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Small-cap stocks, by definition, are publicly traded companies with market capitalizations between $300 million and $2 billion (Investopedia). While a majority of these small companies chose to go public in an effort to raise additional capital to fund their growth, a small percentage of the listed companies turn out to be fraudulent; this in turn has created negative associations for all small cap stocks. In fact, when I first began research small cap investments, I couldn't help but recall scenes from "The Boiler Room" of financial advisors swindling ill-informed investors. However, as I began digging deeper into numerous small cap companies, my opinion changed and I began to see an exciting risk/reward proposition for investors who do their due diligence. Investors must realize that many of today's large cap stocks did not start off as billion dollar companies but instead appreciated in value over time.

There are many reasons why most individual investors largely overlook small cap stocks. It's been said that 80% of institutional research analyst dedicate their time to just 20% of all publicly traded stocks (FirstWilshire). The reason for the lack of institutional coverage is not a reflection of the quality of the companies but rather a resource issue. Institutions profit when transactions occur and are incentivized to publish reports on stocks with the most trading volume as opposed to companies that may be the most promising for investors. This in turn creates mispricing and opportunities to earn substantial returns for the patient and intelligent investor. Additionally, many small cap stocks are restricted from being purchased by mutual funds because they do not meet certain investment criteria such as minimum trading volume, dividend yields, and minimum share price; this is significant because mutual funds represent a substantial portion of stock purchases.

InvenSense (INVN)

One of the small cap stocks that I have been following for some time now is InvenSense. InvenSense is a fabless semiconductor that specializes in Micro-electro-mechanical gyroscopes, accelerometers, compasses, and pressure sensors. To put it simply, the company provides proprietary tiny computer sensors in consumer electronic products such as smartphones, tablets, game controllers, smart TVs, and wearable sensors to provide precise motion tracking. An example of this would be the Nintendo Wii's (InvenSense breakthrough) revolutionary remote that allowed users to use hand gestures to control game characters. Through its industry-leading technology, InvenSense has grown into a billion dollar company and has cornered the smartphone market with only Apple as the only smartphone maker not being supplied by InvenSense. Although it is not currently in Apple products, it is not farfetched to see Apple switch from its current supplier, STMicroelectronics, to InvenSense.

While InvenSense has continued to innovate and grow revenues exponentially, the stock price has been stagnant over the last 6 months. One of the biggest reasons for the stagnant growth is the on-going litigation between InvenSense and its main competitor, STMicroelectronics. Additionally, the company has parted ways with its original founder and former CEO. While intelligent investors will appreciate the company's decision to hire a more seasoned professional, investors may not realize that the former CEO has begun unloading his significant stock ownership following his departure; this creates significant downward pressure on the stock given its trading volume.

Catalyst for Growth

Legal Matters

One of the biggest concerns investors have had with owning InvenSense was the patent lawsuits by STMicrolectronics (NYSE:STM). STMicro has claimed in its lawsuits that InvenSense has infringed on numerous patents they hold and demand InvenSense seize production and forfeit any loss profit STMicro may have incurred. While InvenSense has consistently refuted these claims, many on the outside fear that even if InvenSense is not liable for patent infringement, they may not have the financial resources to battle with its competitor in court. However, in their recent earnings call, management has expressed high level of confidence in their legal battle against STM.

We are pleased with the progress of these matters, with all of the claims associated with ST Microelectronics patents asserted in both cases, subject to reexamination by the United States Patent and Trademark Office, where preliminary work has been completed on these claims by the USPTO, all of the ST claims in these cases have been invalidated. (InvenSense Q4 2012 Earnings Call)

Competitive Advantage: Rising Adoption & Superior Technology

The market for accelerometers, gryoscropes, compasses and pressure sensors is still in its infancy and is growing rapidly. InvenSense is poised to grow as it compete solely with STMicroelectronics in the mobile and tablet market and offers a superior compared to STMicro. At the time of this article, STMicro products do not compare in terms of power consumption, size and compatibility. To compete with InvenSense, STMicroelectronics uses their lower cost as their value proposition. While STMicro has succeeded with selling cheaper quality sensors, I believe this strategy will soon fail because initially smartphone and tablet companies purchasing these sensors were purchasing the sensors as more of a novelty than actual functional purposes to compete with the leading smartphone makers. Going forward, I believe that motion sensors will play a more crucial role in these products as consumers demand more from their products and software developers continue to utilize new hardware breakthroughs. With consistently far superior technology compared to its competitors, InvenSense is poised to take advantage of this trend. From the horses mouth:

I can tell you, historically, Mark, we have not met their pricing. That's -- so I can talk about the history and the track record. We always have garnered a premium because customers value performance. And my feeling is, again, there are customers in the past that they place Gyro in there just because somebody else has it, and it's been more pressure on the pricing. But as the value of the gyro and performance goes up, I feel that we have more opportunity to break away and differentiate. Number one on performance and size and power, number two on the system level. And we're much better integrated into the ecosystem than they are, and customers value that. The time to market they value. So I believe, that, combined with the fact that, I think, we have better opportunity for cost reduction versus somebody who stacks 4, 5 dye on top of each other with a glob of wires and -- that's 50, 60 wire bonds. I think -- and again I don't want to downplay ST. They're a very respectable company, and they've done a great job. They just have a very outdated business model, but it's just not the future, and I think that we can respond much faster to customers.

Diversifying Target Market

Although InvenSense is most known for its smartphone products, it should not be forgotten that InvenSense got its first breakthrough with the Nintendo Wii remote. Continuing with their diversification into other product lines, InvenSense has moved into other consumer electronics such as sports-related devices, electronic tools, GPS, and television devices; Nike Fuelband, Jawbone Up, Pedometers, and Golf Stroke Analysis are some of the products I have recently seen that are benefiting from the companies products. In fact, InvenSense had recently partnered with Black and Decker to produce an award-winning electronic screwdriver that leverages sensors to tighten screws through hand gestures. As technology becomes more intertwined with consumer interactions, InvenSense is poised to offer products to satisfy the demand.

Supplying Apple (AAPL)

Currently, InvenSense supplies the majority of the android operating system market. However, InvenSense has failed to land a deal with Apple, which has given its business to STMicro. While InvenSense does provide superior products, one of the reasons I believe Apple has stuck with STMicroelectronics is because I believe Apple is hedging itself until the legal matters are resolved. This gives STMicro more reason to continue to drag out the legal battles as long as they can. However, should any news of landing Apple come, it will send this stock soaring as it would benefit from the "Apple Effect" like Qualcomm, Broadcom, and Cirrus Logic (NASDAQ:CRUS). One of the reasons why I believe Apple will ultimately switch over to InvenSense is because Apple has been suffering intense pressure to produce another innovative product and must therefore make sure they use the best suppliers to enhance their phone features.

Strong Financial Health

Since 2010, InvenSense has met or exceeded earnings expectations and has padded its treasure chest in return. According to its latest earnings results (Q4 2012), the company currently holds approximately a net cash position of $200 million. With a market cap of $1.1 billion, that means net cash represents 20% of the firms market cap. When asked what the company plans on doing with its vast sum and if there were any buybacks or dividends in its future, management quickly squashed that idea and rightfully so. InvenSense is in the middle of one of the fast growing segments in the semiconductor industry and must continue to dedicate resources to research and development.

Sharing Nasiri-Fabrication Shuttle (NF-Shuttle) Process

InvenSense has opened its patented MEMs fabrication process for other smaller players in the industry to use to design their sensors. While some may question this motive, it is actually quite ingenious. By opening up their patented process, it is safe to assume more firms will utilize their process and their process will become the default industry standard process. In doing so, this would create economies of scale for the process, allow for lower industry costs by foundries to produce chips made using this process and improve the company's gross margins.

Fabless Business Model

Being a fabless semiconductor means that InvenSense does not manufacture the products but only designs the products and holds patents to the processes, a model well known to ARM Holdings (NASDAQ:ARMH) and Broadcom (NASDAQ:BRCM). InvenSense chose to operate this way because it frees resources to focus on its core competencies, which is developing MEMs sensors. Currently, InvenSense has contracts in place with Taiwan Semiconductor Manufacturing Company (TSMC) and Global Foundries. Unlike InvenSense, STMicro does manufacture their own sensors. While this can in theory minimize cost in reality, STMicroelectronics risks depleting resources into building plants and processes on technology that may be obsolete; it is not farfetched too assume this if you consider how quickly new products are introduced into the market.

In Closing

I hope you all enjoyed this article and think twice before you disregard small cap stocks. Always remember to do you due diligence, no matter if its small cap or large cap. Best of luck!

Disclosure: I am long INVN, BRCM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Revisiting Small Cap Investing With InvenSense