Are you one of those investors with a dark secret hidden somewhere deep down in your portfolio? You know, a penny stock (or more, let’s be honest) that, now that it’s down over 75%, you’re not sure why you bought?

You are not alone. Countless non-pro, smallcap and microcap retail investors have gotten smoked since the highs of early 2021. The massive, FOMO-fueled run-up was met with an equally massive dip, resulting in a whole new generation of Average Joe bagholders.

Meanwhile, professional investors have been spending the last year following a strict set of investment criteria, uncovering several sectors (like oil and gas) with smallcaps and microcaps that are showing signs of strong growth ahead.

A professional investor’s superpower is the ability to separate business performance from stock performance and then taking advantage of those who can’t. And when it comes to surviving volatile markets like we have seen recently, remember that the amount of due diligence you do on an investment opportunity often correlates with the amount of volatility you’re willing to endure.

For those who want to be more of a pro this time around, it starts with understanding some basic criteria that every microcap stock should meet.

Revenue growth

Simply put, revenue growth tells us something is working with the company. They could be bringing in more sales, growing their customer base, growing their product line and so forth. This growth reflects positive momentum and value creation.

Any sign of revenue growth is a good thing. But as a rule of thumb we look for at least 25% year-over-year revenue growth per share. However, revenue growth can come from many dubious places; this alone is not enough to really understand how healthy a company is. For that reason, we need profitability.

Profitability

While there are some instances where profitability may not be a deal-breaker, to keep it simple we highly recommend not compromising on this crucial aspect—at all.

We look at profitability as a sign that the company is sustainable. Yes, by the time a company is profitable there is usually a premium to be paid, but it’s worth it—especially in the microcap space, where the majority of companies don’t make it.

Profitability tells you that a company’s business makes sense as customers are willing to pay more than it costs to make and sell a product or service. Profitability also tells you that management knows how to run their business and that they aren’t just continually funding operations from financings. Running a business is hard, and it’s even harder to generate a profit at the end of the day.

And remember: profit allows a company to self fund its operations. And this lessens the risk that the company will dilute your shares.

Our general rule is to see at least two consecutive quarters of profitability. When combined with revenue growth, this shows that you are buying an actual business, not just a stock.

Shares outstanding

As we have noted in previous posts, roughly 10% of profitable microcaps have more than 100 million shares outstanding. And 60% have less than 20 million shares. 60%!

That statistic speaks for itself. And while there is no magic number of shares outstanding, we have found that 30 million and under is a good ballpark.

But why does share count matter? After all, 100 million shares at 10 cents has the same market cap (value) as 10 million shares at $1.

Low share count = sound management

Apple has billions of shares because it’s a massive, money-making machine with a track record of profit growth. As a market-leading mega cap, they need to have a stock that’s incredibly liquid to ensure the hordes of institutional investors are able to buy and sell positions.

Smallcaps and especially microcaps, on the other hand, should have a very small number of shares because they are early in their history. They do not yet have a long track record of revenue growth and profitability, nor do they have established businesses.

When a small company issues too many shares, this is often a sign of bad management running an unsustainable business. How a management team treats its shares is usually a good indicator of how they treat their cash, their staff, clients and customers or any other vital resource. As we have stated before, some management teams treat their shares like toilet paper. Others treat them like gold. We know which ones we would rather be holding.

Also, a low share count often creates a “problem” that’s actually a good thing . . .

Illiquidity

First, a small share count often includes a healthy amount of insider ownership. This leads to a tight share structure, as insiders with a large personal ownership tend to have a vested interest in seeing little share dilution.

And if this company is reluctant to issue shares, large investors will have to pay up in the open market as they face illiquidity. Yes, embracing illiquidity can be uncomfortable, but it’s definitely a key part of successful investing in the smallcap (and especially microcap) space.

No, or Few, Institutional Investors

Once the institutions step in and start buying, a major stage of the investment discovery process has ended. It’s not often too late for the big gains, but if you are buying at this stage you’re now competing against these buyers. Savvy investors want to own before the institutions start buying. And once these funds are positioned and if the market turns, fund managers will turn around and sell almost indiscriminately as they are under pressure to get rid of bad performers to keep their jobs.

Right now, these funds are as far away from microcaps as we have ever seen them.

But they will come back. And when they do they have to buy a significant amount of stock as a requirement of their portfolio. If they can’t finance, they’ll have to nibble until they get enough, and with a tight share structure that’s often a recipe for explosive share price growth.

Just look at one of our recently interviewed companies, Verde Agritech (TSX.V: NPK). We interviewed management in September 2021 when nobody cared. There were very few institutional owners several months ago. They all love it now . . .

Check out the interview here.