The most common question that I get is the following: “How much of my portfolio should be allocated to micro-cap stocks?”
It’s a very personal question and one that I can’t answer definitively. After all, everyone’s personal financial situation and risk tolerance is different.
Therefore, I can’t provide an overarching recommendation that would work for everyone.
However, I can share how I think about a micro-cap allocation.
But before I do, let’s take a step back and cover the case for micro-caps.
The Case for Micro-Cap Stocks
It won’t come as a surprise to you that my favorite niche is micro-caps. It starts with performance – actually, outperformance to be more specific.
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.”
Like any good fisherman knows, you want to go to where the fish are.
But 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 multiples 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 Inc. (ZDGE), a recent recommendation in my Cabot Micro-Cap Insider advisory. The business is growing like crazy (+30% 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 P/E of 9.9x. Zedge’s price is truly dislocated from its fundamentals.
You won’t find opportunities like this in the large-cap world.
Alright, 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 of 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 stomach ache? 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-cap stocks (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 the 15 micro-cap stocks currently on my recommendation list is 53%!