Most investors are familiar with large cap, mid-cap and small cap stocks. But probably a lot fewer are familiar with micro cap companies, or the fact that they can make you very wealthy over time. Micro cap companies are even smaller than small cap companies, and that’s also why they have greater potential to make you wealthy.
What is a Micro Cap Company?
Micro cap companies are publicly traded companies that have a market capitalization (total market value of all outstanding stock) of between $50 million and $300 million. They typically trade on Over-the-Counter (OTC) systems, and appear on the OTC Bulletin Board (OTCBB) or OTC Link LLC (OTC Link). Stocks with a market capitalization of less than $50 million are generally referred to as nano caps.
As a general rule, the larger the capitalization of the company is, the less risky the stock is considered to be. That would imply that micro cap companies carry more risk than the larger cap companies, which is generally true. But since risk and reward are traveling companions in the investment universe, that also means that micro cap companies have greater potential returns.
This is not to confuse micro cap stocks with penny stocks. The small size of the company does not mean that stock price trades at a low level. It is simply a description of a company with a relatively small market capitalization.
Why Micro Caps Stocks Can Make You Very Wealthy
Since micro cap stocks are generally new companies, engaged primarily in a single business, they have the potential to grow dramatically. But there are other factors that can contribute to their potential to make you wealthy.
Micro caps are often undiscovered by “the herd”. Once a stock has been discovered by the mainstream, its performance becomes more predictable and more measured. Micro cap stocks are generally unknown by the mainstream investment community, which means they have great potential to skyrocket once they have been discovered. It’s a matter of getting in line before the company becomes common knowledge and draws the crowds – otherwise known as ground floor opportunities.
Many have unique and innovative products. Many (but not all) micro cap companies have new and exciting products or services. As those lines grow in acceptance and desirability, the company can begin a rapid growth cycle that can cause the stock price to take off.
They could be the next Microsoft or Apple. Somewhere out there are small companies that will one day become the next Microsoft or Apple. If you happen to find an invest in one of these companies, you can ride the elevator up for a very long time.
They can be strong take-over targets. Once a company is recognized by the investment community, it may become a takeover target, either because they have important technology that a larger company wants, or because the larger competitor wants to buy them out and make them go away. Their small size makes them particularly vulnerable to a takeover – and that can be good for you as an investor.
Individual Stock Selection is Everything When it Comes to Microcaps
The small size, and newness of these companies makes them more vulnerable to failure. In fact, as measured by the Russell Microcap Index, the sector has actually underperformed the general stock market.
The annualized 10 year (through January 31, 2015) return on the Russell Microcap Index is 5.94%. It lags significantly behind the broader Russell 3000 index, which has an average annualized return of 7.93% over the same time frame. The S&P 500 index has returned 7.713% over the same period of time, when dividends are reinvested.
This hardly means that micro cap stocks are a poor investment. Quite the opposite, strong performers in the sector can explode in price. But based on the index alone, the number of failures in the sector sees it lagging behind the general market.
This makes stock selection critical when it comes to micro cap stocks. You need to choose companies that have unique and desirable product lines, strong management, good financial management, and a high relevancy to their specific market niche.
Micro Caps Can Add Real Diversification to Your Portfolio
Interestingly, micro cap stocks can actually provide a solid diversification within your portfolio. The reason for this is that the sector often moves independently of the general market.
For the five years ended on September 27, 2012, micro caps as measured by the Russell Microcap Index registered a 12.18% gain, compared to a -5.74% (loss) in the S&P 500 over the same period. This is significant because that five year period included the 2007-2009 stock market crash. It indicates that micro caps were mutually exclusive vis-à-vis the general stock market. It also indicates that the sector produced positive returns at a time when the rest of the market was in the tank.
That’s true diversification, and the kind every portfolio needs.
Micro Cap Stock Risks
If you do invest in micro cap stocks, you need to be fully aware that the sector in general is more risky than the overall market. There are a number of factors that contribute to this higher level of risk.
No SEC reports filed. Many companies in the sector do not file regular reports with the Securities and Exchange Commission (SEC). These reports include quarterly Form 10-Q reports, 10-K reports (annual reports with audited financial statements) , or periodic reports of significant events, known as Form 8-K. The lack of filing makes information on these companies hard to come by.
No minimum standards. Since most of the companies aren’t listed on the larger stock exchanges like the NYSE or the NASDAQ, they are not subject to the minimum listing standards that those exchanges require. Those standards include a minimum number of shareholders, as well as net worth requirements.
There are also promotions issues related to micro caps stocks.
Email spam. Have you ever received any of those stock promotion type emails, reporting on the virtues of a certain stock? Micro cap stocks are particularly vulnerable to this kind of promotion scheme.
Paid promotion. Some unscrupulous companies in this sector will pay a promoter to promote the company’s stock. This naturally increases interest in the stock, and can artificially increase its price.
Bogus press releases. In an attempt to juice the stock price, the company might issue false press releases, in order to drum up interest in the company stock. They may announce merger talks that have no basis in reality, or breakthroughs on certain products that have not actually happened.
Internet fraud. Promoters or company insiders may even lurk around the Internet, and post messages on Internet bulletin boards and in investment chat rooms, giving tips that the stock is about to hit big. The whole idea is to go to places on the web where investors are looking for investment candidates. The fraudsters may even hide behind aliases, and provide credible sounding reports on the new and upcoming company.
These risks are exactly why it is so important for you to do thorough research on any company and the sector, before investing money in the stock. The rumor mill is alive and well in this sector, so you’ll have to make sure that you’re aware of the facts. Also keep in mind that many of the more reputable micro cap companies have registered their stock with the SEC, and do provide regular reports to the investing public.
Be sure that you do your due diligence on any companies that you invest in in this sector. That will help you to avoid many of the risks, and set you up to take advantage of the incredible rewards that these stocks can provide.
At Wall St. Renegade, we have a portfolio dedicated specifically to micro cap stocks.
When I formulated the strategy for the Tiny Gems Portfolio, I developed a strategy for aggresive investors looking to maximize their profits without sacrificing their values. The strategy we use for this portfolio is designed to maximize profits. We do this by combining a series of screening metrics to find companies with strong relative strength. This helps us find micro cap stocks that can crush the market.
To learn more about the Tiny Gems Portfolio CLICK HERE.