6 Steps To Finding The Perfect Micro-Cap

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The summer of 2008 was a brutal period for investors focused on micro-cap stocks (typically defined as companies with a market value below $200 million). Many of these stocks plunged sharply in a matter of months, even more profoundly than their large-cap peers.

Yet the performance of this high-risk asset class has been a lot brighter in recent years. The iShares Microcap ETF ( IWC ) , for example, has surged 63% in the past two years, roughly 20 percentage points better than the S&P 500 Index. The 25% one-year gain is also twice as good as the large-cap benchmark.

Of course, many individual micro-caps have done a lot better than that. This is the only asset class where you'll regularly come across stocks that have risen 300%, 400% or more in value in any given year.

A quick glance at the market's top gainers over the past 12 months reveals a group of companies you likely never even heard of a year or two ago (with the exception of Tesla Motors (Nasdaq: TSLA) and SunPower (Nasdaq: SPWR) ).

And that's exactly the point: To find stocks with potentially explosive upside, you need to search far from the mainstream. These aren't stocks you'll hear about from Wall Street analysts or major financial publications. To find them, you'll often need to venture into new research frontiers. Here are my six "rules of the road" when it comes to finding and assessing micro-cap stocks.

1. Buy The Newsletters
This isn't merely a pitch for StreetAuthority newsletters such as Andy Obermueller's Game-Changing Stocks or Dave Forest's Scarcity & Real Wealth (though I'm a big fan of both). Many newsletter writers are in the business of uncovering wallflower stocks that toil anonymously, far from the gaze of Wall Street's stock jocks.

Mark Hulbert keeps track of hundreds of newsletters, ranking them in terms of their stock-picking prowess, and I often find his rankings to be a good source when I'm looking for a new newsletter subscription.

2. Track The Fund Managers
Though most hedge fund and mutual fund managers focus on large-cap, mid-cap and micro-cap stocks, there is a group of well-respected pros that have established a solid long-term track record in this high-risk asset class.

Chuck Royce launched Royce Funds, a micro-cap-focused firm more than four decades ago, and the various Royce funds continue to lead the pack. Morningstar analysts note that "Royce & Associates' distinctive and enduring culture is impressive considering that it has been part of large asset manager Legg Mason since 2001."

Although the various Royce funds -- such as the Royce Micro-Cap Service Class (Nasdaq: RMCFX) or the Royce Micro-cap Trust ( RMT ) -- are good choices for fund investors, I like to look at what those funds are buying, and research those stocks on my own.

Oberweis Asset Management is another firm that performs extensive research in the micro-cap segment -- and it shows. The Oberweis Micro-Cap Fund (Nasdaq: OBMCX) has garnered an 18% annual return over the past five years, handily topping the S&P 500's 13.4% annualized gain in that time, according to Morningstar.

3. Watch The Burn Rate
These fund managers know the dark secret of micro-caps. Without enough cash in the bank, many of these small companies are poised to burn investors by serially issuing massive new blocks of stock. That's why I never recommend a micro-cap with less than 12 months' worth of cash on hand. You can make that assessment by looking at the prior 12 months' operating losses and comparing that figure to net cash on hand.

Right now, that's a major concern for biotech investors. A wide variety of biotech stocks have plunged sharply in the past week as investors come to assume that a tough stock market in the quarters ahead may prevent these cash-hungry firms from raising fresh capital. Acadia Pharmaceuticals (Nasdaq: ACAD), for example, which has been the biggest gainer of the past 12 months, has slumped roughly 30% since the start of the month. The biotech firm is expected to lose money for at least the next few years.

If you own any biotech stocks, it's a good idea to double-check their financial statements: Ideally, they will have a two- or three-year cash cushion in place, just in case the market enters into an extended slump. In the case of Acadia, the dismal recent trading action may actually spell opportunity. The company raised fresh capital in the second quarter, and now has more than $200 million in the bank. Investors are mistakenly lumping Acadia in with firms that have truly weak cash balances.

4. Seize The Opportunity
For a micro-cap stock to possess considerable upside, you need to be focusing on large addressable markets. Acadia Pharma, for example, is looking to treat people who have Parkinson's or Alzheimer's disease, which both remain difficult to treat with current remedies.

In a similar vein, you need to track the steps being taken by rivals. Any large untapped market means that several firms will be pursuing the holy grail, and micro-cap investors sometimes fail to broaden their focus beyond the company they are researching.

5. Track The Volume
Regardless of how much promise any micro-cap stock may hold, it's irrelevant if nobody is paying attention. That's why it pays to focus on micro-caps that are seeing rising trading volume. That means the company has a promising story to tell, and fund managers like what they are hearing.

Trading volume is an important consideration with micro-caps. If the volume is too low (less than 50,000 shares a day), then the spread between the bid ask and prices will be quite wide, cutting into your net profits.

6. Watch The Insiders
One of the most fertile sources of micro-cap ideas can be found on the insider buying tables. (I am a fan of InsiderInsights.com, though other services such as InsiderCow.com, Insider-monitor.com and Insider Monkey are all worth checking out.) Many micro-caps struggle for investors' attention, and an SEC Form 4 insider filing is one of the few sure-fire ways to pop up on investors' radars.

Of course, insider selling is equally important, and if you find an intriguing micro-cap stock through insider buying, then you should become lot less intrigued if these same insiders start to sell shares.

Risks to Consider: Micro-caps are extremely risky, and no holding should account for more than 5% of your portfolio.

Action to Take --> Although investors tend to move quickly when hearing about a great micro-cap idea, it pays to proceed slowly, taking the time to assess a company's market position and financial strength. It also pays to see what the company has been saying for the past few quarters as well. If a company is continually changing its story from quarter to quarter, then you may just be the latest sucker to hear a good pitch.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

© Copyright 2001-2010 StreetAuthority, LLC. All Rights Reserved.


This article appears in: Investing , Investing Ideas , Stocks

Referenced Stocks: IWC , RMT

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