The small cap team take a look at correlation when it comes to microcap investing and why ​stock movements in the micro cap universe are explained by stock specific factors rather than market movements.

We are often asked why micro cap funds tend to trade at such low correlations to the broader market. With market correlations as low as 0.1 (or less), some micro cap funds could be questioned regarding potential correlation data errors. However, the correlation data does not lie. In our experience, market inefficiencies are widespread in the micro cap universe reflecting low analyst research coverage, which in turn reflects the low commissions on offer for trading in these relatively illiquid stocks. Correlations this low mean the vast majority of stock movements in the micro cap universe are explained by stock specific factors rather than market movements. This is great news from a micro cap investors’ perspective. It means you can do the research on smaller companies knowing that if your investment case is correct, the stock price is likely to move dramatically in your favour as new information is digested and new investors are attracted to the stock. As long as you have an information advantage, the risk- reward equation is decidedly in your favour. 

The quest for high returns with minimal correlation to the broader equity market leads many investors to ask us why micro cap funds tend to trade at very low correlations to the broader market. Equity investors are often heavily weighted towards the larger listed companies where market correlations are generally on the high side, with most long only, large cap funds having market correlations of between 0.5 and 1.0. When these same investors see market correlations of under 0.1 for select Australian micro cap funds, they often wonder if the data is correct. It is.

Many industry professionals tend to look at the R squared of the relationship between two sets of data – in this case the performance of an investment fund and the performance of the All Ords. The R squared number gives you the explanatory power of the relationship between the two variables. For example, a large cap fund with a correlation (R squared) of 0.9 with the All Ords means that the fund generally tracks the broader market up and down – 90% of that fund’s historical performance can be explained by movements in the All Ords. Equally, a micro cap fund with a correlation (R squared) of 0.1 with the All Ords means that the fund performs independently of what the broader market is doing – only 10% of that fund’s historical performance can be explained by All Ords movements. The reason so many investors focus on correlation data is to gain an understanding of their exposure to equity market movements, a key piece of information, particularly in volatile or falling markets. In our experience, fund investors’ generally like to see good performance combined with low market correlation.

​Micro cap investing is a very different game from investing in large cap companies. In our experience, market inefficiencies are widespread in the micro cap universe reflecting very low analyst coverage, which in turn reflects the low commissions on offer for trading in these relatively illiquid stocks:​

As a result, we often meet with the management teams of fascinating, high quality micro cap companies which the market is currently largely ignoring. In many cases there are no analysts at all following these stocks. In our minds this spells opportunity. This brings us to the correlation data. As the table below shows, the correlation of (global) micro caps with the broader (relevant country) equity markets is far lower for micro caps than it is for small caps or mid caps. The relationship between market cap and market efficiency is clear. And interestingly, the data show there has been an increase in the correlation of micro caps with the broader market over the past 20 years, albeit from a very low base. Small and mid cap correlations have been more stable throughout this period.

​Correlations this low mean the vast majority of stock movements in the micro cap universe can be explained by stock specific factors rather than market movements. This is great news from a micro cap investors’ perspective. It means you can do the research on smaller companies knowing that if your investment case is correct, the stock price is likely to move dramatically in your favour as new information is digested and new investors are attracted to the stock.

A recent example of this information advantage at play was seen in Intecq Limited (ASX:ITQ), a micro cap gaming systems supplier which recently reported a half yearly result well ahead of market expectations. The stock has since rallied by some 60%. When so few people are watching, stock price movements following positive news-flow in illiquid, under-followed companies can be significant. The picture is very different in the world of larger company investing where there may be 10-20 or more analysts following a company. With this level of scrutiny all the information released by the company will have been analysed intensively by many intelligent and qualified analysts. The chances of this many analysts missing something of real importance is far lower, and thus the market is far more likely to be efficient at pricing in all the relevant information. This leaves larger companies more exposed to market movements as the primary driver of stock performance.

We expect micro cap correlations to remain well below those of larger companies looking forward. The Fund underlying the TAMIM Australian Equity Small Cap IMA has a correlation with the All Ords since launch of only 0.02 (2% of performance to date can be explained by All Ords movements). We expect it to remain on the low side since we focus on investing in cheap, undiscovered stocks. Over the long term it seems prudent to assume that more investors will become interested in micro cap investing given the superior risk-reward dynamic on offer at present. However, it will be many decades before the considerable information advantage available to micro cap investors is significantly eroded. In the meantime, we will continue to enjoy the opportunities on offer.