Among average individual investors, microcap stocks are never the hype of top stock tips. The primary reasons are that microcap companies are not talked about in the media so investors have no way of knowing which microcap company stocks to invest in unless they did research on their own. There is also low trading volume leading to a greater liquidity risk. This also leads to the risk of trading schemes where frauds give misleading information to the public, inflating the stock price, and then selling them when the stock price is high. However, this creates an opportunity to get in on an undervalued microcap company that is flying under the radar and ride its growth wave. The top reasons to invest in microcap stocks are:
- Portfolio Diversification
Microcaps have a low correlation to the S&P 500, so while large cap stocks move together in response to certain economic events, microcap companies do not move along with them. And what’s more, during a down market, this correlation is observed to be lower, because the small pool of investors who own microcap stocks know the value of their microcap companies, so they don’t sell them off in reaction to negative news.
- Higher Returns
Historically, microcap stocks have returned an annualized 11.7% since 1926, versus large caps at 9.4%, which is a spread of 230 basis points. Over time, the compounding of the spread has a significant return.
- Influence from Activist Funds
Activist funds are funds that invest in stocks with the intention of actively providing their opinion about how the company should perform to the company’s Management and Board of Directors. Often, the media only gets wind about the nasty letters they send to the company and the back-and-forth angry letters between the company and the fund that ensue thereafter. This may have created a negative stigma around activist funds, but on the flip side, activist funds are made up of some of the smartest money managers with a lot of experience and exposure to many different companies, so really, it’s like free advice. Of course, because activist funds are just like the rest of the investing public, they aren’t privy to insider information, so when they try to overstep their boundaries and direct their opinions to Management about how they should run the company, they’re doing so without being visible to the long term vision and strategy that the company has put in place. But, because of the lack of resources smaller companies have, there is value in getting input from activist funds. As a result, more activist funds are targeting microcap companies. And for the regular investors, the advantage of this is that they know that Management and the Directors of the company whose stocks they’ve invested in won’t try to manipulate the stocks artificially, because activist funds that have invested in them as well would more than put in a word or two.
- More Hidden Gems to Discover
Because microcap companies are not covered by many analysts, there is less buzz around them, which leads to a higher probability of discovering those that are undervalued.
- Less Risk of the Agency Problem
The smaller the company, the higher percentage of shares Management owns. As “agents” of the company, Management’s goals are better aligned with the company’s goals when they hold a large stake in the company. And such is the case with microcap companies. Due to this alignment of goals, the agency problem is reduced.
With any stocks, accompanying advantages to invest in them are risks as well. Every investor should do their due diligence and only invest in companies that make sense to their risk tolerance level. Does the company have sound Management? Are their products and services unique in their industry? Do they have strong financials? Look up microcap companies covered here to see where each company stacks up against these questions, i.e. the risks and opportunities.
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