My Microcap Checklist
What I look for in microcap stocks and a few microcap ideas...
As a small business owner I have a renewed appreciation for small stocks. In my experience, earnings are hard to predict, they’re quite volatile, resources are limited, and middle management is weak or non-existent.
Generally, most microcaps aren’t worthy of a concentrated position. Don’t take this out of context, I said most, not all. When I refer to microcaps here, I’m thinking $2-3m EBITDA, but that definition can vary, even for myself. Absent a special situation or severely beaten up entry price/valuation, I prefer to take a basket approach to these smaller stocks.
I have a few simple guidelines that I look for when investing in microcaps:
Excellent margins — Having great margins is important in any business but maybe more so in a microcap. What I’m looking for is at least consistency with industry peers. We don’t need to compete with the industry leader or best-of-the-best… rather, if a microcap can’t keep up with industry averages, then it tells me the business might be subscale and can’t afford the public company costs, management, etc.
Positive cash flow over a multi-year period — It’s hard to make a case for a business without cash flow but perhaps more dangerous to buy into a company with inconsistent cash flow… I want to see consistently positive cash flow and a bonus for less volatility.
Insider ownership — Skin in the game when the company is in a fragile state is imperative… plenty of microcaps have concentrated ownership from hedge funds, management, board members, etc. Watch out for entrenched, long-running management teams, or multi-generational family businesses.
Simple business, simple thesis — The business model needs to be easy to understand. Again, this sounds cliché, but small businesses typically don’t have the bandwidth for a large array of products and services. I want to see a small business that does something simple, focuses on it, and executes well.
Net cash or large cash position — A good banking package is harder than you’d imagine at these smaller sizes. Net cash positions aren’t a must but leverage needs to be viewed differently at smaller companies… 3x leverage for a mid-cap is not the same as 3x leverage for a $2m EBITDA microcap.
Stability over growth — I like growth but I prefer stability and consistent earnings. An income statement with stable earnings at +/- 5% of the same amount each year gets me excited.
Customer concentration — Disclosure is never as robust in a microcap so you won’t always know whether a single, or few, customer(s) make up the bulk of revenue. Generally, I’d steer clear if a single customer represents >50% of sales.
A quick word on valuation and why it wasn’t mentioned above… These smaller stocks can be cheap, get cheaper, and stay cheap. It’s not possible to draw a line in the sand and say a certain multiple of earnings or discount to a peer group makes a microcap attractive because these things can trade very irrationally. Buy cheap and understand that it could get cheaper for no apparent reason. There will usually be an opportunity to add to your position at a better valuation. I find it helpful to buy these sorts of companies at prices I’d be willing to own the whole thing.
With that outline, here are a handful of microcaps I own that fit most of these criteria…