In yesterday's column, I mentioned the tightening of the spread between yields on the two- and 10-year U.S. Treasuries and its deleterious effect on bank net interest margins. Why does that matter for micro-caps? Well, it's not a well-known fact, but financials are much more heavily represented in the Russell Microcap Index than in the other major U.S. indices.
The iShares RUMIC-mirroring Micro-Cap ETF (IWC) shows in its latest fact sheet a 26.7% weighting in financials, by far its largest sector weighting. That is nearly double the 14.2% weighting financials have in iShares' Core S&P 500 ETF (IVV) . Also, information technology has a stronger weighting in the S&P 500 than financials, not surprising given the dominance of Apple (AAPL) , Microsoft (MSFT) , Alphabet (GOOGL) and Facebook (FB) . In fact, the main index for those four stocks, the Nasdaq-100, shows a financial sector weighting of a very round 0.0%. (Apple, Alphabet and Facebook are part of TheStreet's Action Alerts PLUS portfolio.)
So, one might attend a micro-cap conference and see companies with amazing whiz-bang technologies or potentially life-changing therapeutic solutions, but those aren't the companies that drive the RUMIC's performance. It is financials like Pacific Premier Bancorp (PPBI) , Centerstate Banks (CSFL) , Walker & Dunlop (WD) , CareTrust REIT (CTRE) and Lakeland Financial (LKFN) . I have to admit that before doing my research for this piece, I had never heard of those five companies, but they compose half of the top 10 largest holdings of IWC.
I occasionally wander out of a presentation for a tech company at a micro-cap conference wondering, "Why is this company public?" but I never ask that question about financials in the micro-cap sector. Banks need to meet stringent financial standards and common equity counts as Tier I capital. So, there will always be a plethora of smaller banks and REITs that you have never heard of, but they face the same strains as the big boys.
A flattening yield curve pressures the key financial metric for any bank, net interest margin (NIM). Running a bank during a period of contracting NIMs across the industry is a challenge, and owning financial stocks in such an environment should be equally so. I believe the yield curve will flatten further as we move through 2017. In fact, I believe 30-year U.S. Treasury yields will again breach the key 2% level at some point this year. That is not a bullish environment for banks or bank stocks.
So the strong weighting of financials is a structural hindrance to micro-cap outperformance in periods of yield compression. That said, the micro-caps do have one thing going for them by virtue of their lack of size: No individual stock can represent a disproportionate share of the MicroCap Index. So, while Apple, Microsoft, Amazon (AMZN) , Google and Facebook represent 11% of the S&P 500 and 39.5% of the Nasdaq 100, the five micro-cap financials I mentioned earlier combined only represent 1.7% of the value of the Russell Microcap Index. The largest component of the RUMIC, Mercury Systems (MRCY) , a non-financial company, represents only 0.52% of the index's value. The RUMIC is truly a diverse index, and that dispersion among different companies is ultimately what makes it such a useful indicator of the health of the emerging economy.
So I'm not buying micro-caps as a group given my worries about the financials in this environment, but I am still very interested in individual stories. Rest assured I will continue beating the bushes -- reading 10-Ks, meeting with management teams and attending more investment conferences than any sane man should -- to find individual names that will produce above-market returns.
