Entering the Risky World of Micro-Cap Stocks: Some Rules for Success

Micro-cap stocks are an intriguing opportunity to find excess returns. Those returns definitely come with excess risk as well. Not only can you experience sizeable losses, you could also lose your entire investment with a stock, as there are more companies that go out of business from the micro-cap segment.

Micro-caps are defined as companies listed on an exchange with a market capitalization of $300 million or less. Usually the segment is defined by new companies itching to grow, or older companies that have seen their fortunes shrink. Both of these represent great opportunities but also hefty risk.

For example, here is a chart of SDLP – which offers an intriguing 11% dividend, with a P/E ratio of 1.2:

On the surface, it looks like a magnificent investment, but look a little closer, and you see that they are in the offshore drilling industry and they have leveraged up. Basically, this investment requires oil prices to go back over 60 for it to payoff. But it is a very cheap way to put this type of investment in play.

To maximize your return in this murky world with imperfect data, here are a few rules that will help you navigate.

Watch your industries: When large companies get sick due to an industry downturn, micro-cap stocks just kick the bucket. They have less cushion for error, and when an industry is going through difficult times, the large companies can draw on bank accounts, selling stock, and getting loans. The same is not true for micro-cap stocks. Also, the market can become hyper-competitive, and might cause price erosion, which would cut into margins and ultimately lead to demise.

Earnings and estimates: Many of these stocks have very limited analyst coverage. This means that the estimates could be the result of one or two analysts that specialize on micro-cap stocks who don’t necessarily have the pedigree of the analysts covering large-caps. So take the forward estimates with a grain of salt, but you do want to see that Earnings are healthy, and that they have some forward looking estimates that look like there is a real run ahead of them.

Keep an eye on the financials: Debt to equity ratios are very important. If they are floating a lot of debt, that increases the risk. You also want to see revenue growth (these are small-cap stocks after all – we want them to grow). Finally, you should take a look at whether Earnings growth is impacting Free Cash Flow. If a company is showing earnings growth, but it isn’t flowing to cash – then you know that they are investing heavily or paying off debt.

Their story: Micro-cap stocks have a story. It could be a new product, or a new service that will have a great run – remember Amazon was a micro-cap stock at one time. That story needs to be compelling. For stocks that used to be small-caps and have now slid into micro-caps, there needs to be a turnaround that you can believe. They are removing an obstacle or received new financing, or have an upcoming product release. All of these can be catalysts for growth, and could potentially bring the stock back.

Ultimately, micro-caps represent a great opportunity, but come with great risk. It takes more qualitative and quantitative analysis to really understand the story, and determine whether you can find an opportunity. But be prepared to fail often, and spread your money among many micro-caps. It only takes one big win to make up for many losers.