If you don’t want to be part of the carnage, you need to take some precautions. You can do really well with these stocks, but you have to be careful. Here are a few guidelines to follow:

Know How, When and What to Buy

1) Make sure you understand the terms, “penny stocks” vs “micro cap stocks.” Brokers refer to any stock priced under $5 as a penny stock; the term is used here to designate stocks that literally trade for only pennies…even sub-pennies. Few stocks priced under $0.25 to $0.50 have earnings; most are seriously burning cash, or have some other problems. The same can be said for a lot of stocks under a buck. The typical penny stock is a very small company with highly illiquid shares, pre or very early stage revenues and little if any public information that you could sink your teeth into. “Highly speculative” or “absurdly speculative” are the terms that come to mind when we think of these kinds of “penny stocks.”

If you want a pure gamble, go to a casino…the odds are better.

If you want to invest in micro cap stocks (market caps of less than $300 million) find companies that have better than even odds of making it.
2) Look for a solid developing story. Value investors can buy mid to large cap companies that are being ignored and wait for Wall Street to notice them…usually when they start to post attractive numbers. That doesn’t work quite as well with micro caps. A small, yet good company can grind away in obscurity for years before the market takes notice…and that may not be your time line. Look for companies that are starting to attract a little notice on some of the better known financial blogs, or have gained some amount of market visibility from leading small cap editors, or have published research coverage from a credible analyst…then dig through the underlying numbers and make sure they support the story.

3) You might want to hold off on buying micro cap stocks until you’ve been trading for several years. It takes time and experience to learn how to size up these smaller companies and even more time and experience to master the impulses that so often cause novice investors to buy high and sell low. However, if you’re convinced you’re right, stick your toe in the water; but only risk what you can really afford to flush down the toilet.

4) Look out for the hype. Stocks that are hyped beyond reality are generally the classic “pump and dump” schemes: some promoter hypes an unknown stock beyond all relation to its worth, takes a quick profit and leaves a lot of new investors holding the bag. The bigger the hype…the weaker the fundamentals.

5) Diversify. This is no time to put all your eggs in one basket. Micro cap stocks ($50 – $300 million market cap) and nano caps (less than $50 million market cap) are more prone to catastrophe than larger-sized companies, so you’ll need to allow for a few duds. Remember, all you need is for a couple of these stocks to take off and you could do very well. After all, your losers can’t go below zero, but your winners have no upside limit.

6) Never devote more to micro cap stocks than you can afford to lose. The price of outsize rewards on the upside…is increased risk on the downside.

7) Don’t let commissions eat away at your profits. Use an on-line discount broker, and buy enough of each issue to ensure that the commission is not a significant percentage of your purchase price.

8.) Screen for a margin of safety:

• Don’t buy if the debt/equity ratio is higher than 0.5. Better yet are companies with no debt at all…but that’s a challenge in the micro cap space. This makes them much less vulnerable to sudden failure in the event of unexpected problems.
• Don’t buy if the company is bleeding money and the balance sheet looks like they may not make it past next Wednesday. The ideal is for the company to have positive earnings, even if it’s only a penny or two per share.
• If the company has reported earnings, be careful if they have started to decrease; make sure you know WHY.
• A company can have positive earnings, but not generate enough cash to meet its day-to-day expenses. If the free cash flow is a negative number; find out WHY. If a small company is burning through cash, it may not be around long enough to execute its plan…even if it’s a good plan.

It’s not easy finding micro caps with all these characteristics, but they do exist. When you find one, look for even more evidence that it could be a winner:

• Look for insider buying If the insiders are buying, that’s a positive sign to us. In a small company, insiders are usually in a good position to know whether the outlook is favorable.
• Look for a company with a lot of customers. If all its business comes from one or two larger companies, it’s more vulnerable.
• Look for a large, growing market place…a rising tide floats all boats.
• Low P/E ratios are great, but they’re not always essential to finding a good buy in micro caps. The reason is that micro caps earning a penny or two a share can easily double or triple their earnings in a short time when they’re having a growth spurt, which brings the P/E back to earth in a hurry. In contrast, a company with earnings of $10 a share would have a more difficult time increasing their earnings to $20 a share. The important thing here is to know the story well enough to make an informed decision as to whether or not you think those doubled earnings will materialize.

Know When to Sell…and Lock in your Profits

With micro caps, you want to let your winnings run, as long as the story stays favorable. There is no point in buying a micro cap for a 10-15% gain; when you take on a lot of risk, you ought to expect a much higher reward than that.

On the other hand, if your stock doubles or triples within a short period of time, consider selling half of it, take your money off the table and lock in a nice gain.

We call this… “Playing with the House’s Money.”

With this strategy, you can still enjoy the run-up (assuming it continues) and brag, brag, brag…with no risk to your initial capital at all. You have already locked in your gain.

And, if it loses steam and goes to zero (unlikely, but possible), you have locked in your gain and you still get to brag about how smart you are.

You also need to give your losers some room to fluctuate, because micro cap stocks can be exceptionally volatile. And it isn’t always possible to buy them at exactly the right time. But if your pick is down 25% to 35% consider selling, unless it’s clearly evident that a turnaround is imminent. We’ve found that a pre-set stop loss can take the emotion out of downhill slide and save some of your cash for another run at a 10, 50 or even a 100-bagger.

CONCLUSION: The informed, diversified, speculatively-minded investor can make big money in micro caps, but only by selecting them very carefully.

This sector is not for the faint of heart because the vast majority of these stocks won’t make the grade. However, if you’ll follow a few guidelines like those we’ve laid out here, you’ll certainly improve your odds of finding the ones you can ride to the pay window. And, that’s when the bragging begins!!!

Posted by the Research Staff
MicroCap MarketPlace