The Case for Microcaps: A Niche Worth Exploring
“All failed companies are the same: they failed to escape competition” ~ Peter Thiel
To Peter Thiel, noted venture capital and co-founder of PayPal and Palantir, the less competition, the better. Most investors would likely agree with this sentiment. The best companies operate in inefficient niches with high barriers to entry, limited competition, and preferably incompetent competitors.
The irony is that many investors, themselves, do not follow these beliefs. Large cap investors face incredible competition – hedge funds, sell-side analysts, high-frequency traders – all vying for the same small amount of alpha. The individual investor is simply at a stark disadvantage to these high-powered institutions.
What if we told you that there was a niche of the market, unexplored – in fact, incapable of being explored by these big-name institutions – where there are no multi-billion-dollar hedge funds and where, by definition, every successful investor eventually leaves?
Our focus and our lifeblood is investing in microcaps: companies with market caps under $300 million. This allows us to do the opposite of what the “Wall Street crowd” is doing. We firmly believe that interest in the microcap space will pick up significantly as a result of the recent volatility we are seeing in the broader markets. While the media tells investors to fear smaller companies, we make examining them easy, monitoring clues like insider buying and company share structures to help weed out the quality names from the bad actors.
Microcaps can give investors many of the same competitive advantages that make companies great. In a 2017 ValueWalk article, GeoInvesting founder Maj Soueidan outlines the main structural advantages of microcaps. We encourage you to read the article for more specific advantages of the space, but here is the system at play in a nutshell:
Multi-billion dollar institutions face many barriers to entry to investing in microcaps, because they simply have too much capital to build meaningful positions in microcap companies. Further, the negative stigma surrounding “penny stocks” causes even many qualified investors to ignore the space.
Much like with large moat companies, these barriers to entry insulate microcaps from the typical market gyrations. In a bear market, all large caps tend to fall in tandem because large funds and ETFs dump their holdings indiscriminately alongside redemptions; microcaps don’t face the same risks because they don’t have any of these funds invested in them.
This then leads to limited competition, which allows smart individual investors to dominate the niche, and gives them unique resources, such as the ability to interview management teams, attend conferences, etc. In a given year, there are over a dozen high quality microcap conferences to attend, for investors to network, interview management teams, and identify great investments.
Less competition also contributes to a first mover advantage, as microcap investors can essentially front-run institutions to invest in the next great companies. In Geo’s experience, we usually end up selling our fully-grown multi-baggers to incoming “big money”, which aggressively bids prices upwards once a stock grows to their size requirement.
Limited competition also creates more inefficiency (and correspondingly more return potential), simply because there aren’t high-powered institutions trying to value every stock down to the penny. This paper by O’Shaughnessy Asset Management outlines the dynamic by which lack of institutional participation contributes to inefficiencies in the microcap space.
Lastly, it logically follows that the best investors in the space generate such high returns that they inevitably grow to become too big for the niche, leading to (generally) less competent competition in the space.
These competitive advantages are the exact traits that have created the biggest company success stories ever. Most small individual investors would love to find these traits in a stock at a reasonable valuation, but likely don’t realize that the ability for them to compete in a space with the dynamics described above is readily available in microcaps.
There is opportunity here not only for achieving great returns, but also for learning, collaborating, and experiencing the industry. The good thing is that you can still use microcap “hunting” strategies to quickly identify opportunities in bigcap stocks when they arise.