A few posts ago, I put up an analysis of Crystal Rock Holdings where I mentioned that it is a micro-cap stock. What this means is that the total market value of all of the outstanding common shares at the current share price is less than $100 million. Some people like to define micro-caps as having a market cap of less than $25 million, but that’s really just splitting hairs. The important thing is that companies of this size are small enough that they are essentially out of the reach of professional investors. This makes investing in micro-caps perfect for amateur investors as mispriced bargains are generally easier to find if professionals aren’t looking for them.
Micro-Caps – Ignored by the Big Guns
Most institutional investors, hedge funds, and mutual funds can’t invest in micro-caps as they are illiquid stocks. Depending on the company and the amount of money to be invested, it can take weeks to establish or get out of positions without drastically affecting the share price. For most funds, not being able to trade in and out of positions when required disqualifies these stocks immediately. Funds are also generally looking to invest in opportunities where they can accumulate a significant position in relation to their total assets under management so that if the underlying stock does well, it is reflected in the fund’s performance. However, with micro-caps, a large fund may run up against ownership limits while establishing even a relatively modest position.
Examples of a Micro-Cap ‘Mispriced Bargain’
Recently while browsing through a list of Canadian micro-caps I found a stock that for a good portion of last year traded at a price that was below its net current asset value (current assets minus total liabilities). This basically means that at the price the stock was trading at, for every $0.90 you put in, you ‘bought’ $1.00 in cash, receivables, and inventory with the rest of the assets and earning power of the business thrown in for free. This was also an established company that had turned a profit in 9 of the last 10 years. The company’s board of directors, being at least somewhat insightful, authorized an unlimited share repurchase plan that would remain in effect as long as the stock was trading below its net current asset value. In doing so, the company was able to repurchase a relatively significant number of shares on the open market to enhance the return to continuing shareholders at the expense of those who were silly enough to sell out.
If you’re wondering, as far as I know the only time in the last 100 years that profitable large-cap companies sold for less than their net current asset value was at the end of the Great Depression. In general, securities analysts know exactly the asset backing that their companies have on their balance sheets and what their underlying businesses are approximately worth. Because of this, highly covered stocks rarely trade far from their fair value, and will almost always trade far above their net current asset value (NCAV). However, for stocks with no analyst coverage (like all micro-caps), investors actually have to look up, read through, and understand the company’s financial statements to determine a company’s financial position. By just referring to the earnings per share and other ‘standard’ data aggregated by the financial sites such as Morningstar, Yahoo, or Google, investors that sold out of the abovementioned stock at a price less than the net current asset value got hosed as it is unlikely that they could have found a cheaper, higher quality company to invest in at the time. (Note that the stock in question has run up over 50% since this time and while it is still trading at a discount to what I would consider fair value, it is no longer the screaming buy it once was).
Here’s the Catch
Now, the biggest advantage of investing in micro-caps is also its largest drawback. As analyst coverage of micro-caps is virtually non-existent, the only way to find suitable investment candidates is to research them by going through exchange listings, one by one, and reading through company’s annual reports and financial statements. Most of the time, companies can be eliminated from further consideration after looking at their most recent annual report. However, some of the time, you’ll find the hidden gems like the stock mentioned above. Then you just have to make sure that you invest with a big enough margin of safety, be patient, and wait for the market to recognize the value you’ve uncovered.
Until next time,
Nathan @ EngineeringIncome.com
The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question. The investing methodology outlined on this site assumes that a stock will perform in the future as it has in the past. This is generally not true. It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation. For more information, please see my disclaimer.