Advantages of Micro Cap Investing

Micro cap investing can be very lucrative if you know how to spot a bargain. But most retail investors don’t buy micro cap stocks because they’re unaware of them or even ignorant. For example, many people believe that micro caps are the same as penny stocks, which is a misconception.

It might surprise you to know that Warren Buffett did a lot of micro cap investing throughout his career. Besides the many “cigar butts” he flipped in the 1950’s to great success, Buffett purchased See’s Candy–a micro cap–in 1972 for $25 million when his net worth was still well under $100 million.

A couple of years after purchasing See’s Candy, Buffett began accumulating Washington Post stock when it was a micro cap valued at just $80 million.

On a later date, Buffett had this to say about his Washington Post investment:

“In ‘74 you could have bought the Washington Post when the whole company was valued at $80 million. Now at that time the company was debt free, it owned the Washington Post newspaper, it owned Newsweek, it owned the CBS stations in Washington D.C. and Jacksonville, Florida, the ABC station in Miami, the CBS station in Hartford/New Haven, a half interest in 800,000 acres of timberland in Canada, plus a 200,000-ton-a-year mill up there, a third of the International Herald Tribune, and probably some other things I forgot. If you asked any one of thousands of investment analysts or media specialists about how much those properties were worth, they would have said, if they added them up, they would have come up with $400, $500, $600 million…. That is not a complicated story. We bought in 1974, from not more than 10 sellers, what was then 9% of the Washington Post Company, based on that valuation. And they were people like Scudder Stevens, and bank trust departments. And if you asked any of the people selling us the stock what the business was worth, they would have come up with an answer of $400 million.”

So the notion that micro caps are always these scam-ridden, pump-and-dump penny stocks is a misconception. In fact, nearly half of the stock market is made up of micro caps–48 percent to be exact. And while definitions vary, micro caps are generally stocks with market caps under $300 million, although you’ll find many micro cap investors who prefer companies well under $100 million. These are tiny companies compared to giant companies like Facebook, Amazon, Apple, Netflix, and Google (FAANG). Netflix, for example, has a market cap of approximately $150 billion, and Apple was the first company in history to break the trillion dollar mark. In contrast, the smallest micro cap I own is worth approximately $20 million.

Netflix (NFLX) is actually a well-known example of micro cap investing gone well. In the 4th quarter of 2002, just months after its IPO, Netflix’s stock traded under $120 million. If you had bought NFLX then and held for the next 16 years, your money would have grown 1,250 times its original amount–the equivalent of turning $10,000 to $12,500,000.

To put that into perspective, the average American salary is $35,000 a year. If you earned $35,000 a year for 40 years from age 25 to 65, you would have only earned $1,400,000 compared to the $12.5 million in NFLX stock gains from 2002 to 2018. That’s 9 times more money in 40% less time–an eye-opening revelation on how enriching micro cap stocks can be if chosen correctly.

Advantages of Micro Cap Investing

1. Micro Caps have greater room for growth

Mathematically, it is easier for a $20 million company to grow into a $2 billion company than it is for a $10 billion company to grow into a $1 trillion company. In both cases, each company grew 100-fold. But in order for the $10 billion company to become a $1 trillion company, it would need to increase its market cap by $990 billion. That’s bigger than the GDPs of 174 countries! In fact, only 16 countries in the world have GDPs over $990 billion.

This explains why Apple and Amazon breaking $1T is such a big deal. But it’s a tall order to get to $10T. It’s a lot easier in theory for a $300M company to grow to $3B.

In the land of large caps, 20% gains are considered acceptable. But in the micro cap world, 20% gains are nothing. How does 8,000% to 67,000% sound?

Full-time micro cap investor, Ian Cassel, said in a Motley Fool interview:

In 2015, I studied the best-performing stocks over the last five years. Almost all of these companies were small micro-cap companies that turned into small caps. On the list were about 120 companies that were up 1,000% over the past five years. The top 10 companies were companies that were up anywhere from 8,000% to 67,000% in five years. There were eight 100-plus baggers that occurred in a five-year time period on U.S./Canadian exchanges. Those percentages and time frames aren’t typos.

2. Micro Cap Companies Are Easier To Digest

Multi-billion dollar companies are often complex with many products, services, brands, and subsidiaries. Each component of the business takes precious time to study, understand, and appraise. To gain a true understanding of all of Alphabet’s vast operations, for example, it would take months upon months of full-time research from a standing start, not to mention constant adjustments to your calculations and estimates every quarter. It’s no wonder most retail investors would rather just gamble. It’s too much work to keep up.

Micro cap companies, on the other hand, tend to be much simpler. They might only have one product, brand, or service. Seldom are they frustratingly complex, and none of them are anywhere near as complex as Alphabet.

For instance, if a micro cap company happens to operate a number of store locations, the locations will tend to be limited and therefore easy to analyze individually. When I did a deep dive on a small grocery chain, I was able to visit many of the stores and take individual notes on each of them. The ones that were further away and less practical to visit, I was able to “scuttlebutt” through online workarounds. There were probably less than 20 stores in total.

Truly, it would be impractical to do this kind of thorough “boots-on-the-ground” research with a large company such as Chipotle (which has approximately 2,500 locations) or Starbucks (which has over 15,000 locations.) So naturally, there is more “blindsiding” that can occur with larger companies. Therefore, a higher degree of faith is necessary to invest in larger companies as more assumptions must be made in good faith, at best. To offset this, building a higher margin of safety into the valuation model seems like the natural answer. But in practice, most popular stocks trade far beyond what is prudent, with many analysts pricing in “best-case scenarios, and then some” into their valuations.

Since micro cap companies are less complex, it takes less time to gather data, form an opinion, and make a decision on whether they are worthy of an investment. This means more stocks can be covered in a shorter amount of time. So while another analyst might still only be 20% of the way with their research on Alphabet, a micro cap investor will already have completed their research on a number of stocks.

3. Virtually no Wall Street coverage in the micro cap space.

Large hedge funds, mutual funds, and other investment companies command huge amounts of capital. It takes a lot of money to move the needle on their capital horde, and micro caps aren’t big enough to make a dent. For example, if a hedge fund has $5 billion of assets under management (AUM), it would be a waste of resources to analyze and invest in micro caps, because to achieve a 10% return on $5 billion would require capital gains of $500 million after taxes and fees. That is $200 million over the $300 million market cap threshold. In other words, it’s like a shark trying to get full by eating guppies.

Moreover, after accumulating 5% of a company’s shares, the hedge fund would also be required to file a Schedule 13D with the SEC within 10 days of the purchase, which exposes their hand to competing firms. So not only would the hedge fund in this example have used up their analyst’s time and energy to cover the stock; their idea would get poached and coattailed by competitors before they could finish accumulating a full position.

As a result, micro cap stocks lack Wall Street coverage and the natural promotion that goes along with it: the sell-side reports being proliferated to buy-side clients and brokers; the analyst explaining their investment thesis on CNBC; the conferences full of deep-pocketed investors, and so much more. The only reason most retail investors know about a particular stock is because they read or heard something about it. But this doesn’t happen with micro caps, which explains the sometimes-shocking disconnect between market price and intrinsic value in the micro cap world. This lack of Wall Street coverage creates a shady area in the stock universe where approximately 48% of stocks are not being scrutinized by teams of the best and brightest analysts on Wall Street, nor promoted.

As a result, there are opportunities in micro caps where hard work can pay off for an individual investor or even a small investment company. If a micro cap’s underlying business has genuine multi-year growth prospects that can reach the bottom line and benefit its shareholders, then no matter how obscure that company is, it will eventually find its way on the radars of Wall Street analysts and end up in the promotion machine–if it’s not bought out first.

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