Navigating the Microcap Space
Over the last several years, we have continued to generate considerable returns in our portfolio of stocks, and this success is thanks to an accumulation of wisdom—through constant, hands-on learning and studying the successes of those who have come before us.
And along the way, the smallcap, microcap and nanocap market has done what it often does: challenge us.
The market is currently experiencing an ongoing tone of pessimism, brought about by the seemingly impossible optimism in the large-cap space, as the majority of investors keep doing what everyone else is doing.
So our advice is simple.
Ignore the herd
It often seems that everyone thinks they will be the next Warren Buffett by continuing to purchase mega caps on “dips.” This explains why smallcap and microcap investors have had a considerable test of fortitude lately, as many attractive, smaller companies are being left on the sidelines.
The irony of the situation is that Warren Buffett famously got his start in the microcap space. In fact, he made a fortune on largely unknown, small companies, finding them and getting in before everyone else.
And this was no fluke. He is an investing genius who had a very solid strategy.
In fact, his success is a reminder that there is always great money to be made in small companies, but a solid and measurable approach is absolutely needed.
Now is a great time to get started. The market is pessimistic, and most investors are largely absent. The logic is simple: as share prices go down, pessimism increases, and more and more investors stay away.
This also means these companies are getting cheaper, and if nobody is around to buy them then your opportunity is getting better.
However, for those who are new to microcaps, it can be very daunting to know where to start. There is considerable noise, as most companies are simply bad investments, and this casts a negative light over the whole space.
To help you get some clarity, we’re going to break it down into a couple simple steps.
You’re looking for the 5%
In the microcap and nanocap market there are typically two types of stocks: those that have solid fundamentals, are growing—and then the other 95%.
That’s not an exaggeration. This is the market segment where big ideas, lack of oversight, and big risk is part of the game, and as a result failure is common (and healthy). The challenge, of course, is that when you look at this market, you get all 100% of these companies in one basket.
It’s dominated by companies with lackluster to catastrophic performance, and as a result most retail investors don’t bother. But not only do they shy away, so do the larger institutions as they generally require more established, profitable, larger companies as part of their investment mandate.
So, you have a market with almost nobody in it. And, if you know how to look in the right direction, this is actually a great thing. The disappointing 95% provide a camouflage for the exceptional 5%. As we have learned—and demonstrated many times—these companies can produce life-changing gains.
The secret is to know how to find them.
2,750 to 313
If you’re a first-time investor wondering where to start, we’re here to help.
To start, know that what you’re looking for are the gems in a large pile of dirt.
You’ve got around 2,750 listed companies in Canada making up this pile. To reduce this number to something manageable you first need to filter everything out above $100 million market cap.
There are many filtering tools that do this, in addition to just looking up a company’s financials. Once you have done the initial filter, you’ll be presented with a much more manageable pile of companies, many of which are not good investments.
You now must put in the work and sift through every one of these to find the hidden gems—the 10% that are profitable and growing. Whittling it down even further, only 313 companies out of the 2,750 screened as profitable.
You’ll notice there aren’t very many in the end, and you can now apply the various criteria we look for: year-over-year revenue growth, consecutive quarters of profit growth, a small share float, high insider ownership etc.
Of course, this is a simplification of the process we go through, but it highlights the general approach.
How many do you need?
We often get asked how many smallcaps/microcaps/nanocaps an investor should have. The answer is that it completely depends on many factors, most of which are unique to each investor’s personal circumstances.
For instance, you may be happy to hold just one that you really feel good about, or you may want to spread your risk around and have 50. Everyone is different.
Joel Greenblatt, a famous smallcap investor who introduced the “Magic Formula,” advocates for around 30 or less, favouring a concentrated approach.
We have found that around 10 – 15 seems to be an amount that many of the investors we speak to are comfortable with.
Stick to it
And of course, once you’ve gone through the screening process and have your portfolio, ensure that you stick to your strategy. Regularly check on your investments to make sure they still meet the requirements (growth and profitability), adding and removing as necessary.
If you’ve done your homework with the initial list, this final phase is more about tinkering than anything else. Don’t let the latest trends or the headlines of impending doom shake you off.
And above all, enjoy the ride.