It has been well established that micro-cap stocks have some unique advantages over larger companies: namely relative obscurity and a lower base allowing for higher growth potential. However, those advantages come at a cost - micro-caps are obviously considerably riskier than larger companies. A lot of micro-caps have a great story to tell, just ask their CEOs, but I am more interested in performance and financial health. So I have created the following checklist to assist in quickly weeding out the micro-caps that are too risky from the ones worth looking into further.
For clarification purposes, I consider companies with a market cap below $500 million to be a micro-cap. In the checklist, some steps call for outright dismissal of the company if it fails to meet the criteria. I dismiss immediately because those companies on average are far too risky for their size plus there are plenty of other more promising opportunities that deserve your time.
1. Check to see if stockholder's equity is positive. If it is negative, dismiss the company outright and move on. Negative stockholder’s equity means that liabilities exceed assets, and, for a small company, that position is often untenable and can stunt and ultimately destroy the company’s growth opportunity. If stockholder's equity is positive, then look to see if it has been increasing and, if so, if it is due to organic growth or frequent new equity offerings. Organic growth is obviously preferable. Frequent new equity offerings often means the company does not generate sufficient cash organically to fund operations and is likely to continue offering new equity in the future, thereby continuously diluting existing shareholders.
2. Check to see if the current ratio is at least 1.0. If it is below 1.0, then look at the make-up of current assets and liabilities. If deferred revenue is present in current liabilities, then that is not representative of a future cash outlay and can be backed out. If the remaining current ratio is still slightly below 1 after adjustments, then you will need to more carefully consider the remaining steps. If the adjusted current ratio is significantly below 1, then this represents a serious going concern issue and the company should be dismissed outright.
3. Check to see if revenue and gross profit have increased over the periods presented and if they have increased in tandem. Increasing revenue paired with decreasing gross margin can either be indicative of short-term input cost pressures that have not been passed on yet or may be an indication of the company’s lack of pricing power. If revenue has increased while gross margin declined, then you will need to more carefully consider the other steps. Further, when analyzing the company more fully after it passes this checklist, you will need to understand why revenue and gross profit did not increase over time.
4. Check to see if SG&A expenses outpaced revenue growth. If they have, it might be a sign of either poor cost controls or management's interests not being aligned with shareholders. Higher payroll costs as a percentage of revenue are of particular importance because non-shareholder friendly management often has a “pay me first” mentality. When SG&A grows significantly faster than revenue for a few years, I am usually reluctant to continue further analysis.
5. Finally, check to see if FCF is positive or trending positive. If FCF is negative, is it because the company increased working capital or because the company lost money on ongoing operations? Increases in working capital are usually recovered or, at the very least, lead to higher cash flow generation. Conversely, lost money on ongoing operations is generally not recovered. Therefore, an increase in working capital causing negative FCF might still be acceptable. The alternative is not.
Those are my five steps for quickly analyzing a small company to determine if it is worth further analysis. The above list may cause me to miss out on some great companies, but far more often than not, it will prevent me from wasting time on what will ultimately be a poor investment.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.