Micro-Caps: The Toxic Waste Dilemma
Smoldering ashes float gently with the peacefulness of snow above the aftermath of another slew of SEC regulatory meetings. Micro-cap companies have become the Toxic Waste of Wall Street; hated by large institutions, shunned by Investment Advisors and singled out by FINRA. Most large firms refuse to hold, let alone trade them and FINRA sets in from the other side interrogating advisors who have clients invested in them. Micro-caps have become the toxic waste of the industry. How can that be so when 68% of all public companies are micro-cap companies?
Micro-caps are defined as companies with market caps of less than $300 million; nano-caps are companies with under $50 in market cap. While these small companies dominate the public company space, they only represent 2% of the total public company market value. To put it in perspective, the entire universe of micro-cap companies is about the size of Google (NASDAQ: GOOG) Thus comes the argument: “Why should I invest in a mico-cap company when I can just buy Google?”
The case for small cap company investments sits on two fronts: the strength of the US dollar and in their under-representation in portfolios. Historically speaking, small cap stocks rise with the strength of the dollar, representing a stronger economy. And small cap stocks, like large caps have their own cycle. We are currently nearly the end of an 8-year cycle which prompts taking another look at small caps.
Another trigger is the strength of the economy and the dollar which often brings an increased appetite for risk to small caps. Small companies are more likely to have a domestic market for their goods and services which can thrive in an economic uptrend. A strong economy and dollar brings more local spending rather than looking for steep discounts overseas. This bodes well for micro-cap companies to increase their revenues and shareholder value.
While the entire space for microcaps is about $300 billion, approximately $100 billion or 1/3rd of it is still in the hands of company founders. This leaves about $200 billion available to the investing public.
Small companies can be purchased at a steep discount to intrinsic value if you are willing to hold for the long-term. Because micro-caps are off the radar of Wall Street, they don’t correlate with the overall market or larger stocks. Adding micro-caps to a portfolio can produce surprising results from better returns to decreased volatility. Illiquidity can be an advantage because investors avoid thinly traded stocks. This creates a value-gap where bargain prices can produce excess returns. Taking a steep value approach can increase the out-performance and some of the traditional perceived negatives and can actually benefit long-term investors. So what should the investing public be looking for? In essence, what separates the wheat from the chaff?
In a nutshell, rule number one is to take the road less traveled, moving away from mainstream and micro-haters. Look for newsletters and research that focuses on uncovering stocks off the wall street radar. Track fund managers who are successful and when doing your own research, look at the burn-rate, and cash consumption of a company summarized by cash-on-hand and the 12-month operating costs. In the global landscape, look for small companies trying to solve big problems. Observe trading volume which becomes very relevant; when volume is low, the spread gets wider between the bid and the ask, reducing net profits for the investor. And finally, use resources to track insider behavior and filings. Their filing requirements offer insight on what their plans are for the company at large.
As the saying goes, some people’s garbage is another’s treasure. Just be careful where you shop!