How To Outperform The Market

Everyone has their preferred way to make money in the stock market. Some people dollar cost average into index funds. Others try to time the market using stock options. Then there are others who specifically focus on one area such as SPACs.

My preferred way to invest is by investing in the smallest, most illiquid public stocks out there. Microcaps. The tiniest companies around.

I’ve been investing in the public markets for over ten years. Five of those years have been as a professional investor working for a hedge fund. I’ve read through thousands of annual reports. I have spoked to hundreds of management teams. I have watched stocks I own become ten baggers and other lose 50% or more of their value because my analysis was just wrong.

As a life long student of the market there is one thing I have learned. If you can do fundamental due diligence, and the assets you are managing don’t exceed $10-25 million, you can have a significant edge investing in microcap securities.

Bu Why Microcaps?

There are a few key reasons why I love investing in microcaps.

  1. Low competition

  2. You can become the smartest analyst on any individual company

  3. Misconceptions that microcaps are more risky

  4. Access to top brass management teams

  5. Long-term outperformance

  6. Inefficient pricing

Little To No Competition

In business and investing I like to do things that give me an “edge”. Investing in the smallest publicly traded companies is my edge in the investing profession.

I remember when I first started investing I was looking at a large multi-billion dollar oil services company. When I was reading through their annual report it dawned upon me that thousands of incredibly smart analysts have probably already read and studied this company.

As a retail investor at that time I thought to myself that I would never get an edge investing in huge multi-billion dollar firms. There was just no way I could compete with the Bill Ackman’s of the world. So I decided to dial it back a bit. I logged into my stock screener and began to look for oil service companies with a market cap under $100 million.

I was floored with what I saw. There was a significant amount of extremely small companies with half the valuation as their larger counterparts, and no one was looking at them. There wasn’t any sell side coverage. No one was writing these companies up on the internet. And if you looked at the proxy, there was hardly any institutional ownership.

That is when my viewpoint on the stock market changed. The only way I could potentially outperform in the market was to invest in the smallest companies out there. I couldn’t ever compete with billion dollar hedge funds. I wanted little to no competition in an area where I could become an expert. Microcaps served this.

Become The Smartest Analyst On Any Individual Security

When investing in the smallest companies out there, you can easily become one of the smartest analysts on any given stock. Remember, you are not competing with the Bill Ackman’s of the world. Your competition typically is not a multi-billion dollar hedge funds. From my experience, the competition I have seen in microcaps is typically a smaller one man hedge fund or most common, other retail investors.

The lack of competition from sell side analysts and global hedge funds gives me the opportunity to become one of the smartest analysts on any given stock.

There have been multiple times when I have uncovered public information on a microcap that no one else on Wall Street knows about. Material public information like a new contract that could be game changing for a company. A Dutch tender offer with 20% annualized returns. Even management blatantly stating they are going to sell assets in their company and used the proceeds to return capital to investors.

When you are the only one looking at these companies it is highly possible for you to become the smartest analyst on any given security. And in most cases, you are probably one of the only individuals in the world who is trying to forecast future cash flows from a $15 million dollar public security. So if you get your analysis right, you can make significant money where no one else is looking.

Misconceptions That Microcaps Are More Risky

Institutional investors, brokerages and hedge funds have increasingly shunned microcaps given the absolute small size of these securities and the perceived greater risk of these companies.

Sure, microcaps are definitely more volatile than larger securities. But volatility is not a risk if you are buying an asset for the long-term. Volatility is opportunity. And if you take advantage of someone else’s notion that volatility is risk, you can make a significant amount of money.

And sure, there are a lot of fraudulent penny stock scams out there. Pump and dump artists who doge the law and prey on unsophisticated investors. But these are easily avoidable if you actually do fundamental due diligence.

In my ten years of investing, the only time I ever invested in a fraud was when I had no idea what I was doing. I didn’t know what an annual report was. I didn’t know what a proxy statement was. I don’t even think I read one single press release from this company. I blindly bought a few hundred shares because I saw it was being talked about on a Facebook group about penny stocks.

Since then I have never bought another scam company. They are definitely out there — especially if you are looking at OTC securities. But if you know how to read an annual report and you understand basic accounting, the probability of you investing in one is extremely low.

Access To Management Teams

One of the biggest benefits to investing in microcaps is the ability to access top brass management teams. I have met with over 500 different management teams over my career and toured hundreds of different operations across multiple states and countries. I have done this as an individual investor and also a professional. The reason I have been able to do this is due to the ability to access these management teams.

If I was trying to tour Tesla, Amazon or GE, do you think I would be able to get the CEO on phone and set up a meeting? Not likely, unless I was Ray Dalio or Warren Buffett. But focusing on the smallest companies gives me this golden ticket to speak with and meet with management teams, pretty much anytime I want.

And it isn’t really even hard to get a CEO or CFO on the phone. Find their email on the internet and shoot them an introduction. After a 30 minute call ask them if they would be available to meet sometime. 90% of the time they will be thrilled to show you their business.

And let me tell you. You will learn twice as much and twice as fast how a company works if you get a tour set up. It is an excellent experience that will get you that “edge”.

Outperformance

I got started investing in microcaps because of their ability to outperform other sectors of the market. Combine the smallest companies with a value oriented strategy and you have the golden keys to outperformance. Don’t believe me, check out this research.

The research above shows that microcap stocks have historically outperformed other sectors of the market. As the MicroCapClub wrote:

To show how noninvestable stocks distort microcap returns, O’Shaughnessy produces some return data from the Compustat database between 1964 and 2009.  After removing stocks trading below $1, and limiting monthly returns to 2000%, the stocks with deflated market caps below $25 million returned annual compounded returns of 18.2%.  That return is just astonishing.  O’Shaughnessy confirms this result using data from the Center for Research in Stock Prices (CRSP), again for sub $25 million stocks, and finds 17.6% compounded returns for the same time period. 

The data speaks for itself. If you want higher returns, they can be found in the microcap space. These tiny companies have historically generated extremely strong returns compared to large cap counterparts and will likely continue to generate strong returns for those able to invest in these securities.

Inefficient Pricing

Microcaps are one of the most inefficient areas of the global stock market. The main reason for this is due to the illiquid nature of these securities.

As an example, I have found multiple stocks trading below their cash on the balance sheet. Some trading for 1-2x EV/EBITDA. I have even found some trading at crazy cheap valuations despite the management teams calling out the forward year as one of the best cash generative years ever.

Why does this happen? The illiquidity in the microcap space. There is hardly a time when large caps trade below the cash on their balance sheet. If a large cap company tells investors on their conference calls that they are going to have the best year ever, the stock will likely fly.

But for microcaps, first, no one typically is looking at these securities. And secondly, if you ever want to build a meaningful position in one of these stocks it is almost impossible to do so if you are managing over $10 million in assets.

Try to buy make a 10% position in a $30 million dollar company when you are managing $500 million dollars. You would basically need to buy the entire company. And worse, most of these companies only trade a few thousand dollars worth of shares per day.

The illiquid nature of microcaps offers investors with lower assets under management the ability to outperform. You need to be “poor” enough to buy these stocks. Being poor can be a competitive advantage in the microcap space.

Conclusion

Investing in microcaps, in my opinion, is one of the best strategies an individual retail investor can make. Not only have microcaps historically outperformed larger companies, but you have less competition from hedge funds, inefficient pricing, access to management teams, and you can be the smartest analyst on any given security.

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