What is a Micro Cap?
Generally speaking, a micro cap is a company worth between $50 million and $300 million.
How Does a Micro Cap Work?
A company's market capitalization is the market value of all the company's stock. It is calculated according to the following formula:
[Number of Share Outstanding] X [Stock Price] = Market Capitalization
For example, if a company has a share price of $10 and it has ten million shares outstanding, it has a market capitalization (usually referred to as 'market cap') of $100 million, making it a micro cap stock.
There are several categories of stocks. The categorization (e.g. nano cap, micro cap, small cap, mid cap, large cap, and mega cap) can vary among investment advisors and indices. The categories are only intended to give a general idea of the relative size of the company at a particular point in time.
Micro caps tend to trade at a very low volume, usually less than 50,000 shares a day. At those low volume levels, micro caps are truly off Wall Street's radar. As a rule of thumb, if the stock is a member of the Russell 2000 index, it is classified as a small cap and too big to fit the micro cap definition.
Why Does a Micro Cap Matter?
While small caps, mid caps and large caps have much in common, micro caps need to be approached in a truly unique fashion.
Micro caps' bid-ask spread can be quite large, so if you are looking for a quick trade, you may end up buying high and selling low. And these companies are usually immature, which means that a great quarter can be followed by a lousy quarter. So these aren't stocks for trading, they're for investing.
With all that risk, why bother? Well, history has shown that smaller company stocks tend to outperform larger company stocks when we emerge from economic downturns. That's because investors tend to limit their exposure to large companies when the economy slumps, leading small caps and micro caps to underperform. When the economy bounces back, small caps and micro caps benefit disproportionately.
Make no mistake, investing in micro caps requires not just patience but also lots of homework. You have to completely understand the company's strategy, financial position, and track record. If you don't have the time to focus on specific companies, you may want to consider mutual funds that focus on micro caps.
