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What Are Micro-Cap Stocks? [A Beginners Guide]

The answer to the question “what are micro-cap stocks?” is simple, but what’s more important is why they belong in investors’ portfolios.

micro-cap-profit

Let’s start with the basics. What are micro-cap stocks?

It is a publicly traded company with a market capitalization of less than $500 million.

You can calculate a company’s market capitalization by multiplying its share price by the number of shares outstanding.

Or you can go to Yahoo Finance and market capitalization will be calculated for you.

Now let’s move on to a more interesting question:

Why are micro-cap stocks interesting?

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  • Performance

It starts with performance – actually, outperformance to be more specific.
Like any good fisherman knows, you want to go to where the fish are.

From 1927 to 2016, the smallest decile of stocks in the U.S. generated a 17.5% compound annual return, versus 9.2% for the largest decile of stocks.

Peter Lynch, famed Fidelity portfolio manager, once wrote, “The size of a company has a great deal to do with what you can expect to get out of the stock. How big is this company in which you’ve taken an interest? Specific products aside, big companies don’t have big stock moves.”

The most famous investor of them all, Warren Buffett, started investing in micro-caps.

Berkshire Hathaway was a micro-cap at the time of Buffett’s initial investment!

Buffett no longer invests in micro-caps because it wouldn’t move the needle for him. With Berkshire’s billions of cash to deploy, he must go “elephant hunting” to deploy that cash.

Beyond excellent historical returns, there are several other reasons you should invest in micro-cap stocks.

  • Less competition

Almost all professional investors are prohibited from investing in micro-caps because they are too small. Therefore, there is less competition. Even better, the best micro-cap investors eventually attract so much capital that they are forced to move on to bigger stocks. Famous investors, Warren Buffett, Peter Lynch, and Joel Greenblatt all started as micro-cap investors but eventually were forced to seek bigger opportunities.

  • Simple business models

Micro-caps typically only have one line of business, and so they are easy to understand and analyze.

  • Management access

If you want to talk to Apple’s CEO, Tim Cook, good luck getting him on the phone.
But most micro-cap management teams are eager to spend time on the phone with prospective investors.

Just pick up the phone and give them a call!

How I Invest in Micro-Cap Stocks

When evaluating micro-caps, I’m looking for companies with 1) substantial growth, 2) conservative balance sheets, and 3) inexpensive valuations.

These criteria seem mutually exclusive, right?

Usually, you have to choose between buying slow-growth, boring companies, that are trading at cheap multiplies, and fast-growing, expensive companies

As a value investor, you can’t own exciting companies like Tesla (TSLA) because they trade at sky-high P/E multiples.

In micro-cap land, it’s a different story.

Just look at Zedge (ZDGE), a recent Cabot Micro-Cap Insider recommendation. The business is growing like crazy (+41% in the most recent quarter) and generated gobs of cash. Insiders own a significant stake in the business. Yet the stock is trading at a price to free cash flow multiple of 4.0x. Zedge’s price is truly dislocated from its fundamentals.

You won’t find opportunities like this in the large-cap world.

All right, now let’s discuss a framework for thinking about micro-cap portfolio allocation.

Micro-Cap Portfolio Allocation

Everyone’s situation is different, but I think most investors would be wise to invest at least a portion of their equity allocation in micro-caps, given the higher return potential.

A good way to start investing in micro-caps is to buy a small position in a single micro-cap stock and see how you like it. Your initial position will likely be more volatile than the overall market. Pay attention to how the elevated volatility makes you feel. Does it give you a stomachache? Then micro-cap investing probably isn’t for you.

But if you can stomach the volatility, buy another micro-cap and continually build out your micro-cap portfolio slowly over time.

In terms of a total allocation to micro-caps, I think 5% to 20% is reasonable for most people. Personally, my portfolio is heavily weighted to micro-caps (50%+) but that’s just because I’m comfortable with the volatility and have a long time horizon.

At Cabot Micro-Cap Insider, we focus exclusively on identifying high-potential micro-caps.

It’s a lot of fun and historically has been very lucrative. The average return among my recommendations is 25%.

To invest in micro-caps, and to gain an edge on the big money managers and hedge funds with me, click here.

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Rich is a trained economist and Chartered Financial Analyst (CFA). He has researched and invested in stocks for more than 20 years and has become a recognized expert in micro-cap stock investing. He started his career at investment advisory firm Eaton Vance where he covered a wide range of sectors including software and internet, financials, and health care.