Microcap stocks help investors often avoid the dilemma of being involved in a “crowded trade” — a position so popular that few traders are left to jump in. And that could translate into hefty losses if traders surge for the exits.
That’s part of the microcap stock appeal, PGIM Quantitative Solutions Managing Director Patrick McDonough says in a recent interview with Bloomberg.
Tech continues to do well, he said, noting that there has been a reversal of the cyclicals that drove value in 2022. He called it a “nice simple value-versus-growth story with growth coming back.”
Peel back the layers, though, and you’ll uncover fear or at least uncertainty driving the equity market.
Big tech companies, for now at least, are not what McDonough considers growth companies.
Apple, Microsoft, Salesforce, Nvidia are all big companies with expensive shares. Nvidia trades at more than 50 times its forward earnings. They’re not growth companies; they’re grown companies, McDonough observed.
He underscored the belief that there is no banking crisis, no financial crisis.
“Governments around the world have really stepped up and put a floor under financials,” he said. “But it is a little bit of the market hoping that the Fed rising rates isn’t going to last and we’re going to see a reversal of that in the short term. Going back to 2018, the Fed started to raise rates, the market kind of freaked out a little bit. You saw the reemergence of the Faangs — Faangs 2.0 at this point coming back and everything else in the market maybe just hovered there or rolled over a little bit.”
How to think about microcaps
McDonough suggests focusing the hunt for disruptors who are not yet established players like Big Tech.
“Is there an opportunity outside of the VC or private-equity space?” he asked rhetorically, saying microcaps “have been very overlooked.”
McDonough told Bloomberg he thinks quants are the answer to every question, but diversification is key to success in microcap investing. There are microcap stock opportunities in sectors not in vogue at the moment, he said, pointing to banks.
“You could actually diversify in financials,” he said. “You can look at industrials that are actually down the real end of the economic spectrum, if you will, and get into that space in a more diversified way through microcaps.”
Also, traditional institutional investors seldom play in the space.
“It’s something that (institutional investors) have historically avoided,” he said. That could be due to institutional policy — get another manager to look at it – or the assumption that growth can come from other segments of the market.
As result, microcaps are not crowded. “So it’s an area we can go in and get a lot of upside, even above just the pure beta in the microcap space,” McDonough said. “So very exciting from an opportunity set — at least in the long term.”
Patrick McDonough is a managing director and portfolio manager for PGIM Quantitative Solutions working within the Quantitative Equity team. In this capacity, he is responsible for investment strategy as well as portfolio management, research and analysis for Quantitative Equity portfolios.