The original article was written by Bryan Shealy.
Have you ever heard of a microcap stock? It's even tinier than a small cap!
These are some of the smallest stocks in the entire universe of stocks. Microcap stocks have less than $50 million in market capitalization. They can offer amazing returns but are also known to be some of the riskiest stocks in the market. However, are they really any riskier than large cap stocks?
Two investor types to avoid
Almost everyone I know exclusively invests in either large cap stocks or index fund ETFs. They want to be able to “set it and forget it” and not worry too much about the risk associated with their investment. Some of my more “interesting” friends also like to invest in the hot up-and-coming stocks. It just makes for great conversation. Right…?
What do both of these investor types have in common? They both are trying to increase their wealth. One may be willing to increase it with more risk, while the other just wants a steady return with less risk. I don’t like either of these methods. At the risk of losing friends, I would rather have less risk and greater returns — and yes, it's possible.
To examine this possibility, we need to answer a few questions.
- Can the smart money invest in these stocks?
- Do you have the tools to compete?
- Is the company cheap for a reason?
What is smart money?
Essentially, smart money is the hedge funds. Large hedge funds or investment companies just cannot invest in microcap stocks with any meaningful returns — even if they were to buy the entire company and it did well, the impact on the overall portfolio would be extremely small. Small investors, on the other hand, can get their money in and out reasonably easily. Even a small position in the company would have a sizable impact on your portfolio. Most likely, you will just have to put up with some small liquidity issues.
Investing should be just that — an investment. Your time horizon should not be so short that your ability to cash out becomes dependent on emergency situations or a short-term payout. For any reasonable microcap, you should be able to cash out easily within a month. This is a relatively short time frame, and if you need the cash within a day, then you should set aside a small portion of cash for emergencies, not tied up in the stock market.
Why invest in small cap microcap stocks
Earlier, I explained why large hedge funds cannot invest in these small companies, so if they can’t, why would anyone want to? One reason is because they are incredibly cheap! You can even get paid to take over the company!
Many small retail investors enjoy investing in large cap stocks. Like our friend above, these stocks are often flashier and more fun to talk about. However, my friend is competing against the best of the best. I’m talking about teams of data analysts whose sole purpose is to scour the internet and study charts, and they are paid hundreds of thousands of dollars for this task. Even if you had the knowledge, there is no way the average Joe could compete with such a capital intensive process. The good news is you don’t have to with microcaps.
Tweedy and Browne published a study titled, “What Has Worked in Investing.” In this study, they clearly explain why small and nano cap companies outperform:
“Most publicly traded companies are small in terms of their market capitalization. Furthermore, these companies are often associated with higher rates of growth and may, due to their size, be more easily acquired by other corporations.”
There you have it — not only are small cap stocks more have higher rates of growth, but they are also takeover targets! Even better for small deep value investors is that microcap stocks are under-researched because of their unattractiveness to large funds. This leaves a large unfilled gap for less sophisticated investors. Not only is it easier to invest in a less sophisticated arena, but these companies also offer great advantages for quick and outsized returns.
Low book value and small cap stocks
Tweedy and Browne’s published study also offers a rigorous analysis of low book value and smaller capitalization stocks. Again and again, their results showed that smaller capitalization stocks systematically outperformed large capitalization stocks.
Small retail investors should use this knowledge to their advantage. Both Ben Graham and Tweedy and Browne have proven that small capitalization and deep value are important for outsized returns.
While small corporations — and even microcaps — can offer extraordinary returns, it's also important to note how a deep value investor can decrease risk and increase returns.
Companies become cheap for a reason, and it’s important to figure out why they became cheap or if there is any current risk with investing in them. For microcaps, it's important they maintain cash flow and have as little debt as possible. The reasons these are crucial are twofold — it decreases bankruptcy risk and increases the chance of share buybacks.
So, debt is bad. What else should you know about microcap stocks?
It's also important that the stock price is below the book value of the stock. Microcaps with low book values consistently outperform large caps; however, this was not necessarily true for low PE stocks.
Also, make sure the companies are consistently producing a profit. This is especially true for resource exploration companies and R&D companies. These types of companies have large amounts of cash but just burn through it without increasing shareholder value. Avoid these companies!
So, you ask, why can’t I just invest in a microcap index fund or ETF? Sadly, these funds can often be small cap or microcap in name only. These funds can’t easily invest in companies with less than $50 million in market cap with any meaningful returns. As a result, these funds often don’t have enough microcap stocks in them to even be considered small cap funds. They simply have too much money to make it worth their while to own true microcap stocks.
Conclusion
I can’t stress enough how important it is to come to the realization that larger companies are not inherently better. Everything is based on price, and when you are David competing with Goliath, it’s best to find the weakness in your opponent. In this case, it’s size. Just like Goliath, hedge funds cannot move swiftly enough to capture outsized returns and can’t hit small companies with the accuracy or precision that David can.
Read next: How Do Distressed Debt Investors Make Money?
