With the S&P 500, DJIA, and NASDAQ posting continuous all time highs, there is a growing sense among many investors that we are getting into the late stages of a bull cycle. Whether or not this is the case doesn't matter that much for what we will be looking into in this article, since the area we will be focused on has a consistent trend of being under followed and minimally explored. Whether or not you think the market is nearing a peak, and whether or not you are awaiting a coming crash, taking more time to explore the microcap field may give you a few ideas for your buy and hold strategy that have the potential for significant gains regardless of the overall high valuations seen in today's market indices.
Why Microcap Stocks?
A microcap stock typically trades with a market cap under $300 million, has relatively low volume in the 10s of thousands of shares traded each day, and is part of a collection of other microcap companies that taken together, comprise roughly 50% of all publicly listed companies in the market. Due to their vast number, small size, and relatively low volume and illiquidity, most of these companies lack any serious analyst coverage, are not featured in any major articles, even here on SA, and as a result are unknown to most investors. It doesn't help that they are quickly dismissed with the common label of penny stocks, but if we flip the script and look at one of the main sayings that Buffet mentions (be greedy when others are fearful), this whole area is a constant source of fear and as a result, should also be a source of incredible opportunity.
Taking a look at some research in the area from Roger Ibbotson, professor at Yale, we can see that one of the best investment areas to be in since the early 1970s are small, illiquid companies. In comparison, the worst field to be in was small, very liquid companies on the other hand. This is quite an interesting finding, since it illustrates that size alone is not the only factor to consider when looking at this what drives investment returns. A reason for this is likely due to the jump in share price anytime a stock starts to gain volume on a day to day basis, which will happen as a microcap grows, whereas a small company that has substantial daily volume is more likely to be heavily day traded and therefore lack a solid base of long term investors. An example of this is DryShips Inc., (NASDAQ:DRYS) which has a market cap of under $25 million but a volume of over 25 million shares traded daily.
Due to the unique characteristics of microcaps, namely their small market caps and illiquidity, larger funds and money managers can't enter any significant positions in this area. This is a result of the massive, multi billion dollar portfolios these managers run, which make an investment of a few million dollars into any of these firms relatively inconsequential (not to mention the ownership limitations imposed on funds which start to own a significant stake in any one company). To add to this, building up a sizeable position or exiting one would take far too long due to the low daily liquidity, and any large trade blocks would surely be noticed by the entire market, giving a manager limited time to enter at a good price, or exit at one once other investors see the sudden change in orders being executed. Considering these points, when navigating this field, you are doing so in area that large funds cannot explore and therefore price discovery is left to the smaller individual investor. If that is not enough of a benefit, consider that most other retail investors are also likely to shy away from the area due to lack of institutional research in the area. For those who have the time and are diligent enough, these factors set the stage for an abundant hunting ground.
As always however, there are risks with any investment, and microcaps come with their fair share. For one, the lack of coverage and research makes it difficult to get a reading on whether more seasoned investors think the company you found is a solid investment. For larger companies, there is no shortage of articles, price targets, media interviews etc that all provide abundant and easy to access information that can be used to help form your own investment thesis. Also, the sheer number of microcaps out there compared to the number of blue chip stocks shows that going from small to big takes a really special management team and vision. Majority of these smaller companies get delisted and close shop, rely on a single product initially to become successful, and have limited capital, resources, and opportunity for mistakes. The other concern is that they often exhibit quite high volatility, going up and down double digit percantages on a day to day basis in some cases, and at times on no apparent news. This makes holding such a stock quite nauseating if you are someone who takes comfort in low beta stocks.
Things To Look For In Microcap Companies
Due to their small size, and lack of coverage, most companies in this area will not have much in the way of resources and opinion to look through, so thorough independent due diligence is a must. Here we'll take a look at several factors that Ian Cassel, a successful microcap investor and recent guest on the podcast "Invest Like the Best" with Patrick O'Shaughnessy, mentions as things to look for when analyzing a microcap company.
The first point is that the companies must have some sort of revenue or preferably earnings already. This immediately excludes small biotech firms and new technology companies. The reason for this is that their products are very hit and miss - mostly miss. They need extensive and constant infusions of capital, resulting in dilution of shares over the years, and don't generate any revenue or earnings for years, if ever. This isn't to say you shouldn't ever look at such a company, but for the purposes of this article, we will focus on microcap companies with revenues and earnings that are growing as the company grows.
The next point is to go for as low liquidity as you can find, as these firms tend to have the greatest price discovery as evidenced by the above research paper from Roger Ibbotson. A level of liquidity in the hundreds of thousands and especially in the millions of shares traded daily does not have a good return on average for microcaps. A low liquidity will set the stage for significant share price increase once the company starts to become more discovered due to continued solid performance.
Ian also stresses that his favorite market cap size is around $50 million or less, which is technically the nanocap area. The reasoning for this is that once companies start reaching the $200-300 million market cap area, some smaller institutional investors open positions in the companies, the company becomes part of the larger market indices such as the Russell, liquidity increases, and the price gets bid up as retail investors start to notice these positions being initiated. For this reason, being on the smaller end of the market cap scale is preferred, along with having very limited or even non existent institutional ownership positions in the stock.
This next point applies to almost all companies, but is especially crucial for microcaps. You want to have an exceptional management team, where the operators are also the largest owners of the company. Ideally, management should own a quarter or more of the outstanding shares, and this position should be either stable or increasing. The reason for this is because due to a lack of institutional coverage, the best analysts for the company are the owners themselves. If management has a significant position in the company, they have their careers and financial success on the lines with you, and you can be more confident that decisions being made will benefit both the company and all of its shareholders. Companies without a major insider ownership position should be avoided for these reasons.
The previous idea ties into the next few factors. A solid management team will value their shares highly, and as a result, you should not see many outstanding warrants or options. The smaller the share count the better, as many small companies fall into the cycle of quickly raising cash through share issuance regardless of the price. If you are holding for the long term and from the beginning, significant dilution will be one of your biggest enemies if it's a constant source of capital for management.
Finally, look for a company that dominates the industry/market they are in. This is a good gauge on the management's ability to either take market share from other competitors, or establish a new market themselves. If it's the latter, the market should be growing by double digits each year to give some credibility to the company's growth prospects.
Summary and Resources
Overall, for the patient, diligent, small time investor, some of the biggest opportunities for real multi bagger returns will be found in this area. The fact that it's shunned by many and uninvestable for the larger "smart" money makes it an area that should spark some curiosity. Although resources and information is relatively sparse when looking into these companies, there are several quality sites out there where you can get a start. I have no affiliation with any of these sites, or their owners, but recommend them based off of personal use. The first is Ian Cassel's site microcapclub, and the second is Todd Massedge and Scott Felsenthal's site whymicrocaps?, and the last is Roger Ibbotson's research from Zebra Capital Management which posts yearly updated findings on what works best in the area of liquidity, size, risk, and returns in the market.
If you are like many others in search of value and bargains when the current market seems to be slapping higher prices each day on the larger market cap companies, then hopefully this article gives some idea as to where they might be hiding. However, take into account the risks mentioned earlier and smaller margin for error when searching through this area.
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.