Why Micro-Cap Stocks Offer the Biggest Upside to Retail Investors


Do you know what this century’s best-performing stock is?

Here’s a hint: it’s not Google, Apple, or Amazon.

In fact, this century’s best-performing stock started out as a penny stock trading at below US $0.10 in January 2003.

Since then, Monster Beverage (NASDAQ: MNST) has skyrocketed to its current share price of US $84 (as of Aug 26, 2020) and has a market cap of more than US $44 billion.

That’s an 83,900% return for early investors who bought stock at $0.10!

What are Micro-Caps?

While micro-cap stocks are sometimes referred to by their less flattering moniker, “penny stocks”, by definition micro-caps are public companies that have a market capitalization of between US $50 million and $300 million.

Micro-caps are considered “high risk” because early-growth-stage companies are more susceptible to internal and external dangers: burning through cash too quickly, getting crushed by competition, or going bankrupt.

For these reasons, and others, which we will dive into later in this article, micro-caps are not widely covered in the mainstream financial media.

However, Monster Beverage (Hansen’s Natural in 2012) illustrates a key benefit of investing in micro-cap stocks: the potential upside is enormous.

In fact, some of the largest public companies of today started off as micro-caps, including Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B); Wal-Mart (NYSE:WMT); Netflix (NASDAQ:NFLX), and Amgen (NASDAQ:AMGN).

High Risk, Higher Reward

Everyone knows the goal of investing in stocks is “buy low, sell high.”Nowhere is that more possible than in the micro-cap space.

This is why some of the most prolific investors of all time such as Warren Buffett, Peter Lynch, and Joel Greenblatt started their investment careers buying and selling micro-caps.

If your goal is to make significant money in the stock market, micro-caps are where you want to be.

Despite micro-caps being a volatile asset class, they have historically produced greater returns than medium or large-caps. In fact, they are one of the best-performing asset classes out there.

An analysis of historical returns conducted by investment firm DGHM LLC for both large cap and small cap stocks dating from July 1926 to December 2018, found that micro-cap stocks annualized 11.6% total returns over this period, versus large-caps’ 9.4% returns. Micro-caps on average beat large-cap stocks by an annual spread of 220 basis points. This makes a material difference when compounded annually.

According to their analysis, if you had invested $1,000 in micro-caps in 1926, that capital would have grown to $26 million by December 2018. The same $1,000 invested in large-caps would have given you returns of just $4 million.

Going Against the Grain: Why Micro-Caps are Overlooked

As previously mentioned, you’re not likely to see an article about a micro-cap company on the front page of the Wall Street Journal. Despite their huge upside potential, micro-caps are for the most part ignored by the mainstream financial media. They are also overlooked by the large-scale institutional investors, hedge funds, sell-side analysts, and high frequency traders.

Why do micro-caps get the shaft from the major players, and why does this matter?

A key component of a successful investment strategy is beating “the market,” and the market is your competition – the other investors who are playing in the same sandbox as you.

When you’re investing in stocks, not only will you be trying to make better bets than other retail investors like yourself, you’ll also be up against big league institutional investors with way more capital – we’re talking millions if not billions of dollars – to play with.

Not only that, these institutional investors also have access to valuable information that the typical retail investor doesn’t.

They employ teams of researchers and analysts to help them make decisions on buying and selling. All that extra help costs money, which their clients pay in investment fees.

Illiquidity is Your Advantage

These large institutional investors are discouraged from investing in high risk micro-cap stocks due to certain legal and fiduciary obligations to their clients and backers.

They also tend to ignore micro-caps because they have too much money on their hands to bother making such small bets.

Compared to large-caps, micro-cap companies are relatively illiquid, typically trading in the range of thousands of shares per day in comparison to large-caps’ millions of shares per day, and big institutional investors aren’t interested in tying up large pools of their capital in illiquid companies they can’t easily exit from. The relative illiquidity of micro-caps also makes it difficult for institutional investors to secure a large enough position to be worth their time and effort.

Furthermore, for these institutional investors, taking a meaningful position in a micro-cap company (even a relatively small position of a few million dollars) often means controlling stake or buying the whole company outright.

In the US, owning more than 5% of a company designates you a material shareholder: this means filing a 13-D with the SEC, i.e. more paperwork and more hassle when you want to sell.

The Beauty of Inefficiency

The fact that micro-caps are overlooked by the mainstream media, analysts and large-scale institutional investors, actually works to your advantage, because it creates market inefficiency in which high quality micro-cap companies are often under-valued in the market.

This inefficiency means there is less competition in micro-cap investing than in large-cap investing and because you, the retail investor, are not constrained by illiquidity, disclosure bylaws, or minimum position sizes.

You can buy up stock in these smaller, under-the-radar companies at lower prices, before institutional investors and financial media notice.

How to Beat the Smart Money

Ideally, if you are trying to beat the market, you’re placing your bet on a high-quality company early on: before the “smart money” finds it.

If, and when, the institutions decide to buy, they will bid aggressively to take a large position and the stock will climb higher. Once the institutional investors start buying, the mainstream media will report it, causing even more investors to start buying.

If you want to be a successful micro-cap investor, you need to gain an advantage over your competition.

Knowledge is key, and those who do their research can reap huge rewards.

Don’t lose out on the next multi-bagger, micro-cap stock in the making.

Sign up to get access to exclusive research reports, videos, and articles covering the most promising micro-cap stocks today.

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