It’s every investor’s dream…to find a stock that not only doubles or triples in value…but increases by 10, 25, 50, or even 100 times. The best place to find that dream is in small, under-recognized micro-cap companies that have virtually all of their growth ahead of them. Many, but not all, also have very cheap stocks, making them attractive for making small bets with your speculative funds.
Some of those big payout dreams come true, others can go up in smoke, and you can be left with a bunch of losses if you venture into risky micro cap territory.
If you don’t want to be part of the carnage, you need to take a few precautions. These stocks are really good to trade with, but you have to be careful. Here are a few guidelines to follow:
Know how, when and what to buy
1) Make sure you understand the terms “penny stocks” vs. “micro cap stocks.”
Brokers refer to any stock priced below $5 as a penny stock; The term is used here to refer to stocks that literally trade for pennies…even less than a penny. Few stocks priced below $0.25 to $0.50 have profits; Most are seriously burning money or have other problems. The same is true for many sub-dollar stocks. The typical penny stock is a very small company with highly illiquid stocks, pre- or early-stage earnings, and little or no public information to dig into. “Highly speculative” or “absurdly speculative” are the terms that come to mind when we think of this type of penny stock.
If you want pure gambling, go to a casino… odds are better.
If you’re looking to invest in micro-cap stocks (market caps less than $300 million), look for companies that have better than even odds of making it.
2) Look for a solid development history.
Value investors can buy mid- to large-cap companies that are being ignored and wait for Wall Street to take notice…usually when they start posting attractive numbers. This doesn’t work quite as well with micro caps. A small but good company can wear itself down
In the dark for years before the market takes notice… and that may not be your timeline. Look for companies that are garnering a bit of attention on some of the better-known financial blogs, or that have gained some degree of market visibility from leading small-cap editors, or that have published research reports from a credible analyst…then browse the underlying lying numbers and make sure they support the story.
3) Perhaps you should wait until you’ve traded for several years before buying micro-cap stocks.
It takes time and experience to learn how to value these smaller companies, and even more time and experience to master the impulses that so often cause inexperienced investors to buy high and sell low. However, if you’re convinced you’re right, stick your toe in the water. but only risk what you can really afford to flush down the toilet.
4) Pay attention to the hype.
Stocks that are hyped beyond reality are generally the classic “pump and dump” schemes: some promoters hype an unknown stock beyond all relation to its value, taking a quick profit and letting lots of new investors in their pockets the hand. The bigger the hype, the weaker the fundamentals.
This is not the time to put all your eggs in one basket. Micro-cap stocks ($50 million to $300 million
Market cap) and nanocaps (market cap less than $50 million) are more vulnerable to disasters than larger companies, so expect a few duds. Remember, all it takes is a few of these stocks to take off, and you could do very well. After all, your losers can’t go below zero, but your winners have no upside limit.
6) Never invest more in micro-cap stocks than you can afford to lose.
The price of outsized rewards on the upside…is increased risk on the downside.
7) Don’t let commissions eat up your profits.
Use an online discount broker and buy enough of each issue to ensure the commission isn’t a significant percentage of your purchase price.
8th.) Safety margin screen:
• Do not buy if leverage is greater than 0.5. Even better are companies that don’t have any debt at all…but that’s a challenge in the micro-cap space. This makes them much less prone to sudden failures in the event of unexpected problems.
• Don’t buy if the company is running out of money and the balance sheet looks like it won’t make it past next Wednesday. The ideal is for the company to make positive earnings, even if it’s just a cent or two per share.
• If the company has reported earnings, be wary if they start falling; Make sure you know WHY.
• A company may be making positive profits but not generating enough cash to support its day-to-day expenses. If free cash flow is a negative number; Find out why. If a small business is burning cash, it may not be around long enough to implement its plan…even if it’s a good plan.
It’s not easy to find micro caps with all these qualities, but they exist. If you find one, look for even more evidence that it could be a winner:
• Watch out for insider buying When insiders buy, that’s a positive sign for us. In a small company, insiders usually have a good idea of whether the outlook is favorable.
• Look for a company with many customers. If its entire business comes from one or two larger companies, it’s more vulnerable.
• Look for a large, growing marketplace…a rising tide floats all the boats.
• Low price-to-earnings ratios are great, but they’re not always essential to finding a good buy in micro caps. That’s because micro caps, earning a cent or two a share, can easily double or triple their earnings in a short period of time when they have a growth spurt, bringing P/E ratios back to earth quickly. In contrast, a company making $10 per share would have a harder time growing its earnings to $20 per share. The important thing here is to know the story well enough to be able to make an informed decision on whether or not you think these double earnings are going to happen.
Know when to sell… and lock in your profits
With micro caps, you want to let your profits run as long as the story stays favorable. It makes no sense to buy a micro cap for a 10-15% gain; If you take a high risk, you should expect a much higher reward.
On the other hand, if your stock doubles or triples in a short period of time, you should sell half of it, take your money off the table, and make a nice profit.
We call this… “gambling with the house money”.
With this strategy, you can still enjoy the run-up (assuming you keep going) and brag, brag, brag… without risking your initial capital. You have already locked in your win.
And when it loses steam and goes to zero (unlikely, but possible) you’ve locked in your win and can still brag about how smart you are.
You also need to give your losers some room for volatility, since micro-cap stocks can be exceptionally volatile. And it’s not always possible to buy them at exactly the right time. But if your pick is down 25% to 35%, consider selling unless it’s clear that a reversal is imminent. We have found that a preset stop loss can take the emotion out of the tailspin and save some of your money for another run at a 10, 50 or even 100 bagger.
The informed, diversified, speculatively oriented investor can make a lot of money
Microcaps, but only through very careful selection.
This sector is not for the faint of heart as the vast majority of these stocks will fail. However, if you follow a few guidelines like the ones we’ve outlined here, you’ll certainly improve your chances of finding the ones that can drive you to the payout window. And that’s when the bragging starts!!!
The editors below MicroCap Marketplace specializes in issues related to microcap investments as well as small cap investments.