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What are micro-cap stocks and are they a good investment?

by | Last updated 26 Nov, 2022 | Stock Types

Micro-cap stocks are the next step down from small-cap companies. These are the businesses that have a market capitalisation of £50m to £200m.

This category of shares is prone to even higher levels of volatility than small-caps. Why? Because the underlying companies typically have a limited operating history, unproven business models, and rarely deliver any positive earnings, let alone cash flow.

While micro-caps share many characteristics with penny stocks, it’s important to note that the latter has even smaller underlying businesses with even more risk attached.

That said, for the few micro-cap stocks that manage to find success, early long-term investors could unlock massive returns.

How many micro-cap stocks are there?

The Russell 2000 Index is considered by many to be the benchmark for small US stocks. As the name suggests, this index includes the smallest 2,000 businesses by market capitalisation.

While the index is home to many small-cap stocks, as of March 2022 around 1,500 of its constituents were actually micro-cap stocks.

Needless to say, that gives investors quite a large pool of shares to pick from. And the total number of firms in this category is constantly changing for several reasons.

  • The market capitalisation of a company could increase into the small-cap territory.
  • The market capitalisation of a small-cap company may decrease and fall into the micro-cap territory.
  • New small businesses go public through SPACs, direct listings, or IPOs.
  • A firm may decide to private again.
  • A micro-cap firm could become the target of an acquisition.

Investing in Micro-cap Stocks

Micro-cap stocks are publicly traded companies. However, in most cases, they are too small to be listed on the New York Stock Exchange or Nasdaq. Instead, for US stocks, they can be found in the Over-the-Counter (OTC) market. Here in the UK, most micro-caps reside inside the Alternative Investment Market (AIM), a sub-section of the London Stock Exchange.

As with any form of small-cap investing, micro-cap shares create additional hurdles for investors to overcome. Finding detailed information about these businesses beyond what’s inside an annual report can be pretty difficult. To make matters more complicated, their small size means the regulatory reporting requirements aren’t as strict when it comes to the level of detail.

Institutional investors typically don’t venture into this space, creating further issues. Firstly, finding a second opinion or analysis on a micro-cap stock is often impossible without paying a professional to perform unique research. Secondly, with lower levels of institutional interest, the level of trading volume can be very low, raising the cost and time to fulfil buy and sell orders.

Given these disadvantages, why would investors be interested in investing in Micro-cap stocks? Due to their small size, one breakthrough or game-changing contract can set a company on a path to immense success. And by being an early investor, the potential capital gains can venture into millionaire-making territory over the long term.

Is it good to invest in these companies?

These small valuations of these businesses make them incredible volatile. As I previously mentioned, most micro-cap stocks have unproven products or services that often fail to generate meaningful or sustainable cash flow.

Therefore, when good news comes out, the share prices can explode seemingly overnight. But this works both ways. If a firm fails to meet expectations or announces a disruption, delay, or another type of problem, the stock price can tumble by double-digits in a few hours.

Needless to say, this region of the stock market is hazardous. And for investors that don’t have the stomach for extreme volatility, the best course of action may be to focus on more established enterprises in the mid-cap and large-cap space.

Should I buy micro-cap stocks?

Including micro-cap stocks in my portfolio all depends upon an investor’s financial goals, time horizon, and risk tolerance.

Investing in this space can be immensely rewarding if I do my homework before making an investment decision. But I’ll still need a bit of luck on my side since unpredictable external factors, such as a shift in macroeconomic factors, can have disastrous impacts on these businesses with little recourse available.

Personally, there are too many ways for an investment in micro-cap stocks to go badly. But on the rare occasion I decide to allocate some capital from my portfolio, it’s always a tiny part with diversification in mind.

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Saima Naveed does not own shares in any of the companies mentioned. The Money Cog has no position in any of the companies mentioned. Views expressed on the companies and assets mentioned in this article are those of the writer and therefore may differ from the opinions of analysts in The Money Cog Premium services.

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