Practically all investors are looking for the same thing: the biggest return for the lowest amount of risk.
For individual investors, I believe that microcaps present the greatest opportunity for long-term appreciation of wealth.
The historical return on these tiny stocks have been absolutely staggering. If you would have employed a couple of basic techniques, which I will outline in this article, you could be partaking in that return today.
How big would the returns have been over the past 20 years? The average annual return would have been 3x greater than the broad market!
There is no other opportunity that I know of which is even a close second next to microcaps. But you will hardly hear anyone talk about it in the media. If the returns are so high, why the lack of coverage?
The media, analysts and the rest of the investment community follow the trail of big money. The Big Money, coming from institutions and funds, flows into big stocks.
What incentives do the investment community have to cover big stocks?
- Brokerages prefer to provide coverage on bigger stocks that people are more likely to trade since brokerages make their money in trading commissions.
- The media talks non-stop about such massive stocks as Apple, Amazon or Tesla because it attracts a lot of eyeballs which leads to advertising dollars.
- Funds do not talk a lot about microcaps because there isn’t as much investor interest due to the reasons stated above. As well, funds want a lot of AUM as they profit from the expense ratio. Microcap funds are difficult to scale.
So much for the financial community having your best interests at heart.
Assuming you want the big potential that small stocks can offer, how do you go about it? Can’t you simply buy a fund that is chock-full of these tiny titans and sit back to harvest those eye-popping returns?
Not even close.
Many Microcap Funds Hold High-Risk Junk
Some investors feel that microcaps are the playground of con artists and scammers. I wouldn’t go that far but I would agree that there is a lot of horrible high-risk junk mixed in with amazing bargains. And everything in between. You need to be judicious when investing in microcaps to find those high-return powerhouses.
Many microcap funds, such as the Russell Microcap ETF, make no attempt to separate the good from the bad. Stocks are included in many microcap funds almost exclusively based on size. This reminds me of an ‘80s sitcom tune, “You take the good, you take the bad, you take them both and there they have … a disappointing fund.”
Microcap Funds Holding Midcap Stocks
Another reason why I wouldn’t invest in the majority of microcap funds is that they include stocks that I wouldn’t consider to be microcap. Almost no real microcap investor would either. Consider the upper end of the market cap range for two well-known microcap funds.
- Russell Microcap ETF $4.6 billion
- First Trust Dow Jones Select MicroCap Fund $4.6 billion
The problem is that there isn’t a strict definition of what a microcap stock is. Some say it is less than $300 million of market cap while others say $500 million. But some funds include stocks that would generally be considered mid-cap. No doubt they are doing so to increase the capacity of the fund. And while many midcaps are good investments, they are not microcaps.
Favoring Larger Stocks
Finally, many of these funds are cap-weighted which gives the largest stocks the most prominence. Consider how this skews the returns.
Suppose you want to invest in 2 stocks in a cap-weighted scheme which is popular among funds.
- One stock has a $4 million market cap while the other has a $4 billion market cap
- You invest $1,000 in these 2 stocks in a cap-weighted scheme
- $999 is invested in the largest stock with only $1 going to the smaller stock
The larger stock takes the lion’s share leaving you with a fund that doesn’t really represent microcaps at all.
Not all funds are this way. You should analyze each fund on its own merit. There might be a few good funds out there if you dig deep enough. But even if you do find an acceptable microcap fund, I still feel that you can do way betteron your own with a couple of simple screening techniques outlined later in this article.
But before we get to the nuts and bolts of picking microcaps, why are there such high returns in microcaps as opposed to the rest of the market? Why do I feel confident that the microcap outperformance will continue even if most people become aware of it?
The S&P 500 and Everything Else
Microcaps have more opportunity for two simple reasons — a vast number of stocks and few people buying them.
The majority of investors are trading in the S&P 500 which generally represents the 500 largest stocks in the U.S. market. There are currently about 10,000 stocks listed on major US exchanges and OTC (Over The Counter) markets. The 500 largest stocks have more money pouring through them each day than the other 9,500 stocks!
Because so many people are picking over the same stocks, it would be very rare to discover something that someone else hasn’t. And if someone else has already discovered it, chances are that the price accurately reflects the opportunity – no real bargain. Knowing this, why do people still invest primarily in the S&P 500?
- People feel there is safety when investing with the herd
- People feel there is safety in stock liquidity
- People feel there is safety in having easy access to information
Let’s look at those reasons a little closer to discover why the feeling of safety might be false.
- The Herd.Good investors should neither follow nor avoid the herd. Just ignore it as background noise. Following the herd will often lead to a crowded trade with less potential return.
- Liquidity.Unless you are a day trader I cannot understand why you would avoid microcaps due to liquidity. Are you concerned that you may need to sell during a market crash? For one, that’s the worst time to sell. For two, just hedge by short-selling an ETF until you feel that you want to be long the market again. And when you do need to sell, just take your time. You don’t need to liquidate a lifetime of savings in 5 minutes.
- Information.Does a glut of information help investors make better decisions? Usually not. Investors often form an opinion and then seek out information that agrees with them. This is called confirmation bias. Just remember that less public information and coverage equates to a better share price for you. You have a greater chance of discovering a passed-over gem.
Looking to Buy Some Art?
Think about it from a different point of view for a moment.
Imagine someone invited you to a very small art auction of just a few paintings where you needed to bid against thousands of professional art dealers. How likely are you to find a deal?
Next suppose that just you and your buddies were invited to a massive art fair with thousands of paintings, from good to bad, being sold off as part of someone’s estate. If you can enlist the help of an art dealer, you will almost undoubtedly find numerous bargains.
This analogy describes the opportunity found with microcaps. You literally have thousands of stocks with only a limited number of investors looking them over. There are some incredible buys mixed in with high-risk junk. Competition is low so that if you know what to look you will find an under-priced opportunity with abnormally high returns.
Where To Get That Edge?
The question is, how do you get the edge to separate the good from the bad? I have uncovered numerous ways through quantitative analysis and I would like to share just two such filters with you.
- Short Interest
- Free cash flow positive
Short Interest and Microcaps
It is extremely difficult to short sell a microcap stock. Most investment professionals I know will not short-sell smaller stocks. Shares are often difficult to locate, they come with a high borrow cost and share price volatility can have you covering shares at the wrong time. My point is that when you see a very small stock with a moderate amount of short interest – an informed and savvy individual is almost always at the other side of the trade.
To lower your risk of buying a dud, simply look to the short interest. This tells you what percent of shares are sold short. My recommendation is to avoid stocks with more than 10% short interest. Less than 5% is even better.
Sustainable Business Model and Free Cash Flow
Probably the single most important quality I look for in microcaps is sustainability. I find that too many people buy stocks because the idea sounds good. As an entrepreneur I can tell you that many amazing business ideas fail and many so-so ideas take off. Instead of trying to evaluate the idea – look for business sustainability. How can you quickly screen for companies that are sustainable? Look for positive free cash flow.
Free cash flow is a better indicator of sustainability than positive earnings in smaller companies. The reason for this is simple: Free cash flow represents actual dollars coming in (cash flow from operations minus capital expenditures). You can spend cash but you may not be able to spend the earnings.
Consider the difference:
- One company has loads of cash coming in. It adequately covers any large purchases to grow the business. There is a surplus of cash in the bank. They are sustainable and have free cash flow.
- Another company has money owing to them (accounts receivable) but no cash. Profit margins are incredibly tight and they need to spend a lot in capital expenditures to generate positive earnings. If you average out the capital expenditures over 20 years and accounts receivables are paid, this business should eventually have money in the bank. But as for today, they have no cash with bills stacking up. They are likely not sustainable since they have negative free cash flow, although the earnings are positive.
A company can go bankrupt even while posting positive earnings if they are cash poor and are funding growth too heavily with debt. Looking for positive free cash flow is a simple way to remove small companies with higher risk.
So exactly what sort of returns are we talking about with microcaps? Let’s start by looking at average microcap performance with a liquidity filter. These microcap stocks have at least $100,000 of shares being traded each day and have a share price of at least $1.
Since 1999 the average annual return of microcaps is slightly higher than the S&P 500 but with more volatility. The risk-adjusted return, or Sharpe Ratio, is the same as the S&P 500. If this was my microcap return profile, I can understand why the S&P 500 would be attractive.
The next chart will take this identical group of stocks and keep the companies which have positive free cash flow over the past 12 months as well as less than 10% of the float sold short.
The average annual return of microcaps are over 3 times greater than the S&P 500. The risk-adjusted return, or the Sharpe Ratio, is 2.5 times greater by adding in these 2 simple filters. And that’s just the beginning.
The next time someone tells you that microcaps are full of scams and garbage, tell them that it is true. Also tell them that there are thousands of microcaps to choose from and that they should avoid the garbage. There are also a lot of undiscovered gems trading at amazing prices. If they cannot separate the good from the bad, then perhaps they should leave microcap investing to those who can.
To find a microcap with big upside potential you do not need to be some sort of genius that can forecast the future and spot the next big trend. A simple way to isolate high potential microcaps is to remove high-risk tickers by tossing out companies with negative free cash flow and elevated short interest.
If the past repeats itself, what sort of difference in actual returns would this make? Assume you invest just $5,000 each year for 30 years. Based on the S&P 500 return of just over 6% you would end up with $460,809. Based on the annual microcap return of 19.49% you would end up with $7,417,648.
History may not repeat itself but I would rather position my portfolio for the larger return of microcaps than giving up and just following the herd for lackluster performance.