Investing in Small/Micro Cap Stocks

[Hobb]

So I've been lurking through this forum for a while, and have been pretty impressed with several different posters' analyses of whatever financial topics.

As an investor, I've mostly strayed away from small/micro cap stocks for many reasons, including:

1. UN-necessity
2. Risk
3. Poor understanding of what to look for

I am by no means a financial expert, but I like to think that I have some idea what I'm talking about when it comes to stocks. I was wondering what you guys look for when you research a smaller cap stock or a penny stock - I feel like essentially I am looking for a 1-to-1 downside (loss of principal) versus a very high ratio upside.

For example, I read a post about IMMR which I guess Sklansky presented on this forum. I haven't read the post in which he explained why to BUY IMMR, but I see that it has done very well. What, Sklansky, did you look for?

Thanks guys,

C

[TheMetetron]

I would personally just invest in small/micro cap funds unless I really knew what I was doing. There are some good ones out there; the Vanguard ones are adequate but not really as small as a lot of people might like.

[Hobb]

So I feel like Bio/Biotech/Biochem/Lab stocks are the way to go in small-cap investing. You say you want to be comfortable knowing what you're getting into - obviously a fine (and correct) sentiment.

But otherwise, are there websites or other forums you guys go to for stock research/tips, maybe specifically for tech/science research?

[DesertCat]

[ QUOTE ]

So I feel like Bio/Biotech/Biochem/Lab stocks are the way to go in small-cap investing. You say you want to be comfortable knowing what you're getting into - obviously a fine (and correct) sentiment.

But otherwise, are there websites or other forums you guys go to for stock research/tips, maybe specifically for tech/science research?

[/ QUOTE ]

I invest for a living in small cap/microcap stocks, and beat the indexes by substantial margins. I get the feeling you are just gambling here. It's difficult to predict the outcome of any developmental stage business, esp. those dependent upon developing new technologies/compounds/drugs. It sounds like you want high risk stocks but I don't see any evidence you'd be +EV at picking winners.

My strategy is to buy good businesses that are undervalued, or crappy businesses that are way undervalued and facing a catalyst event that will realize that value. My typical pick has almost as much cash as it's market cap, or a PE substantially below 10. It's much easier to find opportunities in the microcap area. It's basically "deep value" investing and it sounds boring, but it has provided me very high returns with much less risk than playing the high growth startup roulette.

But to pursue this strategy you have to be able to value a business. If you don't understand how to read financial reports you simply can't do it. If you aren't suspicious, you'll be at risk of getting snookered, esp. with pink sheet stocks. You have to understand how to detect signs of fraud, stock pumping, and misleading financials.

I think Kimchi is right. I almost always recommend index funds because they protect you from making big mistakes. But index funds aren't probably the best options for microcaps. You might look for a small mutual fund with a strong record in small/microcaps (i.e. it beats the small cap indexes over the last 3 years or more), and get in before it gets too large to be successful anymore. I think a company called Bridgeway (?) has some funds with great track records in this space.

[Hobb]

You're completely right - I wouldn't be picking winners, but I hope to learn to. Thanks a lot for your tips.

So I've had several courses on finance/valuation/etc., but I've definitely not developed the eye for financial reports that it seems you have. Is this developed through experience, or some book, or what?

I've had pretty solid success in my portfolio but definitely don't know all the nuances of a financial report.

Thanks,

C

[DesertCat]

Modern finance courses can teach you things that are clearly untrue or at best useless to a investor (i.e. volatility, i.e. beta is risk, markets are totally efficient, there is a relation between beta and returns, there is an efficient frontier, etc).

For a starter, read The Intelligent Investor by Graham, the latest version with the Jason Zweig commentary is pretty good. It's not an easy read, and it's dated, but it basically lays out the framework for investing, i.e. buy below value with a good margin of safety.

Then read Security Analysis by Graham. Older versions are much better than the latest, they still sell versions from the 50s and 40s that are pretty good, Buffett recommends one from the 1930s. Totally dry textbook, but if you can't get through it, you probably aren't ready.

Those two books should give you a good theoretical framework for valuing stocks/bonds. To translate that into real world applications, read every Berkshire Hathaway shareholder letter written by Warren Buffet, they are freely available on BerkshireHathaway.com. He discusses what makes good businesses, what makes bad businesses, smart investing decisions and dumb investing decisions, plus tons of other interesting stuff like merger arbitrage, etc.

Then to round out your education, read "How to be a stock market Genius" by Joel Greenblatt to learn how to find opportunites and structure your porfolio to maximize returns without excessive risk. Read "common stocks and uncommon profits" by Fisher to go beyond Graham to think about stocks as businesses and what makes great long term companies and hence investments. I think Peter Lynch's "One up on wall street" teaches how to value growth stocks and how to use the scuttlebutt approach to investigating potential investments to see if they are as good as their financials indicate.

Finally, keep reading. Don't ever stop.

[gull]

[ QUOTE ]
I think a company called Bridgeway (?) has some funds with great track records in this space.

[/ QUOTE ]

Just to clarify, Bridgeway does have good small and micro funds. And even though they are tax-managed, they are still great choices for taxable. Also, they are passively managed.

[donfairplay]

[ QUOTE ]
I think Kimchi is right. I almost always recommend index funds because they protect you from making big mistakes. But index funds aren't probably the best options for microcaps. You might look for a small mutual fund with a strong record in small/microcaps (i.e. it beats the small cap indexes over the last 3 years or more), and get in before it gets too large to be successful anymore. I think a company called Bridgeway (?) has some funds with great track records in this space.

[/ QUOTE ]

I'm an investor in Bridgeway's Ultra Small Company Market Fund. The expense ratio is very low (.65%). I've done about average with it, about +11% over the year, but that's mainly because I bought it near its top. It tracks about the same with the CRSP 10 index. Its more of a quant/model based microcap fund than a stock picking fund.

I think the real value is reading John Montgomery's fund reports. He's very upfront about mistakes he's made along with his successes. There's even a section for each fund's top 10 biggest percentage losers entitled "What didn't work".

I've been *occasionally* investing in some of the individual stocks that he picks. However, you need to be very careful if you do that. I used to work for a subprime auto lender that was a big holding of Bridgeway's. The stock dropped real fast after a profit warning, Bridgeway sold every last share after the stock dropped 40%, then the stock dropped even more (around a 65% loss in a period of 6 months). Unfortunately, I'm unsure of when Bridgeway bought into the subprime auto lender, so the 40% loss may have been a long-term holding with steady gains.

[yellowbastard]

You are more likely to find mispriced securites that have market caps of less than $500M. PZI is an ETF that tracks a micro-cap value index that has done 14% for 5 years.

[kimchi]

[ QUOTE ]
You are more likely to find mispriced securites that have market caps of less than $500M. PZI is an ETF that tracks a micro-cap value index that has done 14% for 5 years.

[/ QUOTE ]

If that was then case, then surely an index fund would be the least +EV. Buying/selling mispriced securities are what fund managers are (supposed) to do.

As a side note, many small cap funds that do well attract lots of new money which make it increasingly difficult to maintain performace as size has several disadvantages when investing - especially in small caps.