Why I rarely invest in ‘Micro Cap’ equities

Ask most private investors about their opinion of investing in small companies and they will happily tell you that ‘investing in small caps exposes investors to an information mismatch which enables outperformance’. The idea is a simple one. Big funds with professional analysts have too much capital to deploy to worry about investing in companies worth less than £100m, and as such generally overlook this segment of the market. This creates an opportunity for private investors with smaller portfolios who can take advantage of the price and value mismatches that occur. The smaller the company, the fewer institutional investors are interested and therefore the more numerous and greater the opportunities. Despite this, there are some risks with the smallest of these companies – microcaps. In this article, I’m going to explore the potential of ‘Micro Cap’ investing but also explain why I rarely invest in companies of this size.

First, let’s look at the market capitalisation system. The market capitalisation of a company is simply the value of all the issued equity added together. If there are 100m shares valued at £1 each, the company has a market capitalisation (or market cap, for short) of £100m. The classification system ranges from ‘Large Cap’ companies (over £2.5bn market cap), ‘Mid Cap’ (£350m to £2.5bn), ‘Small Cap’ (£50m to £250m), and ‘Micro Cap’ (less than £50m).

The capitalisation of the company affects what is called the ‘float’ or volume of traded shares in that company. If we presume that on any given day, 10% of a company’s equity trades hands, then a ‘Large Cap’ equity would have upwards of £250m of equity bought and sold on a normal day, whereas a ‘Micro Cap’ equity would only have £5m. If a fund manager wanted to build a £25m position in a business, they would comprise just 10% of the daily volume in a ‘Large Cap’ and could build their position in a single day (or over several if they wanted to pound cost average their position). By comparison, building the same position would take five days for a ‘Micro Cap’ equity and would also likely see the price skyrocket during the process as the buyer would not be the only one in the market and so would substantially increase the volume attempting to be ‘bought’ from normal sellers.

This difficulty in building that original £25m position also plays out in reverse when attempting to liquidate it. For a ‘Large Cap’ equity, the position would make up just 10% of daily volume and less than 1% of total equity. By comparison, attempting to liquidate a ‘Micro Cap’ position would mean attempting to sell at least 50% of the company in one go – a considerably different prospect, especially if the company had suddenly become less desirable (perhaps as a result of a corporate scandal or profit warning).

Despite this, many famous investors have made significant returns investing at the smaller end of markets and there is some evidence to show that these equities generally outperform their larger brethren. After all, if a company with a market cap of £5m and profit of £1m secures orders worth an additional £1m in profit, it stands to reason that the market capitalisation would double, providing no further equity was issued. I realise that this isn’t strictly accurate but the general principle is that as profit increases, the market cap increases with it. The smaller the company, the easier it is to get those increases.

By comparison, ‘Large Cap’ equities tend to have significantly more than £1m profits (not always a given, but generally speaking revenue and profit for large caps are measured in the tens, if not hundreds of millions of pounds). As such, the same £1m in additional profit, although welcome, would be considerably less significant to the company’s finances and would have a considerably less significant impact on the value of the company.

For the ‘Micro Cap’, the value increase in the company from that same order would be much larger. The share price would increase 100%, taking a position of £25m to £50m, whereas with the ‘Large Cap’, that same order likely wouldn’t move the market capitalisation at all. If it was a particularly valuable client or programme, the order may signal a growing pipeline and move the price a few percent, but it would be unlikely to leap to the same order of magnitude.

Of course, this also works in reverse, the same as for order execution – losing a £1m client for the ‘Micro Cap’ would be devastating, likely cratering the share price, whereas for the ‘Large Cap’ it would be an unwelcome, but largely irrelevant piece of corporate activity. This begins to highlight my concern with the ‘Micro Cap’ end of the market which is often more binary in outcome than with their larger brethren.

‘Micro Cap’ companies are not market leaders, they are niche, unproven, and fledgling businesses. Now, before readers that invest in this space start frothing at the mouth in incandescent rage, just hear me out. I am well aware that businesses do not simply pop into existence worth hundreds of millions of pounds – they all start with a small group of individuals, few, if any clients, and little to no revenue. The speed at which this situation changes is a measure of their success – companies that offer useful products and services at a fair market price tend to attract business, if they are able to charge clients more than it costs to provide those goods or services, then they make a profit, and the more profit they make, the more they are worth.

If a shareholder owns equity from day one and holds it as the company grows, that equity generally becomes more valuable. The most commonly cited example of this is that well-known business, Amazon, which was originally run by one man (Jeff Bezos) out of his garage, in a loss-making fashion for years. Thanks to his vision and the hard work of thousands of people over the years, Amazon grew from one man in a garage worth nothing, to a multi-billion pound enterprise which has become a household name around the globe. Anyone that invested at day one (see the afore-mentioned Jeff), would now be worth billions (as he is).

Even if your ‘Micro Cap’ doesn’t become the next Amazon, relatively small ‘wins’ will create outsized value relative to the company’s market capitalisation and therefore should generate outsized returns. After all, it would only take a single large investor taking notice and your ‘Micro Cap’ could double, triple, or even quadruple in value as they build their position! Just think of the returns! Forget making 8% a year with an index, you could be making 200% a year with this if you load up your portfolio! Where is the chequebook? Sell the cat! Sell the dog! In fact, sell everything that’s not nailed down and get me some of those ‘Micro Caps’! This time next year, we’ll be billionaires!

Reader Warning – For those of you not versed with this blog as long-time readers, you might miss the subtle undertone of sarcasm in the proceeding paragraph. For the avoidance of doubt, I am absolutely not suggesting that this is the likely outcome of investing in Micro Caps, nor that it bears any resemblance to my own strategy. Read on, to find out why.

The problem with this strategy comes primarily from a risk management perspective. I have worked in a range of industries during my career including IT, Telecomms, Media and Construction. During this time, I have developed a level of insight into these industries which give me a perspective on their risks and opportunities, along with different business models and economic actors. Despite this, I wouldn’t say I’m an ‘expert’ in any of them – they’re all highly complex, with multiple moving parts and variables. And what about my knowledge of retail, or semi-conductors? How about mining, or manufacturing, or logistics? Well, the knowledge I do have is from my own research, so not nothing, but potentially less well-developed than for the sectors I have worked in.

When you invest in a ‘Micro Cap’, what you don’t know is dangerous, but the real killer is what you know for certain that turns out not to be true. Investor Relations and Equity Sales teams are there for a single reason, and it’s to provide a positive narrative that supports the best equity valuation by the market. As such, the individual investors are presented with plans that includes lots of graphs going ‘up and to the right’. They are provided with lots of forward-looking statements about the ‘Total Addressable Market’ which will be totally amazed with the brilliance of whatever product or service the ‘Micro Cap’ has to sell. The executive team leading the venture will have ‘decades of experience’ and the product or service will be ‘proven’ and ‘market leading’.

The individual investor absorbs this information like a sponge – the better ones apply an element of critical thinking – but in the end they have to make a determination, as with all investments, about the likely success of the venture. This is where the risk begins to pour in. With a larger company, the business model is already proven, demonstrably so, by the volume of orders and hopefully profit which the company has generated over the proceeding years. By comparison, ‘Micro Caps’ do not have this evidence. The orders and profits simply don’t exist on the same scale, and are instead replaced by narrative, which is a poor replacement at the best of times.

This means that the individual investor is now entirely dependent on two things. Firstly, they must ‘trust’ the management that their forecasts are accurate and that the information about the quality and benefits of their product or service are genuine. Secondly, they must make an independent assessment of the potential of these things within the context of the wider market – a feat which is made considerably more difficult the less experience and understanding of the industry they have.

The risk of getting these determinations wrong is often crippling for an investor. If the management turns out to be unworthy of trust, either through overoptimistic forecasts, outsized belief in their product or service, incompetence, or simple fraud, the company will at best, tread water, or at worst, will be worthless. If the product fails to be as desirable or competitive as forecasts suggest, then growth never materialises and the share price doesn’t move. If money invested today fails to make a profit tomorrow, the loss destroys value in the company. If the profit never arrives at all, the company is entirely worthless (and the investment with it).

In my opinion, these risks are significant, and in most cases, entirely outsized relative to the potential rewards. This has been demonstrated time and time again by mines that held no minerals, products that solved no problems, services that were too expensive to deliver, and sales forecasts that were based on nothing more than hopes and dreams. My understanding of specialist packaging material, mineral exploration, aircraft leasing, media IP acquisitions, nano-particles, dry eye macular degeneration, or the international e-gaming market is limited, the time required to understand them significant, and the potential risk of me not understanding them correctly immense. Far easier, to concentrate on larger, profitable and genuinely proven businesses in markets I understand!

Astute readers will immediately notice that I wrote ‘my knowledge’ in the proceeding paragraph, rather than ‘your knowledge’. This is important because I don’t know what ‘your knowledge’ of these things is at all. For all I know, you have thirty years of experience in bio-chemistry and therefore know with absolute certainty that the product developed by ‘Dry Eye Care PLC’ is genuinely ground-breaking. Perhaps you spend your evening pouring over geographic surveys of the Alaskan Klondike, have a PHD in Geological Surveying and spent three summers as part of an exploratory mining crew.

My point is that only you can genuinely assess the limitations of your own knowledge but that doing so is absolutely paramount to investing in the ‘Micro Cap’ space. Trusting anonymous tips online, or in papers, is a sure fire way to blow up a portfolio of ‘Micro Cap’ investments and expose your portfolio to outsized risks in the pursuit of fantastical profits which will likely never materialise. There are ways of educating yourself in this space, and serious profit to be made, but the work involved is immense and needs to be done. As a full time husband, employee, and manager of two portfolios, I know for a fact that I rarely have the time to undertake the extra level of work required to independently verify and assess ‘Micro Cap’ ventures, and am generally quite happy to let those opportunities pass me by.

The thought of stacking my portfolio full of speculative, non-profitable ‘Micro Caps’ is enough to make me break out in a cold sweat – a small investment in this space could prove profitable, but in my opinion, should be undertaken with the cautious warning of “Buyer Beware”.

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