Dick Cancelmo Head of Trading and Portfolio Manager at Bridgeway bio image

Richard P. Cancelmo, Jr.

Cindy Griffin, CIPM

We strongly believe in the potential for ultra-small stocks, and while we do not condone market timing, we believe we may be poised for a unique opportunity to capture a return to the long-term mean for ultra-small stocks.

In March of 2021, we wrote about an opportunity in the small-cap space that we call “ultra-small” stocks.[i]  This exemplified one of Bridgeway’s relational investing[ii] principles of stating where we stand. We wanted to briefly update that piece and re-state where we stand, but also be intentional (another relational investing principle) about disclosing what challenges investors may face by investing in ultra-small stocks.

The Ultra-Small Stocks Opportunity

Ultra-small stocks are smaller than micro-cap stocks and are represented by the smallest decile of stocks defined by the Center for Research in Security Prices (“CRSP”). For purposes of this post, we will use both “ultra-small stocks” and “CRSP 10 stocks” interchangeably. To briefly recap our thoughts from March 2021:

  • Since July 1926, the smallest decile of stocks (“CRSP 10”) has outperformed the largest decile of stocks (“CRSP 1”) and all other deciles of stocks on an annualized basis
  • In the last decade, CRSP 10 stocks have lagged CRSP 1 stocks on an annualized basis
  • The current trend of CRSP 1 outperforming CRSP 10 in the last decade represents an opportunity for ultra-small stocks. Historically, these stocks have experienced a reversion to long-term levels after dramatic periods of underperformance (such as the previous decade)

A year has gone by, and while ultra-small stocks have made up some ground, there is still a long way to go, as evidenced by the following chart:

Source: CRSP

We remain steadfast that ultra-small stocks represent a unique opportunity in today’s market, particularly given historical returns of the asset class. But challenges do exist for any investor who is willing to explore the exciting world of ultra-small stocks. We briefly touched on one in the last paper – liquidity – while two other primary challenges exist: higher potential for bankruptcy and cost erosion in trading. The first – higher potential for bankruptcy – can be addressed by a disciplined, systematic process that assesses a company’s potential for bankruptcy and other issues related to quality that could cause near-term underperformance. The second – cost erosion in trading – will be our focus below.

A Practitioner’s View on Trading Ultra-Small Stocks

By definition, to be a practitioner, one must be “actively engaged in an art, discipline, or profession”[iii]  which in some cases would be better known as an “artisan.”  We have long admired the work of artisans who make high-quality and distinctive products. Their work inspires with great attention to detail and beauty. Their vision and passion for conceiving and executing a project that results in an object – be it a leather handbag, a child’s wooden toy, or something else –  is a singular pleasure to see, to use, perhaps to hold, and sometimes even to give. None of this is possible without talent, time, and significant training.

As investment practitioners, we are artisans of a different sort. We each share the essential qualities of an artisan – vision, attention to detail, training, passion – and have the privilege of working with equally passionate and dedicated colleagues. Together we have created and manage unique investment strategies with an artisan mindset.

One of these strategies is our Ultra-Small Company Market strategy, which focuses on buying those ultra-small stocks in the CRSP 10 universe. The strategy’s overall goal is to achieve the CRSP 10 return net of fees over long time periods by roughly matching the sector and industry makeup and financial characteristics of the CRSP 10 Index.

Our approach to managing the Ultra-Small Company Market strategy is sometimes referred to as “passive, asset class investing” because it refers to the fact that the strategy intends to provide risk and return characteristics similar to investing in a basket of stocks in a specific asset class. From an implementation and trading perspective, we believe that this approach can offer investors a great advantage, particularly in this asset class. As practitioners, we know from more than 25 years of experience and data that trading costs are generally less in a passive or asset-class based approach. This experience holds especially true in the CRSP 10 universe, where active trading can be quite costly and diminish returns. Given that there are known challenges in trading ultra-small stocks, as practitioners, what have we done to mitigate outsized trading costs and improve trading efficiency in our Ultra-Small Company Market strategy?

First, our statistical, evidence-based investment approach combined with our passive trading approach means we have flexibility in which stocks we want to own within the universe of ultra-small stocks. The list of eligible stocks contains stocks that are statistically indifferent from each other and can provide similar contributions to risk and return. In other words, we do not have to own ABC stock. We could just as easily own XYZ. The urgency to trade a specific stock can destroy value through increased costs and higher purchase prices. Our patient approach to trading is a great advantage in the ultra-small stock universe.

Second, we can be opportunistic traders. Our many years of trading in ultra-small stocks have developed numerous beneficial, long-term relationships with brokers who know this space well. We have established processes that allow us to communicate and quickly reply to these brokers, especially when stockholders are urgent to sell an ultra-small stock. In many cases, a seller’s urgency is our opportunity and can result in a better (i.e., lower) purchase price. This is an example of how we have invested in the outcome – one of the principles of relational investing. The relationships that we’ve fostered over time with these brokers have ultimately improved the outcomes for our investors.

Finally, securities lending can be another integral aspect to the process. For portfolios that have an approved securities lending program, securities lent out may generate additional revenue/return. Securities lending is especially lucrative in the ultra-small stocks space as the supply of these stocks is more limited than larger-cap stocks, and demand is high. However, the practice is not without risk – a borrower of the lent security could become insolvent, or the collateral’s value could decline below the cost of replacing the securities. Bridgeway has robust processes, procedures, and controls around borrowers and collateral and works closely with custodian banks in implementing a securities lending program.

Our approach to trading in the ultra-small stock universe has helped Bridgeway provide better outcomes for our investors over the long term. Trading cost analysis and the additional return from securities lending in the Ultra-Small Company Market strategy provide strong evidence for that. For the calendar year 2021, transaction cost analysis[iv] showed our trading costs for the Ultra-Small Company Market strategy were -30 basis points versus the expected estimate of -84 basis points. In addition, the one-year return from securities lending on the strategy was 49 basis points. As noted above, a securities lending program needs to be approved and implemented for each account and must be carefully monitored to mitigate potential downside risks, and as each account is unique, there is no guarantee that this additional return from securities lending will be achieved in any account.

Summary

One of the most striking principles of relational investing is “discover the power in the paradox.”  The ultra-small company space is one of those places where an investor can find the paradox – attractive returns are paired with substantial challenges in implementation and practice. We strongly believe in the potential for ultra-small stocks, and while we do not condone market timing, we believe we may be poised for a unique opportunity to capture a return to the long-term mean for ultra-small stocks. For investors, trading can be a challenge in this universe, so knowing the challenges and how to mitigate them (or how their professional investment manager would mitigate them) can capture the power of the ultra-small stocks paradox.


[i] https://bridgeway.com/perspectives/crisis-and-opportunity-the-overlooked-role-of-ultra-small-stocks/

[ii] Relational investing unites investment results and returns for humanity by taking an innovative approach to asset management. It is a statistical, evidence-based investment approach motivated by a passion for servant leadership and global impact which we accomplish by donating 50% of our firm profits to organizations making a positive impact for humanity.  Relational investing focuses on generating enduring results that meet client investment objectives while fostering transformative change in the world. For more detail, please see https://bridgeway.com/perspectives/an-open-letter-on-relational-investing/ and https://bridgeway.com/perspectives/relational-investing-in-action/

[iii] Oxford Languages

[iv] Transaction Cost Analysis (“TCA”) measures the implicit and explicit costs of trading.  Bridgeway’s third party TCA vendor focuses on implementation shortfall, which measures the difference between the dollar return of a paper portfolio for which all shares are assumed to transact at the prevailing market price at the time of the investment decision, and the actual dollar return they realize in their portfolio. In general, a smaller shortfall is perceived to be better for the investor.

DISCLOSURE

The opinions expressed here are exclusively those of Bridgeway Capital Management (“Bridgeway”). Information provided herein is educational in nature and for informational purposes only and should not be considered investment, legal, or tax advice.

Past performance is not indicative of future results.

Investing involves risk, including possible loss of principal. In addition, market turbulence and reduced liquidity in the markets may negatively affect many issuers, which could adversely affect client accounts.

Diversification neither assures a profit nor guarantees against loss in a declining market.

The Center for Research in Security Prices (“CRSP”) US Stock Databases contain daily and monthly market and corporate action data for over 32,000 active and inactive securities with primary listings on the NYSE, NYSE American, NASDAQ, NYSE Arca, and Bats exchanges and include CRSP broad market indexes. CRSP databases are characterized by their comprehensive corporate action information and highly accurate total return calculations. The CRSP Cap-Based 1 Index (“CRSP 1”) is an unmanaged index of roughly 200 ultra-large companies compiled by the Center for Research in Securities Prices, with dividends reinvested. The CRSP Cap-Based 10 Index (“CRSP 10”) is an unmanaged index of roughly 500 ultra-small companies compiled by the Center for Research in Securities Prices, with dividends reinvested.

One cannot invest directly in an index. Index returns and references to specific company earnings and other financial metrics do not reflect fees, expenses, or trading costs associated with an actively managed portfolio.