Micro-Cap Stocks: The Best Investment Class For Bulls

Written By
Paul Tracy
Updated January 16, 2021

How will the economy fare the next few years? Will growth be anemic or will we finally see the long-awaited economic rebound? If you're an optimist, then you need to own micro-cap stocks.

Small companies tend to outperform their larger peers whenever the economy springs back to life. Sure, they carry greater risk, but if you know the rules of the game, you can avoid most of the potential pitfalls.

What Is A Micro-Cap?
There is no strict definition of what defines a micro-cap. But generally speaking, a micro-cap is a company worth between $100 million and $300 million with stock that trades at less than 50,000 shares a day. At those low volume levels, it is truly off Wall Street's radar. 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.

While small-caps, mid-caps and large-caps have much in common, micro-caps need to be approached in a truly unique fashion. The 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 only large and solid companies when the economy slumps, leading to sharp underperformance for small-caps and micro-caps.
The Russell 2000 is a useful gauge for sentiment towards small- and micro-cap stocks. As the economy dragged into recession in 1990, this index fell -21%. But as the recession ended, it soared, rising +44% in 1991 and another +17% in both 1992 and 1993. The index nearly doubled in just three years. To use market clichés, the market made a "flight to quality" when things looked bad, and investors "moved out on the risk curve" when things improved.

Why do investors shun small stocks when the economy slows? Because these smaller companies have less access to credit than their large peers do. So any cash crunch could lead to bankruptcy or a high level of dilution if they were forced to use new shares to stay afloat. That's why it's best to focus on micro-caps that have at least several years' worth of cash parked on their balance sheet. (Which you can calculate by adding up cash flow -- if negative -- for the prior three years and see if it's larger than cash levels). Micro-caps also underperform in economic slowdowns because they are squarely tied to the U.S. economy while larger companies can still find growth opportunities in robust international markets such as China and Brazil.

We've already noted that you need to focus on a micro-cap stock for a number of quarters or even years, as any short-term investment could be hit by the vagaries of a choppy market. You also need to adjust how you buy and sell a micro-cap. If you want to buy 1,000 shares of IBM (NYSE: IBM), you don't need to worry about whether you'll move the stock price (you won't). But a similar order for a micro-cap stock could push the price higher as shares are found to complete your order. You may only be able to fill 100 shares at the quoted price. The next 900 shares may be filled at ever-rising prices. (And the converse is true for sell orders).

That's why it's best to place a limit order with your broker, specifying the maximum price that you are willing to pay. It may take the broker several days to fill the entire order, but at least you'll be protected from getting a bad price. Alternatively, you can wait for the day when the stock you're watching is seeing a lot of trading volume. The higher the volume, the tighter the spread between the bid and ask price, and the more likely it is that the order will get filled at the price you want.

Make no mistake, investing in micro-caps requires not just patience but also lots of homework. You have to fully understand the company's strategy, financial position, and track record. Coming across a hot micro-cap idea is just the start of the process. Go back and listen to the company's previous conference calls. Has management struck a consistent tone? Does the story keep changing? Bumps in the road are to be expected, but management should provide a clear roadmap of how it will surpass those bumps. As a cardinal rule, whenever a company's story changes, you should look to exit that stock.

If you don't have the time to focus on specific companies, you may want to consider mutual funds that focus on micro-caps. Royce Funds offers several funds that focus on micro-caps, and I've been impressed with their analysts that I have met over the years. Over the last five years, the Wasatch Micro Cap Value fund (Nasdaq: WAMVX) has risen +47% while the S&P 500 has risen just +4%.

Micro-caps should never comprise more than 10% or 20% of your total portfolio. And if one of your micro-cap investments sharply appreciates in value, it may come to represent a large percentage of your total portfolio. That's usually a sign to lighten your position and bring it back down to a reasonable size.

Most importantly, patience is a virtue. Many micro-caps can stumble along without appreciating for several years, and can then tack on massive gains in a very short time. Over the years, I have given up on certain micro-cap investments that felt like dead money. When I checked back on them a few years later, their share prices were far higher. Nothing can be more frustrating then "the one that got away."

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