Thinking of learning how to invest in micro-cap stocks but not sure they’re worth the gamble? Let me assure you: Some of the best, most diligent investors of all time started out investing in micro-caps.
Before investing in Coca-Cola (KO), Warren Buffett was famous for investing in micro-caps like Berkshire Hathaway and See’s Candy.
Legendary Fidelity portfolio manager Peter Lynch loved investing in tiny companies too. In his book, “One Up on Wall Street,” he writes:
“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. In certain markets they perform well, but you’ll get your biggest moves in smaller companies. You don’t buy stock in a giant such as Coca-Cola expecting to quadruple your money in two years. If you buy Coca-Cola at the right price, you might triple your money in six years, but you’re not going to hit the jackpot in two.
“If you find a stock with little or no institutional ownership, you’ve found a potential winner. Find a company that no analyst has ever visited, or that no analyst would admit to knowing about, and you’ve got a double winner. When I talk to a company that tells me the last analyst showed up three years ago, I can hardly contain my enthusiasm.”
3 Reasons to Invest in Micro-Cap Stocks
There are three main advantages to investing in micro-caps.
First, the historical performance has been incredible. Data is a little hard to come by because there are no indexes that adequately track micro-caps (most are too small to be included in the index). But from 1927 to 2016, the smallest decile of stocks in the U.S. ($114MM average market cap) has generated a compound annual return of 17.45%, according to the Center for Research in Security Prices. For context, the second smallest decile generated a CAGR of 12.5%, while the largest decile generated CAGR of 9.2%.
Second, their business models are simpler and easier to understand. Most micro-cap companies have one business line. Further, it’s usually easy to get management on the phone to run through questions that come up during your diligence process.
Third, it’s one of the last areas of the market where it’s possible to develop an informational advantage. With most stocks, prices adjust instantaneously for breaking news, whether negative or positive. Hundreds of highly paid buy side and sell side analysts are scouring financials and press releases to profit from the latest news. At the same time, high frequency traders are making thousands of trades per day profiting from tiny market anomalies.
In the micro-cap world, there are no institutional investors or high frequency traders.
A company may release a positive press release, and its share price won’t react for a day or two. You may be the only investor at the company’s annual meeting or the only attendee on its quarterly conference call.
This allows you to develop an informational edge.
How to Invest in Micro-Cap Stocks
When I evaluate micro-caps, my initial check list includes three key factors:
- A cheap valuation
- High momentum
- Low liquidity
It can be extremely profitable to invest in growth companies as any Tesla (TSLA) or Amazon (AMZN) shareholder will tell you.
But it is also easy to get burned when growth slows, especially if the stock is trading at a nosebleed valuation. In the micro-cap world, you can invest in growth companies at value prices. And the data suggests that it can be very profitable.
O’Shaunnessy Asset Management found that the smallest, cheapest stocks generated annual excess returns of 28.2% from 1982-2016 as compared to the smallest, most expensive stocks.
The next important thing to focus on is momentum, both in the operations of the business as well as in the stock price. If you invest in a cheap stock with weak operational trends and a downward sloping stock chart, odds are it will be a value trap.
From 1982-2016, high momentum micro-cap stocks generated average annual excess returns of 23.9% versus low momentum stocks. Don’t be afraid to by a stock at an all-time high!
The final factor to look into is liquidity. Generally, the more illiquid the stock, the better it will perform. Over the same 1982-2016 time period, the most illiquid micro-cap stocks generated average annual excess returns of 18.4% versus their high liquidity counterparts.
If you think you have found an attractive micro-cap stock but it has 100 million shares outstanding or, even worse, a billion shares outstanding, odds are it won’t be a profitable investment.
One final thing to note.
If you decide to invest in micro-cap stocks, make sure to use limits when buying.
If you place a market order, make sure to use a limit order. If you place a market order, you could spike the stock price by 50% or more all by yourself!
Further, build your position gradually. If you want to buy 1,000 shares of a micro-cap, buy 300 shares first before adding more. This will ensure the price doesn’t spike before you are able to build your position.
Want more help building a micro-cap portfolio?
Join Cabot Micro-Cap Insider. I will hold your hand as you build a micro-cap portfolio.
My current open recommendation list includes 13 micro-cap recommendations, and I publish a new idea every month.
My average micro-cap recommendation is up 59% since our service launched in April 2020. This performance includes both winners and losers (there have been two losers out of 15 total recommendations). Click here to learn more.
Regardless, if you do decide to invest in micro-caps, just remember that Warren Buffett and Peter Lynch would approve.