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
Yet the performance of this high-risk asset class has been a
lot brighter in recent years. The
iShares Microcap ETF (
, 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
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)
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
1. Buy The Newsletters
This isn't merely a pitch for StreetAuthority newsletters such as
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
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)
Royce Micro-cap Trust (
-- 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
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
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
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
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'
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.
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