportunities in micro-cap stocks. The report adds that the current congestion level of micro-cap stocks is at a high historical percentile, with valuations also at a mid-to-high historical percentile. Historical experience indicates that when the PB of micro-cap stocks is much higher than that of the entire market, micro-cap stocks tend to perform poorly, which was particularly evident in 2017 and 2020. The main viewpoints of this article are derived from the special report ‘A Brief Analysis of Micro-cap Stock Strategy’ written by Deng Yulin, Bao Chengchao, and Gong Yanran from Guolian Minsheng Securities. Risk warning and disclaimer: The market is risky, and investment should be cautious. This article does not constitute personal investment advice and does not take into account the specific investment objectives, financial conditions, or needs of individual users. Users should consider whether any opinions, views, or conclusions in this article are suitable for their particular situation. Responsibility for investment based on this article is at one’s own risk.
