Thinking small can pay off big, even though it can be highly risky.
Micro-cap stocks, those of the smallest companies, with market capitalizations of less than $250 million, have struggled along with the rest of the market of late.
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: Remember how many supposedly trustworthy big firms 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. “However, in a market recovery, small- and micro-caps are poised to perform the best because they have the most room to grow.”
Volatile and unpredictable, but also cheap right now, experts said.
Though they could fall further, many micro-cap companies are already trading well below actual book value, the 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. “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 Inc.’s category for funds investing in stocks with market caps under $250 million, is down 4 percent this year, though it has a five-year annualized return of 11 percent.
The $262 million iShares Russell micro-cap index, an exchange-traded fund that tracks the Russell micro-cap index of 2,000 stocks, is a handy vehicle for investing in micro-caps, Isen said. Though down 8 percent this year following 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 $43 million Oberweis Micro-Cap Fund in Lisle. “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 32 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 recently were T-3 Energy Services Inc., GMX Resources Inc., CyberSource Corp., Double-Take Software Inc. and Vocus Inc.
Growth by micro-caps is no sure thing.
“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, chief executive 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 in the Nasdaq stock market must meet minimum listing standards, that is not the case with those either on the OTC Bulletin Board or the Pink Sheets.
Firms that failed 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 big thing. But there are also plenty that deserve to be tiny, including down-and-out former mid-caps.
Fraud is also an issue. For example, the Securities and Exchange Commission recently charged six micro-cap companies amid allegations they engaged in a fraud that put billions of improperly registered shares into the public markets.
While the SEC has cracked down on micro-cap fraud, Lydon said, there are just so many companies that fraud can occur again. He likes micro-cap ETFs because they’re diversified across different companies and mitigate the risks of investing in one firm.
The $18 million First Trust Dow Jones Select Micro-cap is one ETF example Lydon cited. Down 2 percent this year after a decline of 6 percent last year but a 16 percent gain in 2006, it replicates the Dow Jones Select Micro-cap Index.
“Many micro-caps are reputable enough for average investors, but only for investors who like to speculate on small companies,” Isen said. “If you don’t like speculation, stay away from micro-caps.”
Even investors who like to speculate should only commit a portion of their portfolio that is suitable for their personal financial circumstances, he said.
———-
Andrew Leckey is a Tribune Media Services columnist. E-mail him at yourmoney@tribune.com.
