How to Squeeze More Gain Out of Micro-cap Stocks

Many investors are acquainted with the quick gains in bull markets followed by horrific downturns in bad markets of micro-cap stocks. But is there a better way to trade tiny companies instead of merely riding out the highs and the lows for a volatile return? If micro-cap stocks are simply leveraged returns, and timing the market is difficult, how do you profit from these?

Profiting From Micro-cap Stock

Screens, Benchmarks, and Proof

Anyone can make unfounded claims about a superior stock selection method. An investor who does his due diligence, however, will look for proof that such an investment style has merit.

You may be familiar with the adage, "Past performance does not guarantee future results," and a key point here is that we are not interested in buying a stock, fund, or any other sort of investment vehicle that merely outperformed the market in the past. The goal is to find the proper method to pick sound stocks that might be future winners, rather than simply running after the horse that already left the gate.

Before we can discuss the efficacy of certain strategies, we need a suitable benchmark to gauge our results. Using stock screening and back-testing software, use the following filters to create an applicable benchmark:

• On a major U.S. exchange
• Price greater than $1
• Average daily volume greater than 50,000
• Market capitalization between $50 and $300 million

Since 2001, this benchmark has produced an average annual gain of 5.6%. This is in contrast to the S&P 500 returning only 1% annually over the same period. What techniques could we use to single out a handful of companies that will generate higher returns than our benchmark?

Here are four techniques:

1. Micro-cap Value
Value investing is one common approach that looks for low price compared to certain fundamental numbers. Deep value can be found by looking for companies with low price-to-earnings, price-to-sales, price-to-cash, and price-to-book. If we restrict our investable universe of 700 stocks down to less than 100 based on value, what effect will this have on gain?

Historical Results: Gain from buying value-based micro-caps averages 10% annually over the past decade.

2. Micro-cap Growth
Many investors add micro-caps to their portfolio because they expect exceptional future growth when the companies go from tiny to huge. What gains would be realized if we refined our original micro-cap universe, keeping companies with high and accelerating earnings and sales growth?

Historical Results: We see a small boost in returns over our benchmark - from 5.6% to 7.3% annually - but this is far less than our value approach.

3. Micro-cap Margins
Other investors will look for stocks with high quality earnings. A company with high operating margins, asset turnover, return on investment and equity, lots of liquid assets to pay the bills, and low debt will turn up solid companies that should outperform the market.

Historical Results: The "strong fundamental" approach is sound and delivers 11% annual gains over the past decade.

4. Micro-cap Price Performance
Some, despite what they are told about past winners not being a "slam dunk" for future winners, will purchase such companies using price momentum techniques. The idea is to find stocks trading with strength and high relative performance compared to the broad market. This approach may have some merit, as even a good stock can lie dormant for years until noticed. Momentum investors are targeting such stocks when they are being favorably bought up.

Historical Results: Micro-cap momentum only results in a slight improvement, with a 6.7% historic annual return.

There Is Strength in Numbers

Portfolio123, a stock screening and backtesting software platform, put all four of these factors together for a comprehensive ranking system called QVGM. This acronym stands for Quality + Value + Growth + Momentum. Would combining four diverse investing styles result in a useful strategy, or would they counter each other?

Before we answer that, we need to place a couple of restrictions on our results:

1. We can hold a maximum of 20 stocks.
2. Every three months, we re-balance or examine our 20 stocks to ensure they are the top-ranked companies using the QVGM ranking system.

The results of such a strategy since 2001?

In theory, we would have turned $100 of capital in 2001 into $818.70 by early 2012. This results in a whopping 21.28% annual return. Of course, you have to consider the implications of re-balancing: It includes transaction fees and slippage costs, which will lower this amount somewhat.

Final Thoughts

What does all this mean? While micro-caps have historically provided higher leveraged gains than the broad market, it pays for investors to do their due diligence in picking companies with low valuations, high growth, strong financial muscles, and decent price performance. In these turbulent markets, squeezing a little more profit out of your portfolio is a welcome sight.

Kurtis Hemmerling is a full-time equity investor and discusses his best investing tips and strategies on Money Crashers. Some of his strategies include the Joseph Piotroski F-score value investing model and the CAN SLIM stock trading strategy.