Big returns can come in small packages. That’s certainly the case with investing in a micro-cap, the term used to refer to a publicly-traded company with a market capitalization between $50 million and $300 million. Why should you care about these companies? To begin with, the smallest subset of micro-cap stocks have been shown to outperform larger stocks by 14.75% (1927 to 2016). We are surrounded by companies in our daily lives that were once micro-cap stocks like Walmart Inc. (NYSE:WMT) and Monster Beverage Corporation (NASDAQ:MNST). In fact, Monster Beverage has been the best performing stock of this century, up nearly 70,000% at its high.
Here’s a few quick things you need to know about the micro-cap investing advantage, along with some of the risks.
The Pros of Investing in Micro-Cap Stocks
There are numerous reasons that we like investing in micro-cap stocks.
Here are just a few:
Less competition for ideas might be the biggest reason we like investing in micro-cap stocks. Just like in any aspect of life, less competition gives you a first mover advantage. Imagine a playing field where some of the brightest people cannot compete with you due to company restrictions! That’s what the micro-cap universe offers you. That is because most Wall Street institutions cannot invest in micro-caps, or just refuse to invest in them.
Furthermore, the financial medial spreads negative stereotypes about investing in micro-cap stocks that are simply false, scaring investors away. Finally, the 2008 stock market crash permanently removed many individual micro-cap investors from the equation. This means that so much incredibly valuable publicly available information that no one looks at is waiting to be found. We spend our time searching for this information to buy stocks early, knowing that one day other investors will eventually find them too.
Even better, institutional investors will be allowed to buy these stocks after they have risen to a market-cap where they are permitted to invest in them.
A Wide Range of Options
There are more of these small companies than you might think – around 10,000 in North America. In fact, small companies make up 45% of the U.S. GDP. That gives you ample room to diversify your portfolio without having to move outside the realm of micro-cap investing. However, the number of micro-cap stocks available to invest in can also allow you to sprinkle some higher growth opportunities around a core strategy focused on investing in larger companies.
Dividends and Growth
Did you know that over 500 micro-cap companies pay dividends? This allows you to earn income while you wait for a dividend stock to rise in price as it grows its sales and earnings. This compares to larger companies that pay dividends that may just find it harder to grow because they are just too big to experience above average growth. We like to look for dividend paying stocks that are reaching a growth inflection point in sales and earning by applying a concept we call GPR, or GeoInvesting Power Ranking.
The GPR ranks stocks by the number of consecutive quarters of growth in sales and earnings that we expect a company to achieve. The higher the GPR, the more confident we become that a micro-cap stock can achieve returns that beat the market if our financial analysis leads us to believe that the stock is undervalued. However, the stock must meet our tier one quality standards for consideration as a potential buy. Tier one characteristics include things such as:
- Minimum sales and profitability thresholds
- Manageable debt level
- Management owns a minimum amount of their stock
- Proven management
The Cons of Micro-Cap Investing
Of course, there are drawbacks to every kind of investment. And anyone who tries to convince you otherwise isn’t being honest. Here are two risks you’ll need to consider when investing in micro-caps:
More Volatility in the Market
Small stocks can be illiquid and experience extreme volatility in their price per share. So, when markets are crashing or if a micro-cap stock you own issues bad news, you could be in for a wild ride. Now, don’t confuse volatility “price” risk with business risk. Business risk has to do with a company’s operations, industry, debt levels and management’s ability to execute growth strategies. In the end, we actually welcome price volatility. We are always on the lookout to buy stocks that fall due to market dynamics, where the drop in price has nothing to do with the changes in a company’s business risk profile or growth outlook.
Pump and Dump Schemes and Fraud
We can’t deny that certain micro-cap stocks will be prone to pump and dump schemes. But these usually occur with low quality startup companies with little revenue or modest operations. That is why we primarily focus on investing in tier one quality micro-cap stocks. Let’s also not forget that large billion dollar companies like Enron have orchestrated some of the biggest fraudulent investment schemes.
The key lesson is that it’s important to perform thorough research on stocks of interest. You can subscribe to research services you trust with a proven track record of investing in quality companies and avoiding scams. Actually, since 2007, Geoinvesting has actually played a big role in protecting investors by exposing fraudulent companies.
You can read more about why we like micro-caps here.
Article updated 7/14/2020 to reflect more current and relevant links and discussion