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December 20, 2014

Picking Micro-cap Stocks

Our Model Shadow Stock Portfolio holds exchange-listed stocks whose market capitalizations rank within the bottom 10% of all NYSE-listed stocks. Specifically, stocks must have market capitalizations of between $30 million and $300 million in order to qualify for consideration. They are sold when their market capitalizations exceed three times the maximum for addition, placing the current sell trigger at $900 million. (We periodically adjust the company size and valuation rules to reflect prevailing market conditions.)
This range of market capitalization is at a level many would consider to be micro-cap. Micro-cap stocks offer individual investors the advantage of scale. You or I can acquire a reasonable position in several micro-cap stocks either quickly or in a very short period of time without significantly moving the share price if we’re patient with our trades. Institutional investors commonly cannot; they simply have too much money to invest. This gives us individual investors the opportunity to pick up overlooked and mispriced stocks.
The downside of micro-cap stocks is that they are not all the same. Two key requirements for the Model Shadow Stock Portfolio are that candidates must be exchange-listed and must have filed a 10-Q (quarterly) report with the Securities and Exchange Commission (SEC) within the last six months. Many micro-cap stocks fail these two tests. They are not exchange-listed (primarily because they do not meet the either the NASDAQ’s listing requirements or the NYSE’s listing requirements) and either are not current with or don’t file quarterly reports with the SEC. Worse yet, reliable and thorough financial data may not even be available.
When regulators warn about micro-cap stocks, they are referring to those traded over-the-counter (OTC) and often referred to as pink sheet stocks. Such stocks may also be called penny stocks—a moniker reserved for stocks trading at very low share prices. The SEC defines penny stocks as trading below $5 per share and generally traded OTC. (A minimum price per share of $4 is required for all Shadow Stock candidates. This matches the minimum bid price required for being listed on the NASDAQ.) A common misperception is that it is easier for a stock to increase in value from five cents to 10 cents per share than from $50 to $100 per share. In both cases, the doubling of the stock price requires the market capitalization of the entire company to double in value.
What makes OTC stocks risky is the combination of little to no reputable information, extremely low volume and hucksters. It is not unusual for fraudsters to use “pump and dump” schemes to manipulate such stocks. These schemes involve acquiring a position in an OTC stock and promoting the stock via email, telephone calls and/or online commentary. As victims fall for the scheme and buy the stocks, the fraudsters sell their shares. The aftermath is a big drop in the share price, little to no volume and big losses for scheme’s victims. The North American Securities Administrators Association’s (NASAA) warns that this is currently occurring with marijuana industry-related stocks.
Fortunately, not all micro-stocks are the same. There are many exchange-listed micro-cap stocks worthy of consideration. The key word is “exchange-listed.” Such companies are required to meet the requirements of a stock exchange, as opposed to the comparative Wild West that is the OTC market. You can reasonably consider micro-cap stocks if you seek out companies that are exchange-listed, have share prices above $4 and are current with their SEC filings. Low price-to-book ratios and profitability are two additional traits we suggest looking for.
The Week Ahead
The U.S. equity and bond markets will close early on Wednesday, Christmas Eve. The U.S. financial markets will be closed on Christmas and New Year’s Day. The U.S. financial markets will operate on normal hours on December 31 and January 2.
Only one member of the S&P 500 will report earnings between now and the end of the year: Walgreen Company (WAG). The drugstore chain will report earnings before the open this coming Tuesday.
November existing home sales will be announced on Monday morning. Tuesday will feature the final revision to third-quarter GDP, November personal income and spending, November durable goods orders, November new home sales and the University of Michigan’s final December consumer sentiment survey. The weekly initial jobless claims and oil inventories reports will be released a day early on Wednesday.
The October S&P Case-Shiller home price index and the Conference Board’s December consumer confidence survey will be released on Tuesday, December 30. Wednesday, December 31, will feature the December Chicago PMI, November pending home sales, weekly initial jobless claims and weekly oil inventories. The December ISM manufacturing survey and November construction spending will be released on Friday, January 2.
The Treasury Department will auction $27 billion of two-year notes on Monday, $35 billion of five-year notes and $13 billion of floating two-year notes on Tuesday and $29 billion of seven-year notes on Wednesday.
On behalf of everyone at AAII, merry Christmas, happy Hanukkah and (an early) happy New Year.
About The Author - Charles Rotblut, CFA is  the VP and Editor for American Association of Individual Investors (AAII).  Charles is also the author of Better Good than Lucky.  (EconMatters author archive here)

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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