Micro-Caps

By Ernest Schlotter, Analyst SISM Investors

Micro-caps are companies with a low market capitalization, usually ranging between $50 million and $300 million. The market capitalization results from multiplying the company’s share price by outstanding shares, and it changes daily. Micro-cap stocks can either be newly listed companies with very few regulations or smaller companies with significant potential to become large-cap stocks in the future. 

Micro-cap stocks are among the riskiest investment, sometimes significantly than other assets. The micro-caps are mostly new companies and have no proven track record. Some of these companies have no assets, operations, or revenues, and others have products and services in the early respectively are still in the development stage before marketing. Often, microcap stock companies specialize in innovative products or services that may be unknown to the general public.

It is obvious, and past performance shows, not every micro-cap company becomes a giant. Investing in micro-cap companies can be rewarding but also comes with risks that investors need to understand. I want to mention and old favorite Wall Street maxim: “The higher the risk, the greater the reward.”

Here are Some Main Differences Between a Micro-Cap Stock and Other Stocks

The lack of public information

Micro-cap stock companies often have fewer resources to make their information available to the public. These micro-cap stocks are less likely to be published and talked about by stockbrokers than larger public companies. Most large public companies file reports with the  U.S. Securities and Exchange Commission (SEC) that any investor can get for free from the SEC’s website.  Analysts regularly research and write about larger public companies, and it’s easier to find their stock prices on the Internet or in newspapers and other publications. 

Getting the same information about micro-cap companies can be challenging to find, making them more vulnerable to investment fraud schemes and making it less likely that quoted prices will reflect the complete and accurate information about the company.

No minimum listing standards

There are often no minimum listing standards on over-the-counter exchanges. In contrast to the disclosure requirements and high capital standards required to be listed on the NYSE or Nasdaq, companies don’t need to have a minimum level of net assets, the number of shareholders, or even proof of an actual operating business to be traded on OTC exchanges. Many micro-cap stocks trade in the “over-the-counter” (OTC) market rather than on a national securities exchange such as the New York Stock Exchange or NASDAQ. They quote on OTC systems, such as the OTX Bulletn Board (OTCBBB) or OTC Link LLC (OTC Link).

Companies that want to have their securities quoted on the OTCBB must seek sponsorship by a market maker firm that is a registered broker-dealer and have to file current financial reports with the SEC or with their banking or insurance regulator.

Like OTCBB, OTC Link is an electronic inter-dealer quotation system that displays quotes, last-sale prices, and volume information in exchange-listed securities. In addition to publishing quotes, OTC Link provides, among other things, broker-dealer subscribers the ability to send and receive trade messages, allowing them to negotiate trades.

Risk  

We have already mentioned the risk of investing in micro-caps on the very first page of the second paragraph of this blog.

Failing to File Financial Report

An OTCBB company that fails to file a periodic financial report on the day it is due receives a “strike,” even if the filing is following the next day. If such a “strike” is the issuer’s third, the company will be removed from the OTCBB.

Low liquidity

Small-cap stocks are less liquid than their large counterparts. Low liquidity results in the potential unavailability of the stock at a good price to purchase, or it may be challenging to sell the stocks at a favorable price. Low liquidity also adds to the overall risk of the stock.

The Advantages of Investing in Micro-Cap Stocks

Relative to larger companies, micro-cap companies show significantly higher growth potential. Most micro-cap companies enjoy a significant upside potential for future growth compared to large-cap companies, making them attractive diversification for investors. It’s easier for micro-caps to grow their operational and financial base more significantly than is the case for most large-cap stocks. Picking the right micro-cap stock can turn into a very profitable investment.

High Probability of Inefficiencies in the Market

In general, investors ignore micro-caps and overlook this investment sector. Large institutional investors pass over these smaller companies in favor of larger ones to take more meaningful positions. Many micro-cap companies are often profitable, conservatively capitalized, and self-financing. So often, sell-side analysts ignore the micro to the small-cap sector as they have no incentive to offer research coverage. As a result, micro-caps are less well-known, and their shares may trade less frequently. As investors are giving little attention to mico-cap companies; thus, there is a high probability of improper pricing of such stocks. This circumstance creates vast opportunities for investors to leverage the inefficiencies in market pricing and offer investors the opportunity to earn a great return on their investments. Historically, the smallest companies have generated the highest returns.

I like to mention that some of the best stocks to buy in the past 25 years started as micro/small-cap stocks. Amazon was a $7 stock in 1998, and Tesla had a market valuation of just over $1 billion in 2010. Of course, not every small-cap company becomes a giant. Investing in small companies can be rewarding but also comes with risks that investors need to understand.