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3 Key Reasons to Take the Micros Seriously


Micro- caps are characterized by a market cap value of between $50 and $300 million. I like Nano caps (sub $50 million market cap) even better. Here are 3 key reasons you should not exclude small caps, micro caps and nano caps from your consideration and instead give them another glance next time you come across an attractive story in a small stock.

Micro caps likely to offer higher returns

There are studies exhibiting better returns for small cap stocks. However, many of them have severe issues ranging from businesses that are the personal playground of execs, to pump & dumps and other frauds. The former exists at larger organizations as well, though frauds don't make it there as often. Some small cap businesses become micro caps as they are failing and shrinking in value.

Problems come with opportunities for the discerning investor. Because of the large differences between the bad and the great, there is a lot of opportunity for the active investor to apply skill and pick the better stocks.

Michael Mauboussin said in "In Alpha And The Paradox Of Skill:"

"Picking Your Game

How do you find games where you have an edge in relative skill? The answer is complex but we will focus on three areas: diversity breakdowns, institutions versus individuals, and inefficiencies that arise from technical selling or buying. All areas represent pockets of inefficiencies that are likely to persist, but the opportunities move around across asset classes and geographies."

Diversity break-down is whenever the shareholder register of a publicly-traded company is made up of the same type of investors. Examples would be hedge fund hotels or companies that pay a very high yield and are favored by income investors.

Generally, it isn't great to trade against institutions. While there are exceptions, you are much better off trying to trade against people who are not professional investors. For example, you could trade against retail investors who bought a hot IPO and are throwing in the towel 12 months in and 30% down.

Inefficiencies from specialized buying or selling can happen when a stock is hauled out of your NASDAQ or NYSE into the OTC board, or when a stock is added to the S&P 500 or another large index. That can induce a selling or buying frenzy.

Mauboussin included a graph showing areas where dispersions (or opportunities) are larger.

The graph doesn't specify the micro cap domain, but it's clear that U.S. micro caps will have a large dispersion compared to U.S. small cap.

The competition has moved on

Back in 2005, Warren Buffett (Trades, Portfolio) told a Kansas Business-school University Student:

"The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts. It would perhaps even be easier to make that much money in today's environment because information is easier to access."

Warren Buffett (Trades, Portfolio) does not dabble a lot in micro caps any longer, and neither does Stanley Druckenmiller (Trades, Portfolio), David Einhorn (Trades, Portfolio) or even David Tepper (Trades, Portfolio). The best players move on and the dispersion remains as the lesser players keep fighting over the scraps. This can be to your advantage.

I used to play poker professionally. In that game, a key skill is to manage your ego. If you manage to consistently play other players that are below your skill level, you are likely to win. If you are constantly playing at tables that are too hard, it will be very hard to make any money.

It should be far simpler to kill it in the micro caps, and that's been my experience as well.

Efficiency of analysis

"The person that turns over the most rocks wins the game. And that's always been my philosophy." -Peter Lynch

If you've ever browsed 10-Ks of large caps, you understand very well what a challenging endeavor that is. With micro caps, you may understand every line on the balance sheet, as there aren't many lines to go through. Often they have only one type of product.

As I filter through micro cap filings, I'm able to look at a lot more opportunities. It is not about realizing some marginal advantage of 1% by finding one little nugget in hundreds of pages. I want to dig through hundreds of these opportunities and look at a number of important pages. I'll be able to quickly assess whether it is something I want to dig in further. A key clue may be a competitive advantage that's not priced in, or perhaps a turnaround within the company which is not represented from the latest financials. I like situations where it is very hard to lose money (in the losing permanent capital sense as Buffett calls it) and where there's uncertainty around the upside. I don't have to have a good sense of the upside (analysts often call this earnings visibility), but there needs to be a reasonable chance of making a lot of money. If that prospect isn't there, the risks are usually too large by comparison.

Disclosure: No positions.

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This article first appeared on GuruFocus.