Investing in Micro Cap Stocks

Investing in Microcap Stocks

 

A microcap stock is a very small company—usually a start-up or tiny business—whose products or services are typically unknown and whose stock doesn’t trade on major exchanges. Because microcap companies are untested by the market, their stock prices can be extremely volatile, sometimes resulting in bankruptcy if the company can’t attract enough consumers. 

Risks aside, if you have an eye for potential, microcaps could result in some major gains. Before you start treasure hunting for the next Shopify, let’s take a step back. What are microcaps, where can you buy them, and what are the risks involved? Let’s take a closer look. 

What is a microcap?

A microcap is a company that has a market capitalization between $50 to $300 million. Recall that market capitalization refers to the total value of a company’s outstanding shares. So, if a company has 5 million shares, each worth $10 each, it would have a market capitalization of $50 million, thus falling in the microcap range. 

Though each microcap is different, you’ll notice some patterns among them. For one, the general public has typically never heard of the company. It may have a small niche following, sure. But, among the mass of consumers, its products and services haven’t quite caught on yet. 

Additionally, microcap companies are usually in an aggressive growth stage–or at least they’re trying to grow. They may have an innovative product they’re on the verge of releasing. Or they could have a line-up of great products, but they need funding to market themselves. Either way, microcaps are often a long way away from profitability. 

How to buy microcap stocks 

You won’t find microcaps on a stock exchange, such as the TSX. Often you’ll have to buy or sell microcaps “over-the-counter,” usually on the OTC Bulletin Board (OTCBB) or on pink sheets. 

If you’re going to buy microcaps, you should look at the OTCBB first. In general, when a microcap is listed on an OTCBB, it has to meet certain requirements, such as keep accurate information on its finances, as well as make financial records available for investors to review. Pink sheets are a different story. When listed on pink sheets, microcap companies don’t have to make their financial records public. This could be a major problem for investors, as you won’t have much transparency into what you’re buying. 

What are the risks of microcaps? 

Along with penny stocks and nanostocks, microcaps are one of the riskiest stock purchases an investor can make. Here’s why: 

1. Unproven products

Microcap companies often offer products and services that are either unknown to the general public or haven’t quite picked up momentum yet. These products could be innovative, loaded with potential, or known by a niche group of consumers. But because the company hasn’t tested their products in the general market, investors don’t know if they’ll pick up enough momentum to drive the company from microcap to a capitalization of a large size. 

In addition to unproven products, the small size of microcap companies often will limit how much research and development they can fund. If their first products or ideas don’t take ground, they could find themselves going in a bad place all too quickly. 

2. Trade over-the-counter

Many microcap companies don’t meet the minimum standards to trade on major stock exchanges, such as the TSX. That means, you’ll have to trade microcaps over-the-counter or on pink sheets. Stocks that trade on pink sheets often don’t have to reveal information about their finances, which means you usually can’t use metrics to analyze a microcap stock.    

Though buying over-the-counter has its risk, so does selling. Unlike large cap stocks, which are bought and sold with a high amount of liquidity, you could find it difficult, if not impossible, to find a buyer for your microcap. You may see some great leaps in a single day, but unless you find someone to take the stock off your shoulders, you won’t make any official gains. 

Finally, if you’re going to trade microcap stocks, you’ll want to find a brokerage who will help you conduct trades. Many of Canada’s top brokerages will help you do this, but you’ll want to double-check first. 

3. Greater price volatility 

Microcaps are far less stable than companies with bigger capitalizations. This can go in two ways: you could have a company that hits it big, resulting in immense gains for you, or you could see a major drop in a short period of time. Either way, if you want stability in your portfolio, if your risk tolerance is low, if you’re planning to retire soon, you probably won’t enjoy the volatility of microcap stocks.   

4. Little (or no) public information 

One of the biggest disadvantages with microcap stocks is the lack of information about the company. Sometimes, microcap companies won’t even have a website, or, if they do, not enough information to help you make an informed decision. 

One place you could find information on microcap companies is the System for Electronic Document Analysis and Retrieval (or SEDAR). In order for companies to operate in Canada, they must fill disclosure documents on SEDAR. If you get lucky, you could find press releases and financial information there, too. 

5. Greater risk of fraud 

Microcap stocks have a long and notorious history of fraud. By some estimates, microcap frauds cost investors around a billion dollars per year. Often these frauds come in the form of “pump and dump,” which involves hyping up a company—usually with misleading information—so as to inflate the stocks’ price. Inexperienced buyers will often buy stocks at overinflated prices, only to be left with overvalued stocks that eventually tumble. 

What’s the difference between microcaps and nanocaps?

Nanocap stocks represent companies with a market capitalization of $50 million or less. In terms of market capitalization, nanocaps are the smallest classification. As such they have all the same risks as microcaps—less liquidity, little public information about the company, higher price volatility—but at a much higher degree. 

What’s the difference between microcaps and small caps?

A small cap is a company with a market capitalization between $300 million and $2 billion. Like microcaps, small cap companies are typically young startups that have growth potential but lack the stability and security of larger companies. Sometimes, you can find small caps on major stock exchanges, though often you’ll find them on the OTCBB. 

The difference between small caps and microcaps is size: small caps may be small, but they’re certainly not as small as microcaps. For this reason, you may find small caps to have less volatility than microcaps, but don’t expect prices to remain stable for long. Like microcaps, small caps tend to fluctuate immensely over short periods of time. They may be somewhat safer for investors than microcaps, but you’ll still need to keep a long term perspective when you invest in them. 

Are microcaps a good investment?

Microcap investing is often seen as a risky venture that ends more often in failure than success. Because microcaps lack public information, not to mention any track record of success, it can be difficult for beginning investors to uncover small companies with the potential to turn themselves into highly profitable brands. 

But that doesn’t mean microcap investing can’t bring you hefty gains. In fact, savvy investors could hit it big simply by looking where no other investor has looked before. If you can find great microcap companies, you may be able to get in the door before the company’s products and services attract the general public. 

Just be careful. Again, if you’re just starting out, stick to companies you understand, companies that have a proven track record of success, possibly a dividend payout. For those who want a little more challenge, microcaps could be a good venture for you.  

About the Author

Iain Butler, CFA, is Lead Advisor on our flagship Stock Advisor Canada service. In addition, he contributes across our suite of advisory services and manages the Discovery Canada and Partnership Portfolios. Before joining the Fool, Iain was a “buy-side” analyst and through this experience is well-versed in the idiosyncratic ways of the Canadian market. His investing interests are centred on scouring the market for interesting businesses that trade at reasonable prices and offer an appealing risk/reward relationship. Iain has appeared in numerous media outlets including The Globe and Mail, CBC’s The National and BNN’s Money Talk with Kim Parlee. Since joining the Fool in 2012, Iain dedicates each day to spreading Foolishness throughout this great country!