The Investment U E-Letter
Thursday, July 17, 2003 * * * * * * * Mega Gains from Micro Stocks
By Dr. Steve Sjuggerud
President, Investment U
$10,000 into $29 million, without any stock-picking skills whatsoever…
According to the book What Works on Wall Street, $10,000 invested in "microcap" stocks - the tiniest companies that trade on a stock exchange - would have turned into $29 million with your gains reinvested. For comparison, $10,000 invested in the overall stock market (the S&P 500 Index) would have "only" turned into $1,000,000 over the same period - so microcaps beat the overall market by 29 TIMES. The length of time the author studied was 1951 to 1994 (the book is not new, it came out in 1995 or so). Author B claims that even when you adjust for the significant risks inherent in tiny stocks (microcap stocks are over twice as volatile as the overall stock market), the results are still astounding. With high risks and high returns, microcaps offer a unique opportunity where the individual investor actually has an upper hand over the big boys running major mutual funds. That's because microcaps are practically off-limits for big investors… What do I mean by this? Microcaps Under The Microscope Most big-fund managers have internal rules preventing them from investing in stocks as small as microcaps. And even in my business, where I write an investment newsletter with thousands of subscribers, I can't recommend microcaps. The buying by my readers would drive the stock to the moon (that might be great, except for the other side of the trade - the selling by my readers would crush the shares). So I have to avoid them. As a rough rule of thumb, I only recommend stocks with a market value of $500 million or more. When people talk about microcaps, they're generally talking about stocks with a market value of up to $100 million. The big guys avoid these stocks. The big firms don't do research on them - simply put, there's not enough money in it for them. And the typical mutual fund doesn't even consider them - if a fund has a billion dollars in assets, and it likes to hold 1% or 2% of its fund in a stock, that's $10 or $20 million dollars - enough to buy the whole company instead of investing in the stock. Another benefit to the little guy is that most brokerage firms don't allow short-selling in microcap stocks, which ultimately means there is less selling pressure on these stocks. The big risk is lack of information and very light trading making it hard to get in or out. The share price can be crashing, and you won't know why. I saw it happen when I started out as a broker - customers that held microcaps would see them tank with no explanation ever given, and see them skyrocket for no reason as well. When big shareholders want to get out or get in, the shares can move around wildly. For the specifics on microcaps, based on the numbers in O'Shaughnessy's book: Microcaps:
25% a year return
35% a year volatility (standard deviation) The Overall Market (S&P 500 Index):
8% a year return
16% a year volatility How To Pick A Microcap Winner I'll be honest here, I don't know. Since I can't recommend them to my readers, they're off my radar screen, just like they're off the radar screen of most analysts. But we can take a logical shot at it… I ran a screen this morning (using the excellent free PowerScreen at www.multexinvestor.com), whittling a list of 6,552 microcaps down to 144 possibilities. This 144 is a good starting point for using your favorite analysis tools… How did I get down to the 144? I decided to start things off by only looking at companies with positive earnings over the last 12 months. I did this to help avoid the dogs on their way out of business. That whittled the list down to 2,449 stocks. Next I wanted to make sure the stock was at least potentially tradeable, in small amounts at least. So I screened for average daily trading volume of at least 10,000 shares a day, and a market value of over $10 million. That whittled the list down to 1,198. As the next screen, I wanted to get the shares in the likely "sweet spot" for microcaps - above $0.50 cents (as ones below that might be on their way out of business) and below $10 a share (to get to stocks that institutions might avoid and other people can't easily sell short). That whittled the list to 489 names. Lastly, I screened these 489 names for stocks in a uptrend - stocks that are acting well right now, for some reason or other. I asked for stocks that are up by 15% or more in the last four weeks. That whittled the list to 144 possibilities. If I were to consider microcaps, I'd start my research with this list of 144 stocks. Where To Go For More… And The Dangers Involved I wish I could be helpful in referring you to a web site or two. However, the best help I could probably give is to AVOID microcap and "penny stock" websites. Most of these web sites are probably more harmful than helpful, as small-stock promoters (even 14-year-old kids with computers) have fleeced many, usually by hyping stocks they own (so they can sell at a profit) only to have the bottom fall out a few weeks later. In general, I'd say stick with your own homework. Another rule you might follow (in addition to the ones in the screen I did above) is to stick with "listed" stocks (NYSE, AMEX, or NASDAQ stocks) and avoid the "pink sheet" type stocks. You should also consider a rule of getting out at the first sign of trouble - our recommended 25% trailing stop would probably be a good starting rule for your exit strategy. Lastly, don't ever put any more than 10% of your portfolio in the area of microcaps. There's just too darn much risk. When it comes to microcaps, the rewards can be extraordinary, as O'Shaughnessy's book confirms. But the risks are extraordinary as well. If you do venture out and do the homework on your own, I wish you the best of luck. Today's IU Cribsheet - $10,000 invested in microcaps in 1951 would have turned into $29 million, according to James O'Shaughnessy's book What Works on Wall Street. It's not a bad book, and might be worth checking out.
- The free stock screener at http://www.MultexInvestor.com (the PowerScreen) is excellent. (It is free but you do have to register for it.)
Good Investing, Steve | 
