29 Things to Look For in a Microcap Stock

29 Things to Look For in a Microcap Stock

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The Microcap Opportunity

We worked with Howard Group to come up with 29 points to consider when looking at investing in a microcap stock. The key here is due diligence. Good research can help you mitigate the risks that these stocks have.

Benefits of microcaps:

• Higher potential returns
• Small companies outperform big companies over time
• Valuation disconnect
• Lack of visibility = higher arbitrage
• Nimble companies and boards
• M&A potential

Downsides of microcaps:

• Higher risk
• Less analyst coverage = less due diligence by market
• Less trading volume

Investors who do strong due diligence can mitigate the downsides to trading microcaps and can reap big gains.

Due Diligence Checklist

The People

Good people behind a company make a difference – especially for small companies that have big growth potential.

Here are the key things to look for:

• A proven track record in building successful businesses
• A well-established network of connections and ability to nurture strategic relations
• Ability to raise capital in a tough economic environment
• Skin in the game: ownership of shares of the company represents real stake
• Management that is respectful of shareholder funds: not spending excessive money on General and Administrative (G&A) expenses or overpaying themselves

Pro tip: Review annual Information Circular for excessive levels of management compensation or director’s fees, insider shareholdings, any past bankruptcies, and other Boards that senior officers serve on or previously sat as a director.

Capital Structure

The structure of microcaps can tell a story on its own. Here is what to look for:

• The percentage of holdings of retail vs institutional investors, as well as insiders
• How many shares are outstanding and fully diluted
• The expiry dates and strike prices of warrants

Pro Tip: Look at previous financings. Was each subsequent financing done at a higher level than the last? Or does the company have a history of dilution?

The Numbers

The numbers are the meat and potatoes of this checklist. Look at:

• Working capital
• Quarterly expenses with special attention to G&A
• Debt – repayment schedule and interest rates
• Generating free cash flow, or the potential to do so in the near future
• Ability to maintain profitable margins

Pro Tip: Are revenues based on the one-time sale of a product or is there a strong recurring revenue model?

Differentiators and Catalysts

Does the company have an advantage over competitors? What catalysts are on the horizon that could potential impact share price?

• What sets the company apart from its peers?
• Product features, attributes and benefits
• Service features, attributes and benefits
• The company’s client list
• Visibility on events or milestones that will bring significant shareholder value

Pro Tip: Look at management’s past performance to see if they have done what they said they’d do. Have they met the timelines and objectives previously stated?

Valuation:

Relative to the market, is this company fairly valued? Check out:

• For a revenue producing company: how much future potential is built into the stock price versus the fundamental financial situation.
• For a non-revenue producing company: how much potential is built into the ultimate value of the asset and its economic viability

Tricks of the Trade:

Don’t bite off more than you can chew. Could you sell your holdings within three trading days without incurring a loss greater than 10%?

Keep an eye on the insiders. Insiders know the internal workings of the company and buying or selling could be a signal.

Watch the stock like a hawk. A sudden price drop could indicate a pending financing or negative news.

Analyze the analysts. Watch what the analysts are saying and if their opinions are shifting.