By Josh Levine
Editor, MicroCap Investor
Individual investors have resisted fully venturing into smaller stocks ever since the bull market began in 2009. The experiences of the crash and the financial crisis are still fresh in their memories and have served as caution lights both when stock prices climb and when they pull back.
A pattern of tepid buying and selling without committing to the longer term is characteristic of investor behavior ever since the great recession. But it doesn't mean it's the right approach for microcap investors. Let's look at some primary misconceptions many investors have about building winning positions in small stocks.
Myth-Busting for Profit
The power of myths is what makes them so lasting. In the world of microcaps, investors cling to certain beliefs that undermine performance and prevent them from becoming more successful in the long run.
Though this stuff may appear to be pretty basic, it's all too easy for investors to get caught up in the fast-paced market activity and overload of information -- leading to wrong-headed investment decisions.
If you've hesitated dipping into microcap stocks for a while, the current valuations for the best of class such as the game changers in the MicroCap Investor portfolio are too enticing to ignore. As we review the three top myths, apply the lessons to your individual portfolio and your buying strategy.
MICROCAP MYTH No. 1: You have one shot at buying a stock, so make it count!
It's the nature of microcaps that I advise investors to build a position in each stock in one-third to one-fifth portions. In most cases (the only exception being a microcap bull market) this strategy pays off with a lower cost-basis, so you'll be positioned to capture bigger returns.
Many investors are of the mindset that if a stock ticks down after they've made their first purchase, it's wrong to buy more. But that's often the opposite of what you should do. For instance, Microcap Investor subscribers who bought Spectrum Pharmaceuticals (SPPI) below $4 last summer watched the stock rocket 500%. And after dipping below $4 last year, Acorn Energy (ACFN), a diversified cleantech play, is now above $11.
As long as the fundamentals and thesis remain unchanged and there are no red flags, a tick down is an opportunity to lower your cost basis. Microcaps are low-priced, volatile stocks, so they are bound to swing more widely than larger stocks, and you should use this to your advantage.
Here's something else to consider. Buying incrementally enables an investor to get a better feel for a stock's trading pattern and to seize any opportunity stemming from anomalies in those patterns (read: unexplained declines) as they occur.
There is absolutely nothing wrong with accumulating a position in a microcap over several months or even longer. After all, trying to time a microcap buy correctly is often as easy hitting a baseball with your eyes closed.
Under the circumstances it makes perfect sense to take a patient and disciplined approach to establishing a position.
MICROCAP MYTH No. 2: Cost basis is secondary; it's the profit that matters.
Yes, profit is ultimately what counts, but unless investors wisely build positions at low costs, profits will be squeezed. The lower you are able to accumulate shares of a microcap, the easier it will be to profit, and the more motivated you will be to sell when the right time comes.
It can be misleading to view microcaps in the prism of past performance. A number of stocks in the MicroCap Investor portfolio are down from their initial recommendation prices, and a few are trading as if they're the equivalent of burnt toast, rather than being priced based on intrinsic value and prospects.
Despite a rising stock market, risk adversity remains historically high and this has caused valuations of nanocaps and smaller technology firms in general to trade at washed-out prices. Frontier-science firms like DNA-vaccine developer Inovio Pharmaceuticals (INO) have been especially affected by the risk-off attitude for individual investors.
Now, the best way to evaluate any stock is to look at it each day as if it's the first time you ever did. By having this “beginner's mind” as the Zen saying goes, it allows an investor to shed the emotions of owning a stock, to see it more clearly in its current context, and to simply be more open-minded.
When investing in microcaps, cost basis can make a real difference. For example, just consider the difference in buying a stock for $1 versus $2. With a $1 cost basis, when the stock goes to $3 you'll have a 200% return, while a $2 cost basis would mean you'd only make 50%.
Based on a $5,000 investment, that's a $10,000 profit versus $2,500! Clearly, lowering your cost basis takes patience and discipline -- but it is well worth the effort.
MICROCAP MYTH No. 3: Microcap stocks trade like their larger brethren.
The inefficiencies of stocks with market caps under $200 million are what make this playing field wild -- and so very worthwhile. There are a number of reasons for these inefficiencies in comparison to bigger stocks, but the primary ones are:
- Lower share prices
- Poor liquidity
- Lack of Wall Street analyst coverage
- Few institutional investors
If you have the perception that microcaps trade like mid caps and large caps, then you're playing on the wrong field and investing in the wrong type of stocks.
For example, the MicroCap Investor portfolio companies with market caps below $50 million are largely hampered by the deficiencies listed above. In time, however, these will be overcome when the companies sufficiently prove their business models and show tangible results.
The reality is that the further below the $200 million threshold we go, the more likely inefficiencies exist. To uncover the biggest “reality gaps,” we first have to understand the worth of a company and assess its ability to deliver growth at a higher rate than its peers.
Inefficiencies occur when a stock trades significantly below its “true value.” But remember that just because a stock is technically cheap doesn't automatically make it a bargain -- even though some investors mistakenly believe that it's cheap only because other investors haven't recognized its value yet.
On the contrary, it's safe to say that a majority of the tiniest stocks (i.e. sub-$50 million market cap) are not worth buying at any price. That's why it’s essential for investors to do the analytical work to understand the fundamentals for every company.
You're in the Driver's Seat
It is easy for even the most experienced investors to get misdirected by all the white noise, and to forget these basic truths. By just following the few simple lessons outlined here, your microcap portfolio could shape up very differently, and more profitably.
I do the groundwork by exploring the microcap landscape to discover the top prospects with the potential to deliver 100% to 1,000% returns. But how each investor chooses to build and manage their portfolio is in your hands.
The best path to success? Ignore the myths, face the realities of microcap investing, and put yourself and your microcap portfolio in a position to make huge profits in 2012 and beyond.