Investing in a micro-cap stock can be both an exhilarating and terrifying experience for any investor, regardless of experience level. Many people get their first look at a micro-cap stock by hearing about some “under the radar” thinly traded stock on the Pink Sheets or the Bulletin Board from a trusted friend, family member, or broker who has access to an “inside” source for information. Investors are typically informed that stock will likely double or triple within a short period of time, usually based on some disruptive technology that will change the world and make billions of dollars for shareholders along the way.
Following this initial volume and price surge (usually driven by a promoter), investors are told to hang on to their bootstraps because the stock will make them rich beyond their wildest dreams. Downside is never really a consideration because investors are told that the stock just can’t fail. This is the beginning of the “fear and greed” driven trading patterns where emotion overwhelms reason, and reasonable people suddenly forget how to invest.
Micro cap stocks most often trade on the OTC Bulletin Board, the Pink Sheets, or the Pink Sheets Electronic Quotation Service, and are often too small to be traded on the stock exchanges or Nasdaq. The Pink Sheets are sometimes referred to as the “Wild West” of the investing world because they are not subject to the stringent listing standards and reporting requirements of an exchange or NASDAQ, limiting public information. As such, in addition to an initial venue for promising start-up companies, the “Pinks” are also a breeding ground for unscrupulous “pump and dump” type stock promoters to scam unsuspecting investors.
This is not to say that all micro-cap stocks are promotional fluff but it’s critical that investors do their own due diligence to separate the real opportunities from the hype.
Unlike large cap companies, for which historical financial performance is a window to the future, nonfinancial data hold much more value when looking at a micro-cap stock. This non-financial information includes macro industry trends, the company’s business strategy and business model, and its competitive position in the marketplace (SWOT analysis). These are some of the principle factors that drive these stocks. Additionally, it is equally important to identify the most common risk factors.
All equity investments carry varying degrees of risk, but micro-cap stocks present investors with some additional challenges due to their diminutive market capitalization values. Besides outright stock scams, which I will not cover in detail, I believe that management, funding, and products/services are three of the most important risk factors when considering an investment in a micro-cap stock:
Management: “When betting on a micro-cap stock, you should always bet on the jockey, not the horse.” In other words, no matter how promising a micro-cap company and its products/services seem to be, without the leadership and execution of a strong management team, the company will never be successful. To properly gauge a management team, investors should examine management’s experience, background, and track record. For example, someone whose sole experience is as the manager of a fast-food franchise should probably not be at the helm of a biomedical research company. Alternatively, if the CEO has been a successful medical device inventor for 30 years but has never run a medical device company, be equally wary. Additionally, does management have the skill set to successfully market itself and its products/services to the marketplace?
Finally, investors should closely examine how a company’s management team is financially compensated. If the executive team of an early stage development company is compensated with large six figure salaries and generous cash bonuses, be very wary. Ideally, you want your management team to be lean and hungry, and primarily rewarded by strong stock performance.
Funding: Invariably, the primary challenge facing a micro capital company is sufficient access to capital. As with all companies, cash is necessary for meeting working capital issues as well as funding initial development prior to commercialization. Typically, the first round of public financing, the IPO, is not sufficient to cover the company’s expenses prior to the commercialization stage. Accordingly, cash starved companies are forced to explore a number of options to get much needed capital. For many early stage public companies, debt financing is simply unavailable.
On the equity side, prospects may not be much better. Depending on the price of the stock, a second round of financing or “follow-on” offering may be highly dilutive to existing shareholders. Additionally, if the company teams up with the wrong investor looking for cheap paper and a short-term profit, the financial deal will immediately drive down the already depressed stock price and force a desperate situation. For many micro caps, this can be the end of the road.
Exceptional Product or Service: prospective investors should carefully scrutinize what company does or produces. If a company intends to offer an “innovative” product or a service, how does that product or service compare to existing services in the marketplace that already have existing market share? Is the market for this product growing or shrinking? Some industries have specific industry risks for investors. For example, companies in the medical or biopharmaceutical fields face significant barriers to entry and long arduous bureaucratic steps to getting a product from design to market, which may take many years of testing and agency approval. Often these companies will include language in their filings that a product is “about to be tested,” “may be tested,” or that money is being raised that will allow testing. In these cases, investors should expect a longer wait time than promised and should realize that there is no guarantee that the product will ever be approved for commercial release.
The bottom line is that investors should try to anticipate some of the hurdles facing the company based on its industry. Finally, based on many years of personal experience, micro-cap investors should come to the harsh realization that nothing ever happens how and when it was originally planned.
With all of the aforementioned challenges, why would anyone consider investing in micro-cap stocks? Well, believe it or not, according to Thomson Financials’ U.S. Private Equity Performance Index, early/seed venture capital (which is most closely related to the micro-cap sector) investing has significantly outperformed the major market indices over the last ten and twenty year periods by posting 38.3% and 20.5% average annual returns over the respective periods.
