No More Dark Stocks? Invest In Nanocaps Instead

Sep. 07, 2021 7:33 PM ETCYTR, HIHO, ISIG, JLMC, LIFE, MCUJF, SLNH, SLNHP, PFIN, PGNT, QQQ, SCKT, SP500, TORM, WSTL, MPH:CA12 Comments
Ruerd Heeg profile picture
Ruerd Heeg
3.37K Followers

Summary

  • The reason for having a home bias is usually fear of missing information. Therefore, investors with a home bias should not invest in US-traded dark stocks, of non-reporting companies.
  • A much better alternative is US-traded and foreign nanocaps that are filing financial reports. In this article, I show excellent returns for these stocks since the beginning of 2019.
  • Many nanocaps have low trading liquidity. Because there are there so many of them, globally, it is not difficult to invest hundreds of thousands of dollars in such stocks.
  • Looking for more investing ideas like this one? Get them exclusively at Global Quant Edge. Learn More »

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Jonathan Kitchen/DigitalVision via Getty Images

Home bias and dark stocks

Many investors in the US have a strong home bias. They only invest in US-traded stocks. I think the origin of this bias is fear of missing essential information on investments. However, some of these investors go for unknown and small stocks. They hope for better returns when they come across positive information that few other investors have found. Therefore many US investors with a strong home bias invest in very small companies.

There are even US investors with a strong home bias that invest in over-the-counter traded non-reporting stocks, so-called dark stocks. My impression is they still rely almost exclusively on public information, which is often outdated.

I consider investing in dark US stocks highly irrational for US investors with a home bias. A home bias makes sense if you are afraid that information about a company is incomplete or inaccurate. But with dark stocks, investors always have to rely on incomplete or inaccurate information. So instead of investing in over-the-counter dark stocks, it makes much more sense to invest in foreign nanocaps, filing their financial reports.

Moreover, regulators have recognized problems with dark over-the-counter stocks. Because they do not file financial reports they are more vulnerable to fraud and pump and dump schemes. To protect investors they have made new rules. According to these new rules, many small investors cannot establish new positions in dark stocks anymore.

Quantitatively ranked nanocaps

At the same time very small stocks, so-called nanocaps, with market caps below $25 million have high returns. The main difference between dark stocks and nanocaps is the latter are filing financial reports.

On average, the stocks I recommended in my newsletter Global Deep Value Stocks had about 40% annualized return since the beginning of 2019. 29% of these stocks were nanocaps, usually with a market cap much below $25 million but always higher than $5 million. In addition, I require a minimum 10-day trading volume for these nanocaps in order to be actionable for my subscribers.

Twice a month I rank all available nanocaps with a simple ranking system using common multiples and variables related to treading volume, payouts, and financial strength.

Investors can trade these stocks by using a broker that allows trading in foreign stocks, such as Interactive Brokers. Its trading client is available for multiple operating systems: Windows, Android, iOS and Linux. I am not aware of any regulatory restrictions blocking investors from executing trades in foreign stocks.

Below I will show you how extremely well this has worked since the beginning of 2019.

US-listed nanocaps

US-traded nanocaps I discussed and recommended were aTyr Pharma (LIFE, 31.7%), CytRx Corporation (OTCQB:CYTR, 77.8%), Socket Mobile (SCKT, 418.4%), Mechanical Technology (MKTY, 188.2%), Medicure (OTCPK:MCUJF, about 18%), Paragon Technologies (OTCPK:PGNT, about 100%), TOR Minerals International (OTCPK:TORM, about 30%). Percentages are annualized returns. For stocks that have not been played out yet the percentages are estimates.

Of course, there were also US-traded nanocaps stocks that did not play out well: Highway Holdings (HIHO, -31.3%), Insignia Systems (ISIG, -27.8%), Continental Materials Corp (delisted with estimated annualized return -80.7%), Westell Technologies (OTCPK:WSTL, estimated return -6.4%), P&F Industries (PFIN, -22.6%) and JLM Couture (OTCPK:JLMC, -11.6%).

I estimate a 52.6% annualized return per position with 7 positions with a positive return and 6 positions with a negative return. This suggests investing in nanocaps is a good thing to do. On average these 13 US-traded nanocaps did much better than the annualized average return of about 40% for the 411 stocks I recommended. I think part of the returns can be attributed to the extremely good sentiment for US-traded stocks. We also saw the effect of this sentiment on major indexes like the Nasdaq (QQQ) and the S&P 500 (SP500).

Foreign nanocaps

I recommend investors who used to invest in dark nanocaps to switch to foreign nanocaps. There is less uncertainty and there are more of them. So it is easier to build a large portfolio of nanocaps than of small dark stocks. Below is a table of 40 nanocaps. Since the beginning of 2019 I recommended them and then moved to the Played Out stocks 1 or 2 years later:

Ticker Company name Country Annualized Return (%)
SIN:J03 Jadason Enterprises Limited PRC -40
WAR:LSI LSI Software S.A. Poland 35.3
TYO:7462 Daiya Tsusho Co Ltd Japan 208.5
TYO:7922 SANKO SANGYO CO., LTD. Japan -22.1
TYO:8891 MG HOME CO., LTD. Japan -17.1
HKG:60 Hong Kong Food Investment Holdings Ltd Hong Kong -32.1
LON:UVEL UniVision Engineering Limited UK -35.8
WAR:IZB Izoblok SA Poland 16.9
TYO:8225 Takachiho Co Ltd Japan -16.7
WAR:MXC MaxCom SA Poland 7.6
TYO:5284 Yamau Co Ltd Japan 66
LON:OCT Octagonal Plc UK -93.7
ASX:TCN Techniche Limited Australia 21.3
EPA:GIRO Signaux Girod SA France 46.9
TYO:3352 BUFFALO CO.LTD. Japan 23.1
TYO:7273 IKUYO CO., LTD. Japan 56.5
TYO:5610 Daiwa Heavy Industry Co., Ltd. Japan 47.8
TSE:HWO High Arctic Energy Services, Inc. Canada 148.4
FRA:AAH Ahlers AG Germany -3.3
TSE:AJX AgJunction Inc Canada 283
TYO:5458 TAKASAGO TEKKO K.K. Japan 2.1
WAR:PAT PATENTUS SA Poland 7.6
TYO:5285 YAMAX Corp. Japan 79.4
WAR:ODL Odlewnie Polskie S.A. Poland 19
TSE:MCB McCoy Global Inc Canada -1.7
SIN:5AB Trek 2000 International Ltd Singapore 25.8
HKG:389 China Tontine Wines Group Limited PRC -15.6
WAR:MON Monnari Trade SA Poland 91.5
WAR:APE APS Energia SA Poland 219.5
LON:NTQ Enteq Upstream PLC UK 79.9
LON:BLVN BowLeven PLC UK 71.8
TYO:7863 Hiraga Co Ltd Japan 68.8
WAR:DEL Delko SA Poland 50.4
LON:TRU Trufin PLC UK 536.2
TYO:7946 KOYOSHA INC. Japan 4.6
HKG:637 Lee Kee Holdings Limited PRC 55.4
LON:BISI Bisichi PLC UK 26.8
TYO:5753 Nippon Shindo Co Ltd Japan 13.2
WAR:NTT NTT System SA Poland 70.7
LON:RTC RTC Group plc UK 89.8
Average annualized return (%): 54.9

Source: own computations

As you can see the average return is similar to the return of my US-traded nanocaps. But what is much more important is the consistency is much better with only 9 losers among 40 stocks.

I have not computed the returns for the more than 70 foreign nanocaps I recommended that are not on my Played Out list yet. These stocks are not on my Played Out list because I recommended them less than 1 year ago or they were still cheap after 1 or 2 years. I have not computed the returns for these 70 stocks because I would need to estimate them which would take too much time.

A couple of the US-traded and foreign stocks were delisted or became otherwise untradable after I recommended them. Sometimes these stocks had still substantial value when they were delisted. In those cases, I have been very conservative in estimating the remaining value and therefore the return.

Final words

Since the beginning of 2019, both US-traded and foreign nanocaps have had great returns. There is no substantial return difference between my US-traded picks and my foreign picks. But there are far more good-looking foreign nanocaps than US-traded nanocaps and their returns are also much more consistent.

I do not know how well my results compare with those of investors in dark stocks. However, I would imagine it is much more difficult to trade dark stocks since they usually have a much lower average trading volume. So with dark stocks, obtaining good returns depends much more on trading skills than with nanocaps. Moreover, I think investing in dark stocks has always been riskier than investing in nanocaps because of less information for dark stocks.

Nanocaps have often low trading volume although trading volume is usually better than trading volume for dark stocks. Because there are so many nanocaps it is easy to invest hundreds of thousands of dollars in US-traded and foreign nanocaps. Therefore I think nanocaps are a great alternative for small investors, in particular former investors in US-traded dark stocks.

Similar to dark stocks the returns of nanocaps fluctuate with general market sentiment. See also this article by Mark Vonderwell: The excessive history of microcaps. One of the takeaways is that nanocap returns are much higher than the market during bull markets but underperform during bear markets. Long term, his equal-weight strategy produces excellent returns although much lower than the returns presented here.

What is different with my approach is that I do not pick just any nanocap. Instead, I select them using a quantitative algorithm comparing more than 2000 stocks twice a month. As a result, I pick nanocaps with properties predicting great returns such as nanocaps with low earnings multiples, low cash flow multiples, good financial strength, high payout, and low trading volume. As part of my analysis, I also skip those nanocaps with too many governance issues, too much financial distress, or when it turns out fundamental data is not correct.

Of course, success is not guaranteed with any strategy. The problem with successful investment strategies is that over time too many people will imitate them. That means investors will bid up such stocks causing returns to decrease. With nanocaps, this is much less of an issue since they are not investable for large, professional investors. In any case, I think my stock selection based on quantitative ranking and research should outperform an equal-weight nanocap strategy.

Looking for more stocks like this one? Subscribe to my newsletter Global Quant Edge on Seeking Alpha.

This article was written by

Ruerd Heeg profile picture
3.37K Followers
As a mathematician (Ph.D.) I use 7 quantitative strategies with statistically extremely high returns. I select these cheap companies with software comparing thousands of global stocks on value metrics, liquidity, quality metrics, and momentum. I focus on global nanocaps and net-nets. Check Turning Rough Stones: turningroughstones.substack.com

Disclosure: I/we have a beneficial long position in the shares of WSTL, PGNT either through stock ownership, options, or other derivatives. 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.

Additional disclosure: I also have small positions in Octagonal Plc, Techniche Limited, Patentus SA, McCoy Global, Monnari Trade, Medicure (traded in Canada).

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