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Insights: Finance

Micro-cap stocks are proof that great investment gifts can come in small packages
From the Print Edition:
Kevin Bacon, May/Jun 00

Micro-cap stocks (generally defined by Wall Street as publicly traded companies with market capitalizations of $300 million or less) represent the last frontier in the equities markets. With minimal Wall Street research coverage, the micro-cap sector offers exceptional opportunity for investors.  

Micro-cap stocks do not fit into any single category. They include young entrepreneurial companies in the forefront of technology and other fast-growth industries, established companies in more mature businesses, and niche companies serving smaller geographic regions and markets. There are approximately 15,000 micro-cap stocks, divided among the following broad industry group classifications: technology, 40 percent; manufacturing, 15 percent; banking and finance, 10 percent; mining and construction, 10 percent; utilities and transportation, 10 percent; and agriculture, real estate and insurance, 5 percent each. In other words, there is a little something that can turn into a big something for all kinds of investors. This is the "space" where we believe the next Microsoft or Berkshire Hathaway resides.    

THE RESEARCH VACUUM  

Wall Street pays scant attention to micro-cap stocks. This is not a reflection of their investment merit, but rather simple "sell side" economics. Micro-cap companies have small floats (shares outstanding) and therefore do not offer much in the way of trading commissions to the major brokerage firms. In addition, micro-cap companies are not likely to be raising large sums of capital in the near future. So, there is limited potential for investment banking fees. The end result is a research vacuum. Even the dullest S&P 500 company can have hundreds of Wall Street analysts following its every move, while the most dynamic micro-cap stock attracts little or no professional scrutiny.  

In the micro-cap arena, investors willing to do some digging can be the first to hit pay dirt. You often have to be patient. However, if you do uncover something truly special, it will eventually attract the attention of Wall Street and institutional investors, or a corporate buyer. When this happens, you can expect windfall profits.  

Of course, there is also risk. Some micro-cap companies are dependent on just one product or serve a very narrow market. Others lack management depth. If something goes wrong, there is often little to fall back on. Liquidity is also an issue. Owning a piece of a micro-cap company provides exceptional upside potential when things go right and everyone wants in. However, when things go wrong and everyone heads to the exits at the same time, you get trampled.   Risk/reward factors duly noted, micro-caps have outperformed every other equities capitalization sector over the 27-year period (1973-1999) in which micro-cap stock performance data is available, as the accompanying chart illustrates.    

RESEARCH, RESEARCH, RESEARCH  

It is said that the key to successful real estate investing is location, location, location. The key to successful micro-cap investing is research, research, research. As aforementioned, Wall Street doesn't provide much help. We at Gabelli Funds get micro-cap ideas from trade journals, annual reports, industry contacts, and even management of larger companies that we follow in similar or related businesses. In fact, we welcome ideas from Cigar Aficionado readers.  

Regardless of the source of ideas, we always do our own digging. We believe in sitting down with the management of most companies we consider investing in--we call it going belly to belly with Gabelli. It is a particularly critical facet of our micro-cap stock research. Annual reports, 10Ks and 10Qs can do a good job detailing what is, but meeting with small-company management and discussing their business plan and reviewing their business model is the best way to assess what is likely to be.    

FINDING CHEAP STOCKS  


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