29 Things to Look For in a Microcap Stock
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The Microcap Opportunity
We worked with Howard Group to come up with 29 points to consider when looking at investing in a microcap stock. The key here is due diligence. Good research can help you mitigate the risks that these stocks have.
Benefits of microcaps:
- Higher potential returns
- Small companies outperform big companies over time
- Valuation disconnect
- Lack of visibility = higher arbitrage
- Nimble companies and boards
- M&A potential
Downsides of microcaps:
- Higher risk
- Less analyst coverage = less due diligence by market
- Less trading volume
Investors who do strong due diligence can mitigate the downsides to trading microcaps and can reap big gains.
Due Diligence Checklist
The People
Good people behind a company make a difference – especially for small companies that have big growth potential.
Here are the key things to look for:
- A proven track record in building successful businesses
- A well-established network of connections and ability to nurture strategic relations
- Ability to raise capital in a tough economic environment
- Skin in the game: ownership of shares of the company represents real stake
- Management that is respectful of shareholder funds: not spending excessive money on General and Administrative (G&A) expenses or overpaying themselves
Pro tip: Review annual Information Circular for excessive levels of management compensation or director’s fees, insider shareholdings, any past bankruptcies, and other Boards that senior officers serve on or previously sat as a director.
Capital Structure
The structure of microcaps can tell a story on its own. Here is what to look for:
- The percentage of holdings of retail vs institutional investors, as well as insiders
- How many shares are outstanding and fully diluted
- The expiry dates and strike prices of warrants
Pro Tip: Look at previous financings. Was each subsequent financing done at a higher level than the last? Or does the company have a history of dilution?
The Numbers
The numbers are the meat and potatoes of this checklist. Look at:
- Working capital
- Quarterly expenses with special attention to G&A
- Debt – repayment schedule and interest rates
- Generating free cash flow, or the potential to do so in the near future
- Ability to maintain profitable margins
Pro Tip: Are revenues based on the one-time sale of a product or is there a strong recurring revenue model?
Differentiators and Catalysts
Does the company have an advantage over competitors? What catalysts are on the horizon that could potential impact share price?
- What sets the company apart from its peers?
- Product features, attributes and benefits
- Service features, attributes and benefits
- The company’s client list
- Visibility on events or milestones that will bring significant shareholder value
Pro Tip: Look at management’s past performance to see if they have done what they said they’d do. Have they met the timelines and objectives previously stated?
Valuation:
Relative to the market, is this company fairly valued? Check out:
- For a revenue producing company: how much future potential is built into the stock price versus the fundamental financial situation.
- For a non-revenue producing company: how much potential is built into the ultimate value of the asset and its economic viability
Tricks of the Trade:
Don’t bite off more than you can chew. Could you sell your holdings within three trading days without incurring a loss greater than 10%?
Keep an eye on the insiders. Insiders know the internal workings of the company and buying or selling could be a signal.
Watch the stock like a hawk. A sudden price drop could indicate a pending financing or negative news.
Analyze the analysts. Watch what the analysts are saying and if their opinions are shifting.
