The Microcap Frontline - How Small Should You Go?

by: Nicholas Bodnar

Summary

Should you put a limit on the minimum market cap in which you will invest?

Investing in companies under a $5mm market cap requires more than face-to-screen due diligence.

There are real companies under a $5mm market cap out there, but finding these companies takes time and patience.

As a microcap investor, should you put a market cap limit on how small you will invest? According to conventional wisdom, the smaller the company, the more risky the investment. If risk, to you, means volatility and market-to-market losses, then yes, smaller companies are more risky, and you probably don't want to buy a sub $5mm market cap business.

In the past few days I have been on the search for very tiny companies -particularly under $5 million market cap. Why would I be in search of a company this small? One word: inefficiency. The smaller the company, the more likely it will be inefficiently priced.

The thing about large caps is that you have to invest in fear 90% of the time in order to pick up an undervalued deal. With microcaps, on the other hand, you can find companies trading under 3.0x EV/EBIT, 0.25x P/B, 5.0x P/E - you name it - without playing against someone else's emotions. I'd much rather buy a company that is undervalued due to sheer market size than on the basis of fear.

In my opinion, investors should not put a limit on how small they should go. I believe the smaller the company, the better the chance that the issue will be inefficient. Inefficiencies are fun and easy to exploit. However, in order to find inefficiently priced companies, there is a lot of work to be done. Hopefully this article will shed some light on small value.

The Problem with Nano-Caps

The biggest problem that I have in regards to nano-cap investing (under $5mm market cap in this context), is the piles of junk. The search for a quality company of nano-cap size, meeting all of my due diligence requirements, is like finding a needle in a haystack. The biggest problem: Most stock screeners don't register companies that small, so the investor must plow through list after list of crappy companies.

Going through all these names can be boring and very time consuming. However, if you are looking for a hidden gem, it is a "must" that you spend the time. I try to spend one day a week going through Sedar filings, OTC listings and other microcap lists to generate potential ideas. Sometimes I find really unique ideas; other times I find nothing.

The majority of the time I am on the hunt for a very tiny company, I have to spend hours going through highly risky and obscure nano-caps. If you don't believe me about the obscure nano-cap companies out there, just spend ten minutes running through some OTC Pink Sheet or TSX Venture listings. Better yet, take a look at the key metrics and business models of these unusual companies:

The Grilled Cheese Truck (OTCPK:GRLD)

Source: Company website.

Blackcraft Cult (OTCQB:BLCK)

Click to enlarge

Source: Company website.

A company that drives around cities selling unique grilled cheese sandwiches? An online retailer dedicated to selling satanic-themed clothing to rebellious teens? Interesting business models to say the least. At the right price, I may be interested. However, given both valuations, there is much more downside than upside with these companies.

Still don't believe me that there are obscure companies with bizarre business models in OTC/Venture land? This one ought to seal the deal: Lingerie Fighting Championships, Inc. (OTCPK:BOTY).

Value Investing Methodology with a Microcap Pitch

I am still an adherent value investor and always will be. After reading the Intelligent Investor four times, it is hard to be anything else. What I do in microcap land is incorporate value methodologies into micro- and nano-cap investing.

Incorporating value methodologies into the search for small value is really the best way to protect against absolute capital loss. In short, I have been on the search for profitable, properly capitalized, self-fundable and undervalued companies. Since I am such a nice guy (and also because not many people will act on these companies) here is a short-list of a few companies I have found recently:

I have done a significant amount of research on a few of these, such as BONL. The others, I still need to do much more due diligence. I won't go into detail about these companies, but maybe if you are lucky, I will throw out a research report.

After plowing through over 100 companies, I ended up generating a list of four potential investment candidates. That's it, four. And when I continue to do more due diligence on these four companies, I may weed out half of them (if I am lucky). Sigh, the life of a microcap investor…

The Smaller You Go, the Deeper the Research

When you start looking at super tiny companies, you will need to do original research. 90% of the time, there won't be any previous research done. This is one of the reasons for the inefficiencies. Thus, the smaller you go, the more research you will need to do. But isn't that the beauty of microcap investing? The pure original research?

Interestingly, the smaller the company that I have researched, the more I have learned and the bigger my network has grown. The thing about tiny microcaps is that management (most of the time) is more than happy to chat with investors. This is a wonderful thing, for it is almost essential that the investor get a hold of management when dealing with companies of this size.

Face to screen due diligence is not enough for companies of this size. To build conviction, or reach the gamblers 'royal flush', one must step away from the screen and walk into the real world of business and commerce. This can be beneficial for numerous reasons.

First, reaching out to management, suppliers, customers, etc., is a very easy and effective way to understand a business model. Furthermore, there is much more an investor can learn by doing infield research. Don't believe me? Call up a company and schedule a visit. You won't be disappointed.

A second benefit of studying microcaps and publically posting your research, resides along the basis of networking. Microcaps are tiny companies with very little investor following. However, I guarantee you that there is another investor out there looking at that same company. If you put out a decent research report, there is a good chance that one of the investors following that company will reach out to you.

This is a great networking technique. Furthermore, having other like minded investors in your network is a very valuable resource for idea generation. Most of the time, other microcap investors are dying to tell someone who cares about some company they know about. There is a great network of guys out there and it can be very valuable when you connect.

Finally, if you are a business minded investor, studying microcaps and going on company visits will end up making you a better investor and businessman. Every time I analyze a company, I think to myself, would I buy this entire company at the current price if I had the capital to do so? Thinking this way can be very powerful.

Think about it. If you were in a position to buy an entire company, you wouldn't limit your research process purely in the form of face to screen due diligence (at least I hope not). No, you would probably go as far out as possible to learn as much as you could about the investment.

Remember, even if you don't have enough monetary assets to takeover a company or even establish a majority position, investing is done best when it is most business like.

Conclusion

So how small should you go? Should you limit yourself to a minimum market cap? In my opinion, not at all. As long as you have the drive and dedication to do original research, putting a limit on your market cap basis only hinders you. One of my goals for 2016 is to find a real company with real prospects at <$1.0mm dollar market cap limit. It will be a lot of working digging through crappy company after crappy company. But it may end up being worth it. Who knows, maybe I will find the next Wal-Mart (NYSE:WMT) or the next OTC Market Group (OTCQX:OTCM).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.