The roughly 12,000 microcap company stocks representing about 50 percent of all publicly traded companies found on North American exchanges present a smorgasbord of potential opportunities. Few, if any, large cap companies will organically double their revenues within a few years, but plenty of microcaps are always in the running to double, triple, and even grow their revenues 10-fold. After all, those Fortune 500 companies were small themselves at one time, and many managed to make their microcap and small cap investors rich.
However, when picking microcap stocks, it can often be difficult to tell if what you are ordering will end up as boeuf bourguignon with a side of lobster thermidor or a vegetarian-based meatloaf that looks and smells like the contents of a compost bin. On the other hand, small businesses are inherently easier to understand than massive multi-national corporations. A startup microcap company’s operations and management are typically small in scope and straight forward when compared to the multi-tentacled operations and management of a Fortune 100 company. With a little research you can pretty much get the whole picture of a microcap company, whereas a similar amount of research into a large cap company might get you some vague basics with perhaps a sense of which divisions are driving cash flow.
There are dozens of factors savvy microcap investors can examine when seeking out companies with potential to grow from, say, the equivalent of a sidewalk hot dog vendor into a Michelin three-star rated restaurant. And many of these factors can make or—more likely—break a microcap company’s chances for success. But which of these many factors provide the best clues for potential success—what attributes should a microcap stock investor examine first before digging deeper into company operations?
Well, we’ve picked a few attributes that serve as a basic litmus test to determine whether any particular microcap company appears to be a solid investment play warranting deeper examination. A positive rating on any one of them gets our attention but any two combined indicates that the company is definitely worth further vetting to flush out more positives and/or red flags. When we rate multiple attributes on this list as positive, we get excited, and, more often than not, end up developing an investment thesis for the company. Herein, are five attributes to examine first when evaluating microcap stocks:
Leadership
This one’s a biggie. In fact, the quality of a company’s management is one of the biggest investment considerations Warren Buffett makes in his stock picks. Such consideration has obviously served him well, given that he is one of the most successful investors in history. But the importance of management is even more crucial with microcap companies because so much of a smaller company’s future is riding on the leadership’s vision and how it goes about turning that vision into reality.
We look for what we call “intelligent fanatics,” which are leaders with long-term vision, focus, energy, integrity, and superior intelligence. Think Steve Jobs or Sam Walton here, and note that they also are renowned for “execution,” that is, successfully turning the vision into reality. Speaking of execution, we like to see leaders who’ve already proven themselves in this regard. We’re far more comfortable investing in someone’s company if they have a proven track record of turning a brilliant idea into reality than someone who has a brilliant idea but has never tried to actually cook the recipe.
Almost needless to say, but good leaders must also be really good at managing people. For more on our take on what we look for in microcap leadership, check out our June 10 blog—Discerning the Vision, Focus, and Commitment of Microcap Company Management.
Market Dominance in a Growing Market
When looking at a microcap company ask yourself what it is offering and who wants what’s being offered. It’s a simple question but oh so important. The soft drink market is saturated, so to speak. So, a company coming out with a new cola-style drink is entering a market with stiff, already established competition. The only way a new company entering this market can succeed is by doing something outlandish, like jacking up the cola with way more caffeine, sugar, and other stimulants than established brands, and then either ramping up a budget-busting advertising budget and/or get lucky by going viral on social media.
Bottom line is that you should be looking for companies that can quickly establish or dominate a market, even if it’s a small, niche market. And a new market with growth potential is the crème de brûlée, as there is often typically greater potential in a newer market than there is in an existing, flatlined market.
Define Customer Need and Demand Potential
This one’s similar to the “market dominance in a growing market.” But instead of asking what the company is offering and who wants it, try to discern what happens in the absence of whatever the company is bringing to market. This, of course, is often a hypothetical question as many microcaps are at the visionary and early execution stage of their business. But by playing around with the hypothetical you might be able to get a sense of whether the company’s product is the next best thing since sliced bread or just another widget. For a microcap company already distributing a product or services, ask yourself how badly their clients would be hurt if the product/service were to disappear. If it’s a major pain point then that’s a good sign.
Undervalued Holdings
Check out the company’s balance sheets and all the financials—should be easy compared with trying to follow Amazon’s money trail. Some microcap companies have assets alone that are worth as much, if not more, as the company’s market cap. While such assets in these cases are often illiquid, they still have value and provide some support for the company’s valuation. In some cases, a microcap company’s illiquid assets are vastly undervalued with the company’s stock price dampened by the illiquidity. Price-to-book ratio can provide a quick assessment of whether the company may be a cheap stock worth owning.
Small, Under the Radar, and Limited Institutional Ownership
That illiquidity, combined with perceived risk, explains in large part why institutional ownership of microcap stocks is so low compared with ownership of larger capitalization stocks. But this isn’t a bad thing, as it helps keep promising microcaps under the radar. This in turn helps mute excessive stock price increases as the company executes its vision. Bottom line, if you’ve found a potential winner, the less competition for those shares the better during the early days of execution. You want to own a stake in the hot dog vendor’s stand before everyone else figures out that his hot dogs taste like filet mignon and he can’t keep his stand in stock due to demand.
Plenty of Great Recipes Out There
As suggested, a positive rating with any one of these attributes captures our attention. A positive finding in two or more is like getting a first whiff of a slowly simmering boeuf bourguignon sauce. Scents can be deceiving, though, so conduct due diligence research before going all in. Take note of any red flag issues and be prepared to back down should any overweigh the positive attributes found. And, last, don’t let yourself get fixated on one particular microcap based on these great attributes, as there are plenty of great recipes in the kitchen of microcap investing.
