Microcap Investment Theory

Many investors are interested in Microcap speculating because they believe this segment of the market has the highest potential for outsized returns. This article will: 1) make the argument that Microcaps are not favorable to liquid, large caps on a risk-adjusted basis, and 2) provide a framework for gaining exposure to Microcaps if the enterprising speculator is still interested in such opportunities.

Final take:

1. Don’t invest in Microcaps because holding the indices and the largest, most liquid leaders of the market is more profitable;

2. If an investor is going to speculate in the land of Microcaps, credit diligence is of utmost importance;

3. Most theme based ETFs suck and speculators can outperform them by simply holding the best names in such theme;

4. Keep positions small (1% of portfolio) and in names that are trading above the 50 day moving average and 200 day moving average;

5. DO NOT “HOLD THE BAG” ON A POORLY TRADING MICROCAP… MICROCAPS WILL GO TO ZERO IN MANY CASES

What is a Microcap stock anyways? The exact definition depends on who you are talking to, but if we go by Investopedia (and I often do) we’ll say “a publicly traded company in the US with a market capitalization between $50mm and $300mm”. A tangential term is “penny stock” whose definition is a publicly traded company whose stock price is less than $5 / share. Companies can engineer their share price to a certain extent via reverse splits, so I prefer the term Microcap.

Below I will lay out some common reasons investors may choose to speculate in a Microcap name:

1) An investor believes he has found a young company before the institutions such as many BioTech stocks (or the institutions cannot buy the name for some reason - US cannabis stocks come to mind here). If management can execute, the institutions will start buying the stock and he can ride the liquidity of major institutions to a nice profit; or,

2) A speculator believes the microcap stock is “so beaten down it is due for a bounce”. This strategy can work for some trading styles (particularly if the name is on trend - at the time of writing anything related to GPUs/AI Infrastructure), but it is quite important to define the risk/reward of the opportunity; or,

3) The sector is nascent and the company “hasn’t been found yet” or “is pre-earnings”, but as the sector gets hot XYZ Microcap will eventually be found and price will rise, even if temporarily (aka Pump and Dump). Examples of this may in the lithium/rare earths, AI, EVs.

Let’s be super clear about what all microcap names have in common: very little liquidity. 

Next thing to be super clear about: more liquidity is always better than less 

Last item: follow the trend in price

If the stock price is trending upwards (positive sloping 200 day moving average) more liquidity is better, bonus points if the liquidity increases on days/weeks where the stock goes up and decreases on days/weeks when the stock goes down. Recent charts from TraderStewie show the accumulation/upside volume well, and readers should take note of the market caps and the percentage moves - PLTR up 70% in a month ($36BN market cap); LCID highly coiled for what looks like an explosive move in either direction ($13BN market cap). These moves could make any speculator blush - what is so tantalizing about microcaps at all?

Under/Overperfomance:

Microcap names underperform both the indices and “large, liquid leaders”. Large, Liquid Leaders is a term I have seen on social media recently used by disciples of William O’Neil. My opinion is that to attempt and outperform an index on the way up, the enterprising investor needs to be somewhere between Bill O’Neil (RIP) and John Bogle, that is to say “put most of her capital into passive indices (SPY QQQ) and then pursue Model Book Stocks with the remainder”. Not “put most of his capital into passive indices (SPY QQQ) and then pursue tiny companies with very little dollar volume because the ‘institutions have missed this’”. Outperforming an index on the way down (though very difficult) is most easily achieved by simply removing a portion of cash from the market, say 75% SPY and 25% cash — the hard part is knowing when to reenter the market and thus the adage “time in the market > timing the market”.

Large, Liquid Leaders at the time of writing include names like NVDA, META, and SMCI (which is a small cap and the largest holding in IWM and IWO). SMCI is a little known company with an $18BN market cap and a stock chart that is the definition of “nosebleed high”, but the stock has been averaging $1BN of trading volume per day for over a month. THAT gets my attention, period.

How to allocate a microcap portfolio:

Microcap speculation will require credit work and precise portfolio allocation. That is treat each position as you would a call option (that is to say, no more than 1% of total capital) until you see traction in the share price and treat each underlying company “as a credit”, i.e. as a lender.

If an enterprising speculator is determined to invest in an overlooked sector/company, it is imperative that she considers the health of the balance sheet. Being a publicly traded stock is not all it’s cracked up to be, and Microcaps are uniquely challenged when it comes to raising money. A Microcap company cannot simply sell billions of dollars in stock at yesterday’s price. If a stock issuance is conducted it will likely be at a discount to recent trading and may or may not contain warrants (to further increase the upside for the institution). This price will then be of keen interest to retail speculators to see if a floor or ceiling is developed.

In many cases, actively managed ETFs have been created to gain theme-based portfolio exposure. In short, any decent investor can outperform these ETFs over a full cycle by holding only the best companies within the theme and discarding the trash. The principal of “Di-worse-ification” holds true in theme based ETFs.

In many cases, theme based ETFs hold truly garbage companies which may give the appearance of “alpha” (think of alpha as outperformance based on stock selection - the choice of holding ) when the sector is hot, but that “alpha” is really just “beta” (beta is a measure of risk/volatility, if the market goes up 1% will the specific stock go up 0.50% or 2% or 10%?) which exacerbates the downside when the sector inevitably cools (or worse yet some companies in a theme ETF may go bankrupt in a downturn - we’re talking about Microcaps after all). Microcaps are inherently high-beta, that is why they capture speculators imagination. So, if the stock universe is inherently high-beta, we don’t need to take further risk by investing in companies with poor credit. In fact, the stock universe for a microcap speculator should be proactively narrowed via credit screening - we need to take insolvency off the table.

The result is holding the 3-5 best names in a given theme, universe. Recall positions should be initiated at 1% of portfolio value. If price agrees with the position and volume comes into the stock, speculators can size up and ride the move. Stops should always be placed on these trades, and the 50 day moving average is generally a good stop, I prefer to wait for a sustained break to confirm my trade is incorrect. Treat the Microcap opportunity like a credit - we want our money back, with interest.