By Tami Kamin Meyer
Kai Sato, Founder and CEO of Kaizen Reserve, Inc., quotes Charlie Munger when asked about the challenges inherent in the search for microcap “Golden Eggs.”
“’It’s not supposed to be easy. Anyone who finds it easy is stupid.’”
Sato, a serial entrepreneur with an extensive background in microcap investing, follows a common sense approach to investing in microcaps. He paints himself as a “value investor, emulating Warren Buffet and Charlie Munger early in their careers.”
While there is no way to ensure a microcap stock will take off, there are indicators to look for when considering the plunge into microcap investing, he said.
Top tips for evaluating microcap stocks
“Markets move in trends. A trend is successive up and down movements in price that occur more frequently than would be predicted by randomness alone,” said Barry Weinstein, founder and CEO of VolatilityMarkets, referencing observations from Yale University and the hedge fund Applied Quantitative Research (AQR),.
With that in mind, Weinstein advises microcap investors to look for the trend. “If [a microcap] price has gone up 18 of the last 20 days, it’s something to factor in.” However, he cautioned against investing in a microcap that’s “accelerating lower and does not have a recent history of price increases.”
Maury McCoy, President of McCoy Associates, has his own strategies for cutting through the clutter to find the proverbial golden egg.
For example, thorough research and investment information help you predict the future. “The very best microcap managers I know spend the vast majority of their time just reading,” he said.
In addition, because microcap stocks tend to be associated with startup ventures, he suggested literally calling the company on the phone to glean information on the venture.
He also urged investors not to overlook entities that may seem boring on the outside. “A microcap company that makes tables and chairs can be super exciting if profits can be found there,” said McCoy.
Sato employs a distinct strategy when evaluating a microcap for its potential viability. “Since microcaps are usually startups in search of ‘product-market fit’ (PMF), I separate them into three distinct categories: ‘Finding PMF,’ ‘Scaling PMF,’ and a select few ‘Capital Allocators.’ I’ll pass on microcaps that are still finding PMF and only pay close attention once a microcap has found PMF and is showing that it can successfully scale it. The bulk of my microcap investments, however, are for the very few that have proven their business model and also demonstrated sound capital allocation over time,” he said.
It’s the economy, stupid
According to Weinstein, whose company provides statistics and insights to traders, the nation’s economy plays a distinct role in the viability of a microcap stock.
“Interest rates have an effect on the attractiveness of microcap stocks. Interest rates have been going up and the Federal Reserve sees it increasing. Now we’re starting to see some but not all microcap stocks increase in price and return,” said Weinstein.
McCoy, whose firm represents equity and crypto investment managers, agrees the economy impacts the price and value of microcap stocks. However, he isn’t totally convinced the national economy has the impact Weinstein suggests.
“Because microcaps are smaller, some are driven more due to the local economy versus the national economy. But it depends on the region,” said McCoy.
Sato agrees the economy plays a significant role in the viability of a microcap stock, “because so many microcaps are effectively publicly-traded startups who have yet to prove a business model and typically require additional capital to fund operations. Fundraising is generally easier and cheaper when the economy is thriving,” he said.
How much research is enough?
Weinstein said he can’t overemphasize the value of targeted research when it comes to evaluating a microcap stock for investment purposes.
“Do your homework,” he advised. That’s because even if a person has “high-quality market research, markets move quickly.”
Therefore, he urged microcap investors to “spend however long they need” to thoroughly research a potential investment.
“You have to understand both sides of the argument,” he said.
Distinguishing golden eggs from rotten
The reality, said Sato, is that most microcap stocks are not great companies and won’t become large, category leaders or even survive long-term.
Therefore, after performing your due diligence about a potential microcap investment, Sato suggests investors also inject a bit of personal nuance into the transaction. “Only purchase shares in companies run by people you like, trust, and admire,” he said.
Risk management is another important aspect of microcap stock investment.
According to Weinstein, “microcap investors should have an estimate of what their worst-case scenario would be as well as a plan to exit if the trade is a loss.”
While urging microcap investors to “stick with it,” Weinstein also acknowledged the importance of investors evaluating a microcap’s viability with impartial eyes. “Risk management is an important part of the trade,” he said. Therefore, an investor should not only have an exit plan, but they should also be prepared to abide by it, he said.