When investors think of microcaps, they mistakenly assume the term refers to penny stocks. But that’s not the case. There are fundamental differences between a microcap and a penny stock.
For starters, buying penny stocks is a lot more like gambling than it is investing, based more on hype and speculation than any sort of financial analysis or research. They are usually companies that don’t meet the requirements to be listed on a major exchange, with bad sales, inferior products, and poor leadership. They are often unprofitable, illiquid, highly volatile, and exceptionally prone to hype and manipulation. The penny stock landscape is littered with companies that crashed and burned, taking their investor’s money with them. While it is definitely possible to make money trading penny stocks, it is exceptionally difficult and has a lot to do with monitoring technicals, data, and news rather than understanding the fundamental of the companies.
Microcap stocks, on the other hand, are a very different story. They are like penny stocks in that their cheap, usually with a stock price of under $10 and market caps below $500 million. But unlike penny stocks, these are companies with an innovative and successful business strategy and a plan of action to continue growth and create value for their investors. Microcaps are small, well run, under-the-radar companies with fast-growing sales that could either grow to become a mid or large-cap or be bought out by a larger company. With microcaps, it is possible to make higher returns without incurring the great risk of investing in an unstable penny stock. The challenge is finding these good companies amidst the sea of bad ones.
In order to differentiate between microcaps and penny stocks, the company must meet a few criteria.
- The company must have an innovative product or business strategy that will allow them to grow and accumulate market share. Every major company, from Apple ($AAPL) to Amazon ($AMZN) started off small but had an innovative product or strategy that allowed it to break through and grow. This product must be able to create huge sales growth for the company, showing not only demand for the product but also the company’s ability to deliver on that demand. Therefore, we are looking for small companies with a couple of consecutive quarters of sales growth.
- The company must also have great value and clear potential upside. Therefore, the second criterion is a company whose stock trades below their book value per share. Book value represents the company’s total assets minus its liabilities. If a company’s market value is less than the total value of its net assets, the company is currently undervalued and has room to run.
The reason many microcaps trade below their book value is because they tend to be ignored in favor of larger, more established companies. Even if a company’s sales are going through the roof but too few people are covering the stock, the stock price will remain cheap. This gives way to develop an incredible advantage by allowing the retail investor to get in early and cheap. And when the rest of the market realizes the performance of the stock and invests, the stock price jumps.
As we can appreciate, there is a very big difference between what we normally refer to as a penny stock and a small company with huge potential upside.
Let’s use an example we have traded profitably in the past, iClick Interactive ($ICLK). Based in Hong Kong, ICLK provides online marketing services in China. We identified this company in early July when the stock was trading at $5.70 and sold recently at $9. Let’s look at ICLK using our criterion:
ICLK’s proprietary technology platform claims to reach 98% of China’s internet users. Their products include iAudience, which allows marketers to search, identify and customize their targeted audience to generate brand awareness, iAccess, which generates audience engagement for performance-driven campaigns, and iNsights, which monitors and measures marketing campaign results. With more than 650 million internet users in China already (anonymously) profiled on iClick’s platform, the company helps businesses find the right prospects and customers at the right moment. As the world becomes increasingly digitized, data-driven, online marketing will only continue to grow and ICLK is strategically poised to take advantage of this growth. Since Q4 of 2018, ICLK has beaten consensus estimates in both revenue growth and EPS. This consistent growth quarter-on-quarter is exactly what we want to see. While ICLK’s book value per share is slightly was slightly below its share price when we bought in, the quarter-on-quarter growth in revenue and earnings indicated ICLK had room to run, which it did.
Thoughts of a Psycho Trader…