Should You Invest In Microcap Stocks

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Includes: AAPL, BBY, CBI, CCNI, ESV, IBCP, IWRGF, JWN, NOV, OFLX, RELL, SPRS, TPX, WM, ZAGG
by: Nicholas Bodnar

Summary

Investing in microcap stocks can be very lucrative.

If you have the dedication and time to put into research, microcap investing may be for you.

History has shown that a microcap investing strategy can outperform major indices.

Why Do I Invest in Microcaps?

When I first started investing, I was a full time college student also working full time in a meat department (>40/week). Not only was I going to school full time and working full time, but I was engaged to my soon to be wife, running a few small business ventures, and reading voraciously (mainly books on finance/economics). Balancing all of these activities while having a social life really was not that easy. So when I started to get into investing, I really was not doing very heavy due diligence.

The due diligence that I performed on a company mainly consisted of reading one year's worth of 10-Ks and 10-Qs, looking/reading other investment research on a chosen stock, and maybe, just maybe writing a quick thesis on why I wanted to invest in that company. Compared to what I do now, my due diligence was pitiful.

Since I did not have the time and energy to dig into a company, I pretty much bought into popular companies that everyone else on Wall Street was buying (Apple (NASDAQ:AAPL), Waste Management (NYSE:WM), National Oilwell Varco (NYSE:NOV), Nordstrom (NYSE:JWN), and Tempur Sealy International (NYSE:TPX)). I made okay returns and the dividends were nice, but the returns that I did make were not exceptional.

As time passed, I ended up graduating from college, and getting married. I soon had a lot more time to research companies. I ended up buying a company called Independent Bank (NASDAQ:IBCP), and within a few months, made >50% return. That is when I started to realize the potential unfollowed microcap stocks had over large cap stocks. Check out what has happened to IBCP in the past three years.

I do not work in a meat department anymore, I am not going to college, and I am not planning a wedding. What I do now is research and write about investing ideas full time. Since I now have the time to dig into companies that others tend to overlook, the microcap world of investing is perfect for me. I have always been the kind of person who does things the majority of individuals do not do (the white sheep/rebel). Investing in overlooked companies that the masses are not piling into is perfect for me.

Note: Readers should know that I do not limit myself strictly to microcap stocks. If I see value in a large cap stock, I am not hesitant to take a position, if I see value and opportunity. In fact, a percentage of my portfolio is in a few large cap names (NOV, Ensco PLC (NYSE:ESV) and Chicago Bridge & Iron (NYSE:CBI)). They are not huge positions and only make up a small percentage of my overall portfolio. As time passes there will be less of a dedication to my portfolio to names like these and more of a dedication to microcap stocks. I would not be surprised to see 100% of my portfolio dedicated to stocks with a sub $50mm market cap in the near future.

The Types of Microcaps I Buy

There are basically three different microcaps stocks that I buy for my portfolio. The first type, which to me is very interesting and really shows that the stock market is not efficient is the world of NCAV stocks. NCAV stocks are companies that are trading for less than their net current asset value. These stocks are very badly punished companies that look like they are pretty much headed for a bankruptcy. Despite the poor past performance of these companies, they have a proven statistical history of outperforming >28% average return/year.

If you are going to buy a NCAV stock, you must be an active investor. These companies are not buy and hold companies. You buy these companies to get one last puff on that cigar. You can make very good money buying and selling NCAV stocks, but you must be an active investor. Most investors do not like buying broken businesses, so NCAV investing is not for them. Overall, if you want to beat the market, buying and selling NCAV stocks, gives you a very good chance of making the former happen.

Note: When Warren Buffett was young, buying and selling NCAV stocks is how he made tons of money. He has said that the years in which he was buying these kinds of companies were his best years ever as an investor.

Another kind of microcap stock that I buy are low EV/EBITDA companies. It has been said that the EV/EBITDA ratio could be the single best ratio around. In the past 20 years, low EV/EBITDA stocks have returned 2,227%, which has destroyed the returns of the S&P 500.

Now if you incorporate low EV/EBITDA ratios with microcap stocks, you can make a significant return. It has been proven that the smaller the company the better long-term results. Check out the picture below that goes to prove the former.

I believe that incorporating the low EV/EBITDA ratio into a microcap strategy can be very rewarding in the long run.

The final microcap investing strategy, that I have just started to incorporate in my research is a microcap stock that is growing at a very fast rate >20%/year. If you can find a microcap stock that is growing at a double-digit rate, staying profitable, and has a very bright future, you may have the potential to invest in a multi-bagger. Take a look at a company called Zagg Inc. (NASDAQ:ZAGG).

Back in the day, you could have bought this company for <$0.70/share (in 2008). In the late days of 2008, ZAGG got a contract with Best Buy (NYSE:BBY). After that, earnings skyrocketed and the price took off (in 2008, ZAGG had a market cap of <$25mm. Today the company's market cap is $211mm). What I am trying to say is that if you can find a microcap stock with potential to grow, you can really make a huge return.

These are three different microcap strategies that I am using now (the former two more than the latter one). If you are a microcap investor and you use similar or different strategies, feel free to comment your methods below.

Some Microcaps that deserve a Second Look

I believe that having a very concentrated portfolio is your best way to become very wealthy. I mean when has someone ever become super rich buying into a mutual fund that measures the whole market? Below, I am throwing out some microcap stocks that deserve a second look. I am not suggesting that you should go out and buy all of these stocks tomorrow (for that would be irrational), plus it would go against my belief of a core concentrated portfolio. Your best bet is to find your top three investments and bet heavily into them.

Richardson Electronics (NASDAQ:RELL)

Market Cap

82.54 M

Cash

98.23 M

Shares Outstanding

11.46 M

Debt

0.00

Revenues

136.96 M

NCAV

11.59

EBITDA

-6.38 M

Stock Price

6.07

RELL is a very deep value play; in fact, it is a company that is selling below its NCAV. The company has more cash on the balance sheet than its stock price is worth, and it has zero debt. The company is also paying a dividend and is buying back its shares. There is a lot of risks associated with buying this company since it is unprofitable, but I believe there is one last puff on this cigar.

Surge Components (OTCPK:SPRS)

Market Cap

7.5 M

Cash

6.84 M

Shares Outstanding

10.00 M

Debt

0.00

Revenues

28.37 M

NCAV

1.06

EBITDA

776.96 K

Stock Price

0.75

SPRS is currently a profitable net-net stock with a huge cash position and zero debt position. In 2014, SPRS made $1.8mm in FCF and in the past three years, revenues have grown at a 6.8% rate annually. SPRS also has a very low EV/EBITDA of 0.98, which suggests that the company is very deeply undervalued. It is a very thinly traded security so it may take a while to build a meaningful position in the company.

IWG Technologies (OTC:IWRGF)

Market Cap

7.72 M

Cash

1.96 M

Shares Outstanding

38.95 M

Debt

296.10 K

Revenues

6.83 M

Insider Ownership

7.27%

EBITDA

1.37 M

FCF

500 K

IWRGF is a company that has very little competition operating in a niche market. The company's EV/EBITDA is 4.24 and it has not had an unprofitable fiscal year since 2008. The company trades for ~$0.20/share and it is a very thinly traded company. In the past nine months, the company has grown its revenues at a 30% rate. Management expects revenues to continue growing 10-15%/year in the future.

Omega Flex (OFLX)

Market Cap

302.75 M

Cash

20.43 M

Shares Outstanding

10.09 M

Debt

0.00

Revenues

91.37 M

Insider Ownership

76.84%

EBITDA

23.58 M

Enterprise Value

282.32 M

OFLX is currently trading for a richer valuation. I would not suggest buying this company just yet since it is not undervalued. Lately, there has been decent downward pressure on the company's stock. If the company's stock falls ~$22/share, I would consider a position. This company also is in a niche market and competition is thin. Revenue and earnings are growing >20% and are expected to continue. This company would be a great long-term holding at the right price.

Command Center (OTCQB:CCNI)

Market Cap

39.05 M

Cash

5.15 M

Shares Outstanding

65.62 M

Debt

1.24 M

Revenues

93.50 M

Insider Ownership

26.30%

EBITDA

5.87 M

FCF

7.5 M

CCNI has gotten hammered lately since the company is indirectly tied to the energy industry. Despite the stock falling, the company has been able to grow its revenues, and it still remains profitable. Management is currently buying back shares and has plans to continue as well. I really like how this company is FCF positive and the simple business model of this company. CCNI's EV/EBITDA is 5.26 and is significantly undervalued on a comp basis.

These are just a few microcap stocks that I am currently following. As of right now, I hold SPRS and I am planning on taking a position in IWRGF as time permits me to do so. There are a ton of other microcap stocks that I watch and write on as well. I would really love to know what kind of microcap stocks you invest in or are watching. Message me if you have an idea. If it looks intriguing I may do research for you.

Should you Invest in Microcaps?

Microcap stocks are not for everyone. If you do not have time to dedicate to studying microcap investments, I would suggest not to invest in microcap stocks. I believe that you must be an active investor willing to dedicate tons of time to microcap stocks if you are interested in investing in them. Thus, investing in microcap stocks is not a passive pastime like buying ETFs or mutual funds. But if you are an active investor who loves to do in-depth research, microcap investing may be for you. I have provided a few Seeking Alpha authors below who are great microcap writers. If you are interested in microcaps, I suggest that you follow them.

Good luck everybody and happy microcap investing.

Disclosure: I am/we are long NOV, SPRS, ESV, CBI.

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.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

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