Microcap Stock Investing

Microcap companies are plentiful but frequently obscure

Publicly traded companies are categorized according to the amount of investment capital they hold. This is determined by the number of shares they have issued and the price per share. There are “Giant caps” “Large caps” “Mid and Small caps” and “Micro caps”. Microcaps generally have investment capital of less than $500M. By comparison, Small caps have between $500M and $1B market capitalization. Some define Microcaps as having between $200 million and $350 million of market capitalization. 

A microcap company is usually a newer company of an age between just issued and ten years old. Some brand new companies are issued and immediately appeal to investors and start out as small or even midcaps. The microcaps I am interested in are newer and relatively unknown. Because they are so new, the products or services they are marketing are almost all innovative. Their products or services are unusual and may take some time to find wide public acceptance and applications to the economy. The following are some examples.

Medicines and medical appliances are innovative. They are developing cures or preventive measures for disease. Research and development can be very expensive and trials of these may take a long time. However, if they prove to be effective, they can find very large consumer demand and be very expensive. The new company can become very profitable in a very short time. On the other hand, many new pharmaceutical companies fail to produce viable medicines or they may fail to be approved by regulators. Investors lose their money.

Some companies develop new materials that have the potential to be used in a wide variety of products. Think of polyester and other petroleum-based plastics. The development of these materials may have taken years and been very expensive yet these have found very wide application in thousands of products. Companies such as DuPont became wildly profitable. Once, they were new, and small. 

Globally there has been much discussion about the climate. Many people, and many scientists are convinced that the climate is changing due to human activity; principally by increasing amounts of carbon dioxide being released into the atmosphere. There is wide agreement that this is happening because of the use of fossil fuels to create the energy to power machinery such as cars and trucks. So there is a very strong movement to reduce the consumption of fossil fuels and find alternative sources of energy. This is a disruption to social and economic life. Disruption is the gateway for innovation. Electric vehicles are widely viewed as superior to gas engine cars and will replace them in the near future. This has made Elon Musk, the founder of Tesla, the richest man in the world. Tesla is viewed as the most likely producer of vehicles of the future. Tesla has disrupted the automotive industry. 

Due to their small size, newness, and innovative products and/or services, microcaps are risky. They have great potential for gain or loss. For this reason, it is prudent to limit exposure to this asset class. It should be part of a total allocation to equities. It is important to carefully assess your risk temperament to ensure you have the proper allocation. The risk of loss can be mitigated by investing in more than one company and companies of a variety of industrial classes. Since these are typically volatile, it is important to keep a close eye on them and rebalance them as their prices change.

Keep investigating microcap companies. Learn their stories. Check out their management. When you are satisfied this is a company you want to see succeed, invest in it. Your investment returns will follow.

Asset allocation changes

In 2018 I changed my asset classes in my portfolios in response to the high price to earnings ratio of US equities and as a response to the political uncertainty in the USA. I also changed my fixed income asset classes to reflect the likelihood of interest rate hikes. If you would like a copy of my client letter that details this change and my reasons for it, please request it via email.

Rebalance your portfolio in the face of the storm

Calm in the face of the storm

Please find this very good article from the New York Times (via the Arizona Daily Star) that helps to put the current market instability into perspective. The article points out that retirement portfolios usually take years or even decades to come to fruition, so it suggests that impulsive moves to cut losses by selling stocks may hurt retirement portfolios that an investor may need to rely upon for 30 years.

Here, at Jim Hannley LLC we were busy during this upset examining our client accounts to determine which, if any of our allocations needed to be rebalanced. (For more detailed information about rebalancing; especially how tactical and strategic rebalancing differ, please find that elsewhere on our site.) Not surprisingly, due to the sharp sell off of equities last Friday and Monday, we found that our allocations to our large cap funds, our international funds, our emerging markets funds (both equities and fixed income) and our core bond funds had moved away from their target allocations. In response, we placed many orders to buy or sell these funds to restore their model allocations.

This is strategic rebalancing because we are not increasing or decreasing our allocations away from our models (sometimes referred to underweighting or overweighting an asset class) by speculating that one asset class or another will be a winner or a loser. However, this does not mean that strategic rebalancing cannot result in a short term gain. For instance, if we find that the AJAX large cap fund is down 2% and, as a result, our 20% allocation to AJAX as our Large Cap vehicle is now 19.6%; we will buy more AJAX to restore it to 20%. This means that in a $100,000 portfolio AJAX, for example, prior to the event was selling at $10/unit and it is now selling at $9.80 we might need to buy $400 of AJAX to bring the AJAX allocation of $20,000 from $19,600 back to $20,000. We now own 40.8 more units of AJAX than we did before the event. If the price of AJAX cycles back up to $10.10/unit we find that we now hold 2040.8 units with a value of $20,612. If we rebalance once again, we will sell 60.6 units for $612 and realize a short term gain of $212 ($612-$400).

Conversely, because our international, domestic and emerging markets equities are collectively down 4% in the portfolio, our fixed income allocation has grown from 30% to 31.25% (up 4%) in our depressed portfolio now valued at $96,000. The fixed income fund has not increased its share price, but its proportional amount to the entire $96,000 portfolio has increased. We are going to have to sell $1,250 of our bond fund to bring the bond fund from $30,000 to $28,800 ($28,800/$96,000 = 30%). We now have another $1,200 in cash with which to buy more equities while their share prices are (temporarily) depressed.

This exercise will, hopefully demonstrate that roiled markets bring investment opportunities to investors who know how to strategically rebalance their portfolios to take advantage of price changes in their funds.

Strategic changes to my model portfolios

I have been for some time considering changes to my model portfolios. This has been precipitated by questions I have about traditional models that I was exposed to while I held my book of business at Genworth Financial Wealth Management and, prior to that as a financial planner in the capacity of Investment Advisor Representative at AXA Advisors.

Elsewhere here, I describe my practice philosophy as adhering to principles of Modern Portfolio Theory. MPT places great emphasis on asset allocation. Model portfolios are guides to investing client funds by diversifying their investments in mutual funds that hold various distinct classes of assets. Also elsewhere here I  list those I use. The models reflect a range of investment objectives and risk tolerance from “Capital Preservation” to “Aggressive”. The exact models I use are proprietary so I don’t display them to the public.

While my book of business resided at Genworth Financial Wealth Management I employed various institutional wealth managers to compose model portfolios for my clients. I assessed their risk tolerance and investment objectives and based upon these I would advise them to use a model portfolio of one of the wealth managers. Because these wealth managers held different views, they composed different models. Some were “strategic” some were “tactical”. The tactical portfolios could change their asset allocations for asset classes with some limitations. For example, they could have a target of 20% for Domestic Large Cap Growth but they could “overweight” or “underweight” that 20% in a range from, say 10% to 30%. They would adjust the allocation based upon their best guesses for near term Market moves. I don’t tactically adjust my portfolios.

Recently I attended a workshop organized by the Tucson Chapter of the Society for Chartered Financial Analysts and the Financial Planners Assn. Tucson Chapter. The presenters were from Oppenheimer Funds. Brian Levitt, economist and head of capital markets research for Oppenheimer Funds spoke extensively about the outlook for financial markets globally. The upshot of the presentation is that it is time for investment advisors to examine their views on allocating stocks and bonds in light of the increasing market capitalization of non-US companies. He stated that at this time US based companies own just 43%  of the share value of all the corporations publicly offered in the world. It is for this reason I am increasing the proportion of foreign stocks in bonds in my portfolios.