There are more companies in the microcap space than in all the rest of the American-listed universe…

Excluding financial companies and international companies with secondary listings in the U.S. (i.e., American depositary receipts, or “ADRs”), roughly 2,500 microcaps are listed on U.S. stock exchanges. All of these companies have a market cap between $10 million and $1 billion.

This massive universe is both a positive and a negative. It offers investors the chance to make multibagger returns.

But it also makes it even more important to do your due diligence before investing.

Because of this, as well as the perceived higher risk, a lot of people shy away from microcaps. Investors – both Wall Street pros and regular folks – as a whole are largely afraid of them.

That has created a lot of misinformation about the space. With so few people paying attention to microcaps, it’s a veritable Wild West out there. So to take advantage of its multibagger potential, you need to separate fact from fiction.

Most investors think microcaps are synonymous with “penny stocks”… are riskier than larger companies… or are at risk of having their competition wipe them out. Let’s address these concerns one by one.

1. Microcaps are not the same as penny stocks.

People often confuse microcap companies and penny stocks as being one and the same. The truth is, they’re anything but.

Any stocks that trade for less than $5 per share are often considered penny stocks. These get a bad name, though, because “true” penny stocks are those that trade for less than $1 per share.

These companies are viewed as a speculator’s paradise, where a $0.05-per-share tick higher can mean a huge move in the share price. The problem is, true penny stocks are often cash-burning companies with no products or revenue.

But these stocks are just a small fraction of the microcap universe. In reality, the vast majority of microcaps are real companies.

We’re not interested in recommending a speculative biotech stock trading for $0.10 a share that might jump to $1 a share in a month because management announces research on a new compound.

Instead, we’re looking for the microcap company that could become the next Domino’s Pizza (DPZ)…

And thanks to how big the microcap universe is, lots of those setups exist… if you know where to look.

2. Microcaps are not riskier than larger companies.

With recency bias and the rise of the “FAANG” stocks over the past several years, many investors assume that large-cap companies will outperform small caps. But the numbers suggest this trend won’t continue for the foreseeable future.

If anything, this recent outperformance for large-cap companies is what makes microcaps so attractive today.

That’s because we typically see a “reversion to the mean” over time in terms of size.

Research from Nobel prize-winning economist Eugene Fama and finance professor Kenneth French discussed this idea in what has become one of the most heavily cited papers in all of finance…

Large-cap companies tend to fall in value over time. Once a business is that large, the probability that it can keep on creating incremental value and see its market cap rise is lower. The probability that any action the company takes could lead to lower returns in the future rises.

That becomes especially true when large caps have outperformed for as long as they have. Reversion to the mean says that things tend to return back to equilibrium over time… And we’re primed for that trend.

Part of the reason is that large-cap names – having outperformed for so long – are now overvalued.

At the same time, microcap names – having underperformed for some time – are likely to see a similar reversion. But for them, it will be to the upside. These companies become inexpensive relative to large caps and are now set up to also revert to the mean.

Microcaps aren’t higher-risk than large caps… They’re setting up to be higher-return.

3. Larger competitors won’t put microcaps out of business.

Once they’ve started to generate real cash flow, microcap companies don’t typically get annihilated by their competitors… They get acquired by them.

One of the advantages of microcaps is that they’re easily digestible acquisitions for their larger peers. That means once a microcap company’s fundamentals start trending higher, they’ll command a much higher valuation.

Second, many of the companies we focus on operate in niches that don’t move the needle for larger companies… yet.

Take a tiny company that makes key satellite components, for instance. Rather than being at risk of a large-cap competitor putting it out of business, the microcap is much more likely to be the large-cap company’s supplier.

If its customer wins a major government contract, it might barely move the needle for a large cap… but would be a game-changer for the microcap supplier. These types of opportunities happen all the time in the world of microcaps.

One of the most common misconceptions about microcaps is that rather than being real businesses with real cash flows, they’re “pump and dump” companies whose operators are merely waiting for the next sucker to come along so they can cash out.

It’s true that some microcaps have these characteristics.

But armed with the right investment approach and data, investors willing to do the work can use these perceived concerns to their advantage… and unlock triple-digit upside.

Regards,

Joel Litman

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Source: Daily Wealth