When people talk about the stock market, you will often hear them quote the S&P 500 and the Dow Jones Industrial Average. These are two large indexes that account for many of the largest companies in the United States (and for that matter, the world). But while investing in these stable indexes typically perform well (averaging about 10 percent annualized ROI), they are really just the tip of the much larger investment iceberg and ignore the microcap market.
Microcap stocks are stocks that have a market capitalization between 50 million USD and 300 million USD. These companies are a bit larger than nanocap stocks (microcap less than 50 million USD), but smaller than other publicly traded companies, including all the companies appearing on the major indexes mentioned above.
Microcap stocks are smaller, meaning they are typically experiencing the “growth stage” of the business cycle. Accordingly, they often have very high potential for growth. Investors that are able to identify the right microcap stock selections can earn significantly higher returns than they’d be able to find in the more “popular” parts of the stock market.
With a high potential for returns, you will also be exposed to increased risk. Microcap investing can be incredibly lucrative, but you will certainly need to know what you’re doing.
Below, we will discuss some of the most important things you need to know about microcap investing.
A Value-Driven Approach
Benjamin Graham, the author of the Intelligent Investor (Warren Buffett’s favorite book) once famously quipped “Buy not on optimism, but on arithmetic.” Essentially, Graham’s time-tested approach to investing involves carefully looking at the numbers and fully understanding what you’re purchasing.
A good investment, whether in microcap stocks or anywhere else, is one that could be justified by much more than a “good feeling.” As Graham also stated, “You must never delude yourself into thinking that you’re investing when you’re speculating.”
Ideally, investors will seek to identify assets that are underpriced in the status quo. To find profitable microcap stocks, you will not only need to know what the stock currently costs—anyone with an internet connection can figure that out—but also determine what the “correct” price ought to be.
When considering a prospective investment, begin by asking yourself, “How does this company create value?” If you can’t answer this question, you probably shouldn’t invest. But if you can clearly recognize the value the company provides, it is time to take a closer look at the business’s current financial status.
Selecting Microcap Stocks: Key Things to Look For
If a company is publicly traded—whether on the NASDAQ, NYSE, or any other exchange—it will be required to disclose some basic financial information to the public. Taking the time to review this information can help you determine which stocks are most likely to be underpriced in the status quo.
Some of the most important things to keep in mind include:
- Revenue Growth: ultimately, revenue is what makes all other components of running a business possible. Companies that are in the early growth stage need to generate continual revenue growth—especially if they are accruing negative profit. Ideally, revenue growth will be at least 20 percent per year (with many exceptions). Comparing the company’s revenue to others in the industry can also help you determine if the stock is overperforming or underperforming.
- Profit Potential: though many microcap companies are not yet profitable, they need to be at least moving in a direction where profitability will someday come to fruition. Profit is generated by adding and accumulating value over time. If the company is not profitable, take time to think about what would need to happen in order for this to change. Looking at broader financials, including EBITDA, free cash flow (FCF), and cash in hand can help you get a broader picture.
- Total Addressable Market (TAM): for revenue and profit to grow, the company will need to find new (and many) people to sell to. The total addressable market suggests how many potential buyers currently exist. For consumer goods, the TAM could be in the hundreds of millions. For other products (like aircraft), the TAM will be much smaller. Regardless, this key figure is a great way to gain long-term growth potential.
Of course, these are a few of the things that microcap investors will take into consideration. For each prospective investment option, you should be able to answer the following questions.
- Why do I believe the asset is underpriced in the status quo?
- What changes would need to occur for the stock’s value to increase in the future?
- Are these changes likely to occur? If yes, why has the broader market not yet identified this opportunity for growth?
- Do the company’s financials, ideas, and infrastructure chart a path towards a profitable future?
While there is no way to completely eliminate the risk of investing, taking the time to do your homework can help get your exposure to risk under control. With practice, investing in microcap stocks can help you significantly improve your ROI.
Finding Value in Microcap Stocks
Though the big indexes, such as the S&P 500 or Dow Jones Industrial Average, attract a lot of investors’ limited attention, these mainstays represent just one part of the broader investing world. For those that are willing to do more research and take some additional risks, the world of microcap investing can be extremely lucrative.
In fact, historically, micro-cap stocks have significantly outperformed their large-cap counterparts. Microcap stocks—which we will loosely define as stocks with a market cap between 50 million and 300 million—have outperformed large-cap stocks the vast majority of years since 1936.
During the past 84 years, there have only been about 20 where microcap stocks underperformed. About half of these years were in the 1990s, where heavily investing in mid-cap tech funds was ubiquitous and, consequently, created a bit of a larger-cap bubble. Still, the historical performance of microcaps is without a doubt impressive. Since 1926, microcaps have yielded an annualized return of more than 16 percent. In some years, like 1985, microcaps outperformed larger stocks by as much as 15 percent.
Lately, the microcap market has experienced more remarkable growth. As stated in one recent white paper, “Microcap investing offers compelling returns for the long-term investor well in excess of large-cap returns because microcap are an underfollowed and less efficient asset class.” The paper then states, “Many of these companies take an entrepreneurial and dynamic approach to managing and growing their business.”
With the right investment strategy—and the right information in hand—both amateur and experienced investors can enjoy the impressive price swings found throughout the broader microcap market.
Reward and Risk of Microcap Stocks
Before investing in any microcap stock, it is important to realize that these stocks are fundamentally different from their large-cap competitors. With limited size, these stocks cannot operate via the same economy of scale—this creates structural inefficiencies, but because these efficiencies are effectively “built-in” to the existing price, a situation arises in which many microcaps are “incorrectly” valued.
As a result, countless microcaps possess the potential to experience a significant price swing in a short amount of time. As stated by Ian Cassel, “Exposure to micro-caps can further boost potential returns, augment diversification through non-correlated performance and deliver many of the benefits of private equity and venture capital within a liquid vehicle.”
Microcaps’ structurally limited capacities creates a situation where dramatic price swings are likely. Of course, many of these stocks will end up losing value, which is why having a diversified portfolio remains important. But even still, the historic record continues to demonstrate that investing in microcaps is a measurably more reliable investment than investing in large-cap stocks. Not only have these stocks outperformed large-cap stocks about 3 out of every 4 years, but their potential upside (15 percent overperformance) has been notably larger than their potential downside (5 percent underperformance).
Some investors might be wary to buy stocks they know very little about, something that is not uncommon in the microcap sector. But for these investors, lack of coverage is not necessarily a bad thing—in fact, lack of coverage and publicity combine to keep many of these stocks “flying under the radar” and remaining underpriced in the status quo.
Finding the Right Investment
To enjoy the general growth of the microcap sector, you may want to consider taking a highly diversified position. These help reduce asset-specific risk that is attached to any given stock. One of the best ways for traders to increase their diversification is to invest in a microcap index fund, such as the Russell Microcap Index (this position is often paired with the small-cap Russell 2000 Index). But beyond basic index diversification, actively selecting specific stocks can also yield tremendous returns.
Microcap stocks have been described as being “among the investment world’s worst-kept secrets.” The same experts at Altair Advisers claim, “We believe their risk has been exaggerated and their potential rewards overlooked.”
Ultimately, success in this competitive yet overlooked sector depends on one’s ability to find which stocks are currently mispriced. Naturally, this is easier said than done. Most investors will start their comparative process by taking a look at the microcap’s financials, namely, revenue growth, total addressable market, and profit potential.
From there, a closer look at the stock’s ongoing coverage can also be beneficial. As suggested, many microcaps tend to fly under the radar. When a microcap stock is pushed into the public spotlight, its dynamic value can change incredibly quickly.
Nowhere was the potential for microcap stocks made more evident than the recent GameStop (GME) rally that occurred in late January (2021). Through public forums and mass exposure, the stock’s value rallied “out of nowhere”, jumping in value from approximately 20 dollars per share to over 400 dollars per share.
While microcap rallies will not always be this dramatic, the nearly unrivaled potential for growth is widespread. By paying close attention to this underappreciated sector and taking the time to understand what drives these changes in values, investors can distinguish the “makers” from the “fakers” and enjoy incredible returns.
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