A lot of investors avoid microcaps. They're hard to trade, their prices are volatile, slippage and market impact present major headaches, and there's just not enough information out there about them to enable investors to easily judge their worth.
I love microcaps. Here are the seven reasons why.
1. Inefficiencies. The bigger the company, the more efficiently its stock is going to be priced. The only way I can make alpha is by exploiting market inefficiencies, and there aren't as many in the large-cap space.
2. Measurability. I call things that affect the price of a stock but don't show up in financial statements or analyst estimates "unmeasurables." They include the pipe dreams of Elon Musk, the customer-is-always-first philosophy of Jeff Bezos, and the various reasons Yahoo is always playing catch-up to Google. This is the stuff of water-cooler conversation, and when it comes to large companies, they are some of the biggest influences on stock prices. I can't take any of this into account by looking at financial statements. With microcaps, though, there are few unmeasurables. Almost everything I need to know is in their financial statements.
3. Expectations. The only way to make significant money in the stock market is to invest in stocks that beat the expectations of other investors. It's easier to do so with microcaps and small caps than with large caps because most large-cap companies are studied and pored over. Low-volume stocks can be primed to outperform without anyone noticing.
4. Growth. The great investor Thomas Rowe Price Jr. believed that companies, like all living things, go through a period of growth and a period of decline. The most profitable form of investing is in companies with strong potential for growth. Those are mostly (but not exclusively) found in the small and microcap arenas. (So, of course, are companies that have gone through a long decline.) If you look for small companies with strong earnings growth and high profit margins, you're following the path that Price blazed.
5. Value. Value investors believe in buying low and selling high. As for buying low, large caps, by definition, aren't cheap. It's harder to find stocks with very low price-to-earnings, price-to-sales, or price-to-book value among large caps than among small caps. For example, 4.8% of the S&P 500 has a price-to-sales ratio of under 0.5, while 8.9% of the Russell 3000 does. As for selling high, large caps' potential for large price increases in a short time period is much lower. 4.1% of the Russell 3000 has doubled in price in the last year, while only 0.8% of the S&P 500 has.
6. Ethics. Small businesses are, on the whole, not destroying the environment, exploiting their workers, sheltering their profits overseas, engaging in monopolistic practices, or undercutting their competitors in unethical ways. The same can't be said of large companies.
7. Curatorship. I've always enjoyed finding obscure things of value and celebrating them. Now I can do so not just in the music I listen to, the books I read and publish, the films and art I see, and the subjects I write about, but in the companies I invest in.
So here are my favorite microcaps at the moment: MEI Pharma (NASDAQ:MEIP), an oncology company; Finjan Holdings (NASDAQ:FNJN), a cybersecurity company; YuMe (NYSE:YUME), which provides digital video advertising solutions; Vivus (NASDAQ:VVUS), a wide-ranging small biotech firm; Taseko Mines (NYSEMKT:TGB), which digs for copper, gold, and other metals; and InTest (NYSEMKT:INTT), which makes products for testing integrated circuits. All of them reported strong earnings growth last quarter compared to the same quarter last year; and in terms of value, all of them have high ratios of EPS to price and unlevered free cash flow to enterprise value, two of my key value metrics.
Disclosure: I am/we are long MEIP, FNJN, YUME, VVUS, TGB, INTT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.