Knowing the goal will define the strategy
Seasoned stock-market players know all too well that the microcap sector is fickle.
It’s a high-risk, high-reward space that requires diligence, defined goals and an understanding of overall market dynamics.
But most importantly, players must take a moment for self-introspection to determine if they’re going to be an “investor” or a “speculator” in a particular microcap stock. Because these are two entirely different things.
- An investor looks for longer-term opportunities and stays focused on the fundamental health and growth potential of a microcap. Taking advantage of equity declines or market mispricing to increase a position size. Investors consider themselves part of the company and look for future dividends while aiming to prevent capital loss.
- A speculator willfocus on short-term opportunities, technical analysis, price volatility, and potential catalysts that may create arbitrage in microcaps. Traders consider themselves renters of a stock, looking to both buy-and-short, and generate large gains through volatility.
Both have pros and cons. That’s why it’s crucial to understand the long-term goal at the beginning. Once that’s decided, it requires understanding the microcap lifecycle and where the potential sweet spots reveal themselves for both investors and traders.
The Microcap Lifecycle
The lifecycle of a microcap – as with any company – can vary widely depending on a range of factors, but there’s a general overview of the stages that many go through.
According to Aswath Damodaran – New York University Professor of Corporate Finance and Valuation – there are six-stages in a company’s lifecycle. This is a good lens to use when evaluating microcaps.
- Start Up Stage: the beginning of a company that’s entering a market. Requiring capital and investment to begin development. Usually reports zero earnings or has large net losses on earnings as reinvestment is very high. This is the most fragile stage in the cycle as equity dilution is rife and there’s a high risk of failure.
- Young Growth Stage: the company remains fragile, depending on equity or debt to expand. But begins to build momentum and generate income, narrowing net losses. And reinvestment remains high. Potential catalysts – such as partnerships or large contract deals – are pivotal here.
- High Growth Stage: the company begins turning a potential profit and reinvestment begins scaling down. Allowing the company to begin repaying debt and lower equity raises. Valuations begin to stabilize and turn positive. Further catalysts to expand business remains important.
- Mature Growth Stage: Profits grow more quickly, and reinvestment begins to decline faster. Cheaper costs of capital allow debt to subsidize reinvestment. The company may use its income to start buying back shares or pay out a dividend to shareholders. This stage is most often the peak for revenue growth.
- Mature Stable Stage: The company’s revenues, profits, and reinvestment level off as economies of scales diminish. Debt remains stable. And buybacks and dividends continue. Due to lower reinvestment costs, this stage is referred to as “cash cow.”
- Decline Stage: The company feels pressure from new entrants trying to capture market share. This added competition puts pressure on prices, affecting revenues, profits, and growth. The company may begin to divest marginal assets in order to scale down and repay debt faster, or look to diversify their business. The company’s high growth era is over and is now reverting to its mean.
Investor vs. Speculator Sweet Spots
Investors will likely benefit most getting in the earlier-to-mid stages – specifically the young growth and high growth stages.
These stages give investors upside to significant growth potential longer-term if they’re willing to remain patient and hold their position as the company’s value, revenues, and profits materialize over time.
But this comes with risk that the company may sputter out in the early stages and never grow. Or worse, fall into bankruptcy.
There’s also risk of a microcap becoming a “dead stock” – when the company continues growing but the stock doesn’t move with it.
But this creates value investing opportunities as the company’s fundamentals remain undervalued by the market.
“An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”- Benjamin Graham
This is in contrast to what a speculator finds lucrative – which is volatility, liquidity, and price trends.
Things such as catalyst events or news – earnings reports, product launches, regulatory approvals, or industry news – can cause sudden price shifts that traders look for.
Microcaps also tend to have illiquidity pockets – where the stock trading volume is extremely low – and is a result of imbalanced supply and demand (the bid-ask spread). Either the price wanted is too high relative to the price offered, or vice versa.
This may put traders in large positions that they can’t easily get out of quickly at the desired price.
Traders know the expression, “the trend is your friend,” and will look for a clear point of entry – whether up or down – on large market buying or selling.
“What differentiates between speculation and investment is probability of an expected outcome combined with timing or holding period,” says Fahad Khalid, founder & CEO of Jaguar Analytics. “A sweet spot for an entry in both cases of speculation and investment is exclusively determined by the technical picture on the chart. When entering, the goal is to minimize the risk of a loss. I never think about how much profit I will generate. Profits will take care of themselves. I exclusively focus on loss. For that reason, entries must align with support on the chart, so I know where to put a stop loss. For me the sweet spots are light volume gap fills.”
Microcap Case Studies
Many microcaps may become large caps over time, but there’s also a vast graveyard of those that didn’t.
There’s two sectors where microcaps traits are relatively common: gold/silver mining and biotechnology.
Both of these sectors are high risk/high reward as they depend on either a major discovery or pharmaceutical development that ultimately wins FDA approval.
Some of these microcaps ended up becoming extremely large companies.
- Barrick Gold Corporation (originally known as Barrick resources) started as a microcap precious metals exploration company (burning cash to drill for potential resources) in the mid-1980s. But over time, it grew through a series of strategic acquisitions and mergers of major producing mines – giving it the cashflow to organically explore and grow. Now it’s one of the world’s largest gold companies per market cap.
- Gilead Sciences began as a microcap in the early-1990s (only raising $86M from its IPO) and focused on developing treatments for viral infections – including HIV/AIDS. And after the successful development and innovation of antiretroviral therapies, this propelled Gilead into one of the largest biotech firms globally. Gilead’s share price hovered under $1 for more than five years at the beginning.
These are two examples – big ones in hindsight – of the upside in microcap lifecycles.
Early and patient investors were rewarded significantly. Meanwhile news of major discoveries and developments created opportunities for traders.
There are times when trading makes more sense. And there are times when investing is the better play.
Microcaps follow a lifecycle – although delicate – and create openings for both.
