From the May 2005 issue of Investment Advisor • Subscribe!

The Promise of Micro Caps

If you manage the risks in the right way, you can reap the micro-cap rewards

When it comes to investing, few asset classes evoke more enthusiasm and consideration than micro-cap stocks. While the historically strong performance of micro-cap stocks make them very attractive, the returns may seem too good to be true, causing some investors to be concerned about the viability of micro caps and others to conclude they have already missed the upside. Not necessarily so. Opportunities for sound and rewarding investments in this asset class abound. The key to benefiting from them lies in removing emotion from the decision-making process, and maintaining a strict bottom-up, bottom-line discipline.

There are many good reasons to consider micro-cap investing for your clients. According to the Center for Research in Securities Prices (CRSP) at the University of Chicago, micro-cap stocks are clear winners. CRSP, which has tracked the returns of various asset classes for the past 79 years, found that a dollar invested in micro caps in 1926 would be worth $13,661 today compared to $6,713 if invested in small caps, $4,997 in mid-caps, and $2,533 for large-cap stocks (see "Mighty Micros" chart below).

In recent years, micro-cap mutual funds have turned up at the top of many performance rankings with some eye-popping and enviable returns. Investor interest has grown to the point where the asset class is about to be legitimized with its own benchmark, the Russell Micro Cap Index, which is coming out in June. Like any investment, micro-caps have a downside. Understanding their underlying risks, however, begins with a clear definition of the category.

Defining Micro

Micro caps are defined as those stocks with market capitalizations of $30 million to $300 million. They emerged as a distinct asset class when small-cap investors realized that their biggest winners were often at the lowest end of the capitalization range. Because they are smaller, they can be more volatile than their larger counterparts and their prices can be more sensitive to news or rumor. In addition, many are thinly traded by a limited group of investors, meaning that the reaction of any one investor can also have a big impact on the stock price. This can be a positive factor, however, because a micro-cap company with solid growth prospects that has yet to be discovered by the wider investor population can represent a good value.

While micro caps may be confused with penny stocks, the two are clearly different. Penny stocks tend to trade exclusively over the counter in the so-called "pink sheets," where accurate price information can be hard to find. Micro caps, on the other hand, frequently are listed on the Nasdaq, AMEX, or even the NYSE. The important difference is that although micro-cap companies may be too small to be covered by Wall Street analysts, their financial reports are available in required and regular filings with the Securities & Exchange Commission.

There are currently 2,371 listed micro-cap companies in the investing universe, representing more than 55% of all publicly traded companies. Compare that to the 349 large-cap stocks that make up just 8% of publicly traded companies and get all the attention. Given the sheer number of opportunities--coupled with historical performance--it makes sense that even conservative investors commit a small portion of their equity allocation to micro-caps. As a case in point, pension funds are beginning to show an interest in this asset class, with allocations of typically 10% or less of their total assets.

The best micro caps are the ground floor opportunities--those companies that will thrive, maintain healthy growth rates, and become the next Intel or Microsoft. The challenge, however, is to identify them, buy them at reasonable valuations, ride the winners, and sell those that don't perform. Surmounting that challenge requires strict discipline on both the buy side and the sell side.

Discipline on Buy and Sell

Start with a bias toward stocks that already have reported earnings and trade for at least $5 a share. It's also preferable to choose stocks that are listed on an exchange, because those companies have to comply with listing requirements and report to the SEC.

Next, look for the fastest-growing companies selling at the lowest P/E ratios relative to the future earnings growth universe. Factors to consider include the last 12 months' earnings growth, the next 12 months' earnings projections, positive earnings surprises, P/E relative to future earnings projections, and price to cash flow. From the companies that emerge from this analysis, consider more closely those that have a niche product or service or have only one or two customers, but higher-than-average reinvestment rates. That's a sign that they are positioned to grow.

Most important, stay objective. While it is common practice for investment professionals to spend time visiting companies and talking to management, it can be counterproductive because it introduces emotion into the equation. Many investors make their biggest mistakes when they fall for a stock's story as preached by the company's management or by a salesperson.

This approach has proven to be effective with two of our investments in the Touchstone Micro Cap Growth Fund: True Religion (TRLG.OB) and Hansen Natural Corporation (HANS). True Religion makes high-end distressed jeans sold in upscale stores in the United States, England, Canada, and Japan, and its earnings have been growing at 160%. We started buying it in January at around $8. It's now up to $12.20.

Hansen Natural Corporation distributes juice, smoothies, and iced teas, and demonstrates strong earnings growth. It recently reported 61 cents in quarterly earnings against a consensus of 11 cents. We bought the stock in June 2004, at around $24 and it's now at $56.

Maintaining strict discipline on the sell side is as important as it is on the buy side. While at the outset it may be desirable to hold a stock for a couple of years, if it fails to perform as expected, it's advisable to sell it immediately. Any of the following four flags may signal that it's time to divest:

  • the price goes too high and the stock becomes overvalued
  • an earnings surprise arrives on the downside
  • the company's industry falls out of favor
  • the stock price falls by 15% or more and it loses its relative momentum.

There may be extenuating circumstances--a big order getting pushed from one quarter to the next, for instance--that could warrant holding on to the stock, but generally speaking these four signals are sound sell signs. Rae Systems (RAE), a company that develops and manufactures multi-sensor chemical and radiation detection monitors, is a recent example. We bought it last August at between $5 and $6. It went to $9 and then fell back in February when it reported flat earnings for the year. After holding it for seven months, we got out at approximately $5. The stock has continued to fall after reporting that its auditors found material weakness in its internal financial reporting controls.

The point is that turnover is a healthy part of the process. There's no reason to keep a stock that hasn't met expectations when there are other names on the buy list.

Some people say successful micro-cap investing requires luck. It may look like luck, but performance is really a function of analysis and consistently applied discipline. A portfolio needs 40-50 stocks to be adequately diversified so that the occasional poor performer does not erase other gains. Each one has to be monitored very closely and doing that well takes time.

It also requires good information networks such as Bloomberg and Telemet, which provide financial statements and news on companies going back a year or more. Advisors and investors who have both access to the information and the desire to rigorously follow each stock can do it on their own, but it becomes quite a challenge when coupled with other professional responsibilities.

In short, while it's prudent to carefully consider any investment decision, there's little reason for pause and potentially lots to gain in micro caps. Because of the lack of analyst coverage, micro-caps are an area where active management adds value. For most people, a well-chosen mutual fund or individually managed account is the better way to participate in this asset class.

O. Thomas Barry III, who manages the Touchstone Micro Cap Growth Fund (TAMCX), is the chief investment officer and senior executive VP of Bjurman, Barry & Associates, which is the sub-advisor of the fund. He also manages Bjurman, Barry Micro-Cap Growth Fund, which was launched in 1997 and closed to new investors in May 2003. He can be reached through info@bjurmanbarry.com.

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