Are Micro-Cap Stocks Worth Buying, How to Identify Them?

Today’s e-commerce giant Amazon.com was a micro-cap company in 1999, with a share price of US$5 and with a total market-cap of ~ US$1.5b. Similarly, Netflix – a household name now, was a micro-cap in 2014, with a total market cap of somewhere around US$1bn. Getting stocks like Amazon and Netflix in micro-cap arena is indeed enticing, but on the same time, there were many micro-cap companies like Amazon and Netflix, who started out as a small business and got bankrupt and went out of fashion.

However, successful investing in micro-cap stocks require an insight of risk attached to them and expertise of how to segregate worthy business from bad ones. Screening for worthy micro-cap stocks during the investment journey is both art and science, and, it takes time to fructify.

What is a micro-cap stock?

Before we start discussing the micro-cap stocks, it is necessary to understand that it is demand and supply forces that determine a company's value in any recognised stock exchange like the London Stock Exchange. When we hear jargons like small-cap, mid-cap and large-cap companies, they basically mean the extent of a company based on its outstanding market capitalisation. Market capitalisation is calculated by simply multiplying the total number of shares in the issue including shares held by the company's executives as well as all other insiders, with the current share price traded on a recognised stock market exchange.

For example, if a company has a total of 100 million shares outstanding and GBX 20 per share was its last price quoted on a major stock exchange, such as the London Stock Exchange, then the company's market cap would be £20m.

However, there is no threshold of market-cap for a micro-cap stock in the UK, but generally, a market capitalisation of less than £200m is considered to be a micro-cap company, these are a small business with significantly higher risk and return trade potentials and are more speculative in nature.

Risks faced by the small-cap investors?

In your investment journey if micro-caps suit your risk appetite, then you need to understand that the overall volatility in the small-cap arena may overestimate returns and underestimate the risk associated with buying and selling of any individual micro-cap stocks.

Since many micro-cap stocks are typically younger companies with little to no earnings or little cash on their balance sheets. Also, the ratio for filing bankruptcy in micro-cap companies are typically higher than their larger peer group companies. This is the single most riskier element in micro-cap investing, especially when the season is rough because these businesses rely heavily on issuing new shares to raise capital for operations and growth as compared to their large-cap peers, and during economic or industry downturns, investors are less willing and able to buy newly issued shares to keep a company afloat, which heightened bankruptcy risk into these micro-cap companies.

Also, companies belonging to this micro-cap arena, rely heavily on a selective number of clientele, and if things go wrong with their one or two clients, it could have a severe impact on the company, and this is among the biggest risk the mid-caps witnesses. They also have to go through steep competition, such as the new entry to the market that impacts the prices of products or services down, and they may not have sufficient finances to survive the race.

Micro-cap investors like the small cap investors, also have to assume liquidity risks. There's typically less market interest in micro-cap stocks arena, so there can be inadequate supply when you want to buy or go long on shares, or they can have less demand when you want to sell shares. Because average daily trading volume for the medium-cap stocks, like the small cap counterparts remain low than for the stocks of large-cap stocks, their prices may show extreme volatility, which can result in small-cap stock investors paying more than expected when buying or accepting less than expected at the time of selling.

One should also take into consideration that smaller companies are often new and less mature younger and therefore, may not yet have enough processes and mechanisms in place in terms of their financial accounting. The initial phase for young companies can be sharp and sticky, which may result in unexpected downsides, including the reiteration of past financials or monitoring inquiry.

How to identify worthy Micro-Caps or Micro-Cap Stocks?

While shopping for micro-cap stocks on the trading terminal, one pays closer attention to their business models, rather than crunching their financial numbers. If a business model is unique and their offerings have huge scope for penetration in future, and also the company is in the hands of reliable and trustworthy management, this should be the first level of screening for the micro-caps. One can read about the company's business model in their annual report, corporate presentation, industry presentation and on search websites as well; also, you can get to know about the quality of management team from there. Then the second step is to try and understand demand potential for their offerings or products and supply for a similar product from other competing players.

A thorough analysis of the degree of competition prevailing within the sector of the screened company is required, and if there is a cut-throat competition within the industry, then look what unique competitive advantage your company has, it could be new technology, new process, availability of fund, location advantage and clientele.

After taking through these above-mentioned tests, after that its turn for financial analysis of the company’s reports and financial statements, few things that should raise eyes like, the higher debt levels, significantly lower cash position, lower or thin margin, non-operating items contribution in the group’s revenue.

However, there are many other factors which should look closely. After the company passes all the filters, you put for stock quality examination. Then one can buy those stocks, because these could be hidden gems and could turn their investors' fortune in future, like how Amazon.com and Netflix did in the past. Your one right bet in the micro-cap arena could significantly enhance your financial conditions forever, but on the other hand, it requires higher risk appetite and patience too. One needs to thoroughly analyse the market and the prevailing conditions for taking any investment decisions.