KCR Micro Model Explained

In our last missive, A Penchant for Pain, we highlighted that our Microcap Model Portfolio was lagging the Russell 2000 – one of its two principal benchmarks.[1] We went on to note that some of our most timely highlights have been when we draw our readers’ attention to our worst performing products. Evidence based and systematic, we have been fortunate to see every period of pain followed, eventually, by outsized prosperity.

We suspect the same will be said for our Microcap picks. As if to egg us on, after highlighting the poor performance, we published write-ups of two highly ranked Microcap stocks; Overseas Shipholding Group and ARIS Water Solutions. Within weeks, OSG, which was trading below a takeout offer at the time we published, saw the buyer increase their takeout price by nearly 30% and the deal appears to be closing.

We’ll chalk that one up to “better lucky than good” but would note that when we published the piece, we highlighted both the fact it was at a discount to a takeout bid, that there were zero analysts on the stock, and the company was trading at an almost impossible-to-believe discount to fair value. We find these types of situations to be incredibly common across the mid, small, and microcap universe.

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Today we intend to rip through the case for our Microcap Model Portfolio in broad and blunt strokes. Summarily: using our screens, it takes very little work to build high conviction around names with a significant margin of safety. For SMID managers there is an outsized opportunity in some of these small stocks; for those fortunate enough to have an explicit microcap mandate, we think our Micro Model Portfolio and Rankings can accelerate the research process.

First, the asset class. Our missive in August of 2021 explained that while the press bemoaned that value stocks had suffered a lost-decade, the data simply didn’t fit the narrative. The growth bubble that has become dominated by a dangerously concentrated group of stocks is a post 2017 phenomenon. The chart below shows the annualized returns by size and style since 2017.

Since May of 2021 this newsletter has maintained a simple but nuanced view:

1. There was incredible fundamental value for sale in the small and midcap space but
2. The indexed vehicles for gaining exposure to these sectors suffered terrible deficiencies

In this moment of mass-indexing, KCR has been relentless in advocating for evidence based active management in every corner of the market – but particularly in smaller stocks. Our Microcap Model Portfolio has been in production since January of 2011. Designed to beat both the Micro bench and the R2000, it provides a systematic edge for micro managers and gives R2000 mandates smaller, off-bench names to work on.

Even in this seemingly relentless growth bubble, our Micro Model Portfolio has managed to hold its own. The chart below is identical to the one on the prior page. The only difference is we have added our Micro Model Portfolio’s annualized returns in the red bar. While it has failed to keep up with Large Cap Growth, we still believe it has put in an admirable showing considering its benchmark is the first two bars on the left. As we mentioned in our last piece, this admirable performance includes a 15-month period where the Micro Model lagged the Russell 2000 by 10% from year end 2022 through the end of March 2024.

If you’re wondering why we are so interested in evidence based active management in the microcap space, the next couple charts should hopefully pique your interest.