Downtrodden micro-caps still attract some investors
Thinking small can pay off big, even though it hasn’t in 2008.
Micro-cap stocks of smaller companies, those with market capitalizations of less than $250 million, are struggling along with the rest of the market.
Yet they continue to capture the imagination of investors aware that whenever micro-caps do revive, it usually occurs with a dramatic pop. Five years ago they were among the hottest of investments.
They also fit into the investment logic that one must have a hand in all pieces of the market. Just note how many supposedly trustworthy big firms have turned out to be complete busts this year.
"Micro-caps can be tricky for the average investor because companies that small can be a challenge due to their small size," said Tom Lydon, editor of ETF Trends in Newport Beach, Calif. "However, in a market recovery, small- and micro-caps are poised to perform the best because they have the most room to grow."
Micro-caps are volatile and unpredictable, but also currently cheap.
Though they could conceivably fall further, many micro-cap companies already are trading well below actual book value (the total value of the company’s assets that shareholders would theoretically receive if the company were liquidated).
"Companies delivering 200 and 300 percent annual growth rates have stocks going nowhere with a downside bias," said Larry Isen, editor and publisher of The OTC Journal in San Diego. "Deterioration started in November of last year and they have been in a bear market ever since."
Even $65 million Pinnacle Value Fund, top performer in Morningstar’s category for funds investing in stocks with market caps under $250 million, is down 4 percent despite its five-year annualized return of 11 percent.
The $262 million iShares Russell Microcap Index, an exchange-traded fund that tracks the Russell Microcap index of 2,000 stocks, is a handy vehicle for investing in micro-caps, said Isen. Though down 11 percent this year after last year’s 9 percent decline, it had a 15 percent gain in 2006.
"Over a period of time, micro-cap stocks have tended to yield higher returns than mid- or large-cap stocks, but the caveat is that they experience more year-to-year volatility," said James Oberweis, portfolio manager of the $43 million Oberweis Micro-Cap Fund in Lisle, Ill. "You must recognize that every decade or so we get a nasty period like the one we’re encountering now."
To get an idea of that volatility: Oberweis Micro-Cap Fund is down 30 percent this year. Yet it was up 10 percent last year; up 109 percent in 2003; and has a 10-year annualized return of 13 percent.
Top holdings in the Oberweis 73-stock portfolio were recently T-3 Energy Services Inc., GMX Resources Inc., CyberSource Corp., Double-Take Software Inc payday loan payday loans. and Vocus Inc.
"The companies that expand and become small- to mid-cap companies do well, but an inordinate amount of micro-caps founder aimlessly," said Barry Ritholtz, CEO of FusionIQ, a New York research firm. "If a stock is traded on the Nasdaq Stock Market, you’ll get full disclosure. If it’s not, you may not get that, and in this environment that’s not exactly ideal."
Lack of public information is the primary problem with many micro-caps. While those companies that trade on major exchanges and on the Nasdaq Stock Market must meet minimum listing standards, that is not the case with those either on the OTC Bulletin Boards or the Pink Sheets.
The OTCBB is not actually a part of the Nasdaq Stock Market and should not be represented as such. Pink Sheets is a daily publication of the National Quotation Bureau, which has bid and ask prices of OTC stocks. Firms that fail to meet the minimum standards of larger exchanges and become delisted often wind up listed on the OTCBB or Pink Sheets.
Micro-caps include many sturdy "up-and-coming" companies, with the lure that they could become the next Microsoft or Genentech, which also started out small. But there also are plenty that deserve to stay tiny, as well as "down-and-out" former mid-caps and some fraudulent examples that surface from time to time.
For example, the Securities and Exchange Commission recently charged six micro-cap companies for their roles in an alleged scheme that put billions of improperly registered shares into the public markets.
While the SEC has cracked down on micro-cap fraud and taken considerable action against wrongdoers, Lydon noted, there are just so many of these little companies that fraud could easily occur again.
Lydon likes ETF micro-caps because they’re diversified across so many different companies and mitigate the risks of investing in just one firm.
The $18 million First Trust Dow Jones Select MicroCap is one ETF example given by Lydon. Down 6 percent this year after a decline of 6 percent last year but a 16 percent increase in 2006, it replicates the Dow Jones Select MicroCap index.
"Many micro-caps are reputable enough for average investors, but only for investors who like to speculate on small companies," said Isen. "If you don’t like speculation, stay away from micro-caps."
Even investors who do like to speculate should only commit a portion of their portfolio that is suitable for their personal financial circumstances, Isen cautioned. History has shown that not all bets pay off.
andrewinv@aol.com
2008, TRIBUNE MEDIA SERVICES INC.