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Wall Street Is Noticing These Micro-Cap Stocks -- Here's Why You Should Too

David Sterman

Investing in little-known micro-cap stocks can be frustrating -- but it can also be rewarding.

Even if a company appears to be making substantial progress with product design or customer orders, shares can move nowhere for an extended period. Indeed, before they finally get noticed, shares can fall further in value as freshly injected growth capital dilutes the share count.

Investors like micro-caps for their potentially stunning gains. I've come across two micro-caps that are finally getting notice, and if they can execute on their game plans, they have the potential to soar. (And in a moment, I'll note promising micro-caps that have not gained traction but are worth monitoring.)

1. Biodel (BIOD)
This stock epitomizes the trials that micro-cap stocks put investors through. The company was developing a promising device, known as Linjeta, that was designed to inject insulin into the bloodstream more rapidly than other approaches. The device could automatically respond to blood glucose levels, regulating the amount of insulin needed. The FDA ultimately rejected it due to efficacy concerns, and management was forced to return to the labs and build a better device.

BIOD-123 may be that device. It can deliver insulin in a rapid fashion, and thanks to built-in sensors, it can identify when blood sugar gets too low and provide more insulin. This device is unlikely to reach the market for several years, but investors are already bidding up shares in anticipation of solid phase II clinical data due out later this summer.

Note that this stock traded above $75 five years ago. That's because any new diabetes device that could more precisely dose insulin would be a blockbuster. Shares will never reach that level again, simply because there has been and will be a hefty amount of shareholder dilution before BIOD-123 reaches the market. And the still-low share price, relative to where it once stood, tells you many investors must think BIOD-123 will suffer the same fate as Linjeta.

Yet as Biodel moves closer to the clinical testing finish line, expect this company to pick up a deeper analyst following, and look for analysts to more squarely address potential market sizes. This is surely a company to closely monitor in the weeks and months ahead.

2. Mazor Robotics (MZOR)
I first came across this company in a recent issue of Andy Obermueller's Game-Changing Stocks newsletter. He caught my attention with this stock, comparing it to Intuitive Surgical (ISRG), which is now a behemoth with a $20 billion market value and more than $1 billion in annual operating profits.

Intuitive Surgical's success comes from a line of robotic surgery equipment, known as the da Vinci Surgical System. Many firms have tried and failed to replicate Intuitive Surgical's success, but little-known Mazor may have a decent shot with its equally impressive set of robotic surgery tools under the name Renaissance.

Can this little Israeli company, with a sales base of around $20 million, move into the big leagues? Investors are betting so, as Mazor's stock has more than doubled this year. The spike in shares has pushed the market value up to $160 million, which is still less than one-hundredth of Intuitive Surgical 's market cap.

The differentiator: Mazor is tackling the spinal surgery market, which is a $7 billion opportunity and a big source of profits for hospitals.

But how effective are Mazor's robotic surgical arms? In 2010, a study found that the company's Renaissance system operated with 98.3% accuracy. Another study, conducted a year later, found that Mazor's equipment reduced the chance a patient would suffer complications or need to re-enter surgery when compared to traditional spinal surgery.

Convincing doctors to change the way they operate will take time, so Mazor won't become an overnight powerhouse in the spinal surgery market. Jeff Cohen, who follows the company for research firm Ladenburg Thalmann, sees sales rising from around $21 million this year to $42 million by 2015. That's still a drop in the bucket compared with Intuitive Surgical. But that company had less than $100 million in sales in 2003 -- and more than $2 billion a decade later.

As with any small, speculative stock, a few caveats apply. Mazor will probably need to raise money to fuel further growth, which could dilute existing shareholders. And Mazor won't likely be profitable before 2016.

Still, even Intuitive Surgical had to start somewhere, and investors who focused on that stock when annual sales were below $100 million have generated a return in excess of 1,000% since then. I don't predict that kind of upside for Mazor, but game-changers like these can post solid gains for an extended period.

Here are other micro-caps ignored by investors but that appear to have robust potential:

  • InspireMD (NSPR). This company has developed a cardiac stent that is reported to have a stronger safety profile than stents on the market. The company has been presenting clinical trial results in tandem with robust recent insider buying activity.
  • ID Systems (IDSY). This micro-cap has been working for more than a decade to build a customer base for its system that manages and monitors fleets such as warehouse forklifts and rental cars. For years, sales growth was unimpressive, with revenues never exceeding $27 million. Yet sales surged to $40 million in 2011, and analysts expect them to hit $60 million next year. This company's long-awaited promise may finally be paying off.
  • Capstone Turbine (CPST). Back in February, I suggested this stock could double in 2013. Shares have been up 30% since then, but a number of recent new customer wins indicates further gains ahead.

Risks to Consider: Micro-caps typically carry great risk because of their low trading volumes and persistent balance sheet weakness, so no holding should amount to more than 5% of your portfolio.

Action to Take --> With risk comes reward, and when the stars align in this asset class, the gains can surpass any mid- or large-cap stocks. Find companies that aren't on the cusp of a new round of dilutive financing or are on the cusp of meaningful sales growth.

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