fbpx

Understanding Microcap Stocks

A microcap stock is a higher-risk investment because it’s offered for smaller businesses. Also, because they are smaller businesses, there’s often less information on them to use when deciding to invest. Research into microcap stocks is essential before beginning to invest in them. Take the time to find out what microcaps are, how to obtain information on microcaps you have an interest in, and the red flags to watch out for when considering microcaps.

Key Takeaways:

  • Microcap stocks are those from a company with a market capitalization between $50 million and $300 million.
  • These stocks carry a higher inherent risk than larger-cap stocks because of market volatility.
  • Available information is limited for microcap stocks, making it imperative to do your research.
  • Microcaps have limited liquidity because of limited analyst coverage and institutional buyers.

What Are Microcap Stocks?

A microcap stock is typically a smaller-sized company with a market capitalization between $50 million and $300 million. There are slight variations between brokers and analysts, but companies usually fall into one of five categories:

  • Large cap: $10 billion or greater.
  • Mid cap: $2 billion to $10 billion.
  • Small cap: $300 million to $2 billion.
  • Microcap: $50 million to $300 million.
  • Nanocap: Under $50 million.

However, the cap that a company’s stock falls under is not indicative of the stock price. Stock prices can fluctuate significantly in any of these categories, and a microcap stock could be higher priced than a large cap stock, for example.

Image via Flickr by cafecredit

Stock Price and Market Capitalization

Market capitalization is a measure of market value calculated by multiplying the stock price and the total number of outstanding shares.

There’s no correlation between stock price and market capitalization other than using the stock price in the calculation. You can have a large cap stock trading for $20 a share while a microcap could be trading at $300 per share. It completely depends on the number of outstanding shares and the stock price.

Key Differences Between Microcap Stocks and Large Cap Stocks

Here are some of the key differences between microcaps and their larger counterparts:

Limited Public Information

The first and probably most significant difference is that there is less publicly available information regarding a microcap company. Large companies typically submit reports to the Stock Exchange Commission (SEC) that investors can access free of charge. Smaller companies don’t submit these reports, which takes away the best source of information and puts the investor at an increased risk of fraud schemes.

Lack of Minimum Listing Standards

To list stocks on an exchange, companies must meet minimum listing standards set forth by the exchange. One example of a listing standard is a minimum requirement for net assets and the number of shareholders. Since you typically find microcaps on over-the-counter markets, these standards are not applicable. The purpose of listing standards is to ensure the stability of the company, and without them, research is paramount.

Higher Risk

Investing of almost any kind is an inherently risky venture, but microcaps rank high in risk. Microcap companies are often newer companies that don’t have a history to prove their viability. Many of these companies lack assets and stable revenue streams. Some of them offer products still being developed or that need to be tested in the market. However, when the market is in a time of bullish strength, microcaps often outperform the larger caps.

Lack of Liquidity

When applied to a stock, liquidity typically refers to how quickly you can buy or sell a stock without significant price impact. Stocks with low liquidity, like most microcaps, may be difficult to unload when you want and may lead to a more substantial loss if you’re unable to sell them.

Higher Volatility

Volatility refers to how much a stock’s price can fluctuate in a short period of time. The more volatile a stock, the broader and faster the price swings can be. All stocks experience volatility, but microcaps are typically much more volatile than large caps.

Learn about Microcap Companies Before Investing

It’s best to learn as much as you can about a microcap company before deciding to invest in it.

You can start by talking to your broker or advisor to find out if the company files any reports with the SEC. Carefully examine anything you find, such as a prospectus, financial statements, or other information. Also, be very wary of any unsolicited email or other forms of communication. It is easy to be sent false or misleading information, and these need to be treated with high skepticism. Here are some other places to get information:

  • From the company itself: Ask the company if they file with the SEC. Any question you have, you could just ask them directly. However, their answers also need to be treated with skepticism as they may try to mislead you to inflate the stock value.
  • The SEC: The SEC is the best source of information, if they have any on the microcap company.
  • State securities regulator: The next stop after the SEC and the company itself is to contact the state securities regulator. Even though the company might not need to file with the SEC, they may need to file with the state. The Sstate securities regulator will be able to let you know if the company is cleared to sell in your state.
  • Other government regulatory entities: These can vary depending on where the sector(s) in which the company operates is. For example, banks may not have to file with the SEC, but they may have to with local and federal banking regulators. You can find information at the Federal Reserve System’s national information center, the office of the comptroller of the currency, or the Federal Deposit Insurance Corporation.
  • Websites, commercial databases, and reference books: Head over to your local public library, business school, or law library. There will be materials available that contain information about many companies. Included among these resources is access to commercial databases that may provide information regarding the company’s history, management, products, services, credit ratings, and revenue streams. Talk to the librarian about other resources and how to access those already mentioned.
  • The local Secretary of State: Here you can find out if the company is in good standing. They may also have incorporation papers and annual reports available for you to read.

Red Flags to Be Aware of When Investing in Microcap Stocks

Watch out for these warning signs when you’re considering evaluating investing in microcaps:

  • SEC trading suspensions: The SEC can suspend trading of any stock for up to 10 days if it deems it necessary to protect the public interest. There are many reasons for a suspension, but one of the more common is the lack of current, accurate information about the company and its stock. Both if they have been subjected to a suspension and why are vital considerations.
  • Stock marketing promotions: These include email, texts, and social media sites that are pushing a stock. Is the stock more marketed than the product or services themselves? If so, that can indicate a potential scheme in which the stock price is artificially inflated with misinformation and marketing fluff.
  • Sudden changes: Both increases or decreases in price and volume without a viable explanation are warning signs. If there are severe volatility periods without a discernible rationale, be wary. This could be a sign of manipulation.
  • No history of success: If a company is touting massive revenues but doesn’t have the history to back it up, that can be a red flag. This is especially true if the information is more focused on the industry the company’s in rather than the company itself.
  • Corporate insiders own a large portion: Many fraud cases involving microcap stocks occur when the officers and promoters own most of the available stock. It’s easier to artificially manipulate the price if you own most of the shares. This can prove difficult to ascertain, however.
  • Lack of any real operation: If the company has frequently changed its name or type of business with little or no explanation, has no assets to speak of, or has minimal revenue streams, these may indicate it’s nothing more than a shell company. Be very careful here.
  • Reverse merger: If a company became public via a reverse merger, that warrants extra diligence when researching the company. The same goes for a reverse stock split. If these both happen within a short time, that’s even more reason to be wary.
  • Lack of written information: Stay away from brokers who will not provide written information to back up the investments they are recommending.
  • Requests for personal information: Unless accessing an account that you created and have used, never provide any sensitive information such as account numbers, passwords, PINs, credit card information, and social security numbers.

T he key to investing in microcap stocks is research. Develop in-depth knowledge of the company’s business strategy, services, and products. Verify all information you can find, make sure it is from a reliable source, and search for confirmation from another source that is reliable. Once you have vetted the information and gathered all you can, then you can intelligently consider whether microcaps are right for you.