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Microcaps Offer Explosive Growth Potential

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Definitions of the market cap range for Microcap stocks can vary. One conventional measurement is $50m-$300m. Another is the bottom two deciles of stocks ranked by market capitalization. The Russell Microcap Index, as of 12/31/23, is comprised of the smallest 1,000 companies in the Russell 2000 plus additional companies that meet listing requirements.

The index excludes OTC and pink sheet stocks and contained 1,495 companies as of 12/31/23, representing less than 2% of the total US equity market capitalization. The index skews towards Healthcare and Financials with each category representing 24.9% and 20.6% respectively. The average market cap of the index is $858 m while the median market cap is $235 m.

The largest market cap in the index is $7.4 B. Zacks has elected to define “microcap” as stocks with a market cap below $1B, realizing that stocks with market caps below $50 m can also be categorized more formally as “nanocaps”.

Microcap and small cap stocks typically occupy an allocation in diversified portfolios. Smaller companies have unique characteristics compared to their large cap brethren. For instance, they typically have lower trading liquidity, less international sales and operations, and less research coverage by Wall St. It is also perceived by the investing community that smaller companies are more burdened by interest rate increases, suffer more macro-economic sensitivity, and have less financing options.

Smaller companies have also historically been more volatile (i.e., higher standard deviations) in terms of market performance. It is easier for a $50 m market cap company to double or triple in size over the next 12 months than say a company like Google or Microsoft. And this same type of volatility can occur to the downside.

The general allure of microcaps lies in the notion of an “asymmetric information” advantage. If one believes that the market is not perfectly efficient, and that returns can be achieved in excess of the market, the only way this can be achieved is through betting on some knowledge that the market is not efficiently pricing in. Is the next Amazon with outsized returns somewhere out there?

Anecdotally, it is much harder to know something new and valuable about say Apple or Meta that a legion of Wall St analysts hasn’t already commented on. However, it is possible that there is a small medical device company in say Minnesota that has developed a more efficacious heart catheterization device that could become the standard of care for implanting stents, and such market potential is not adequately factored into the current stock price.

In this vein, we highlight three microcap companies which we believe are under the radar and have no current wall street analyst coverage. The first company is Innodata Inc (INOD - Free Report) , a “picks and shovels” play on AI. While an AI arms race is clearly afoot, it is difficult to predict which types of technologies and which companies will prevail. Innodata’s products are the tools companies needed to test and train new AI products, so it’s agnostic to the type of AI and can serve many masters to speak. We believe that the company will benefit in the near term from the rampant cap ex investment spending on AI by the large technology players. Customer concentration, or reliance on these large players, could become more of a risk factor down the road if the company is unable to successfully broaden its customer base to smaller players.


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Another low-profile company, in our opinion, is Red Violet Inc. (RDVT - Free Report) , a high Gross Margin (adj. GM~80%) software company providing identity verification and fraud detection products across multiple verticals. The Identity verification and fraud detection markets are expected to grow with a CAGR in the mid-teens according to Grandview Research. An unexpected slowdown in financial transaction processing like mortgage applications would be the biggest risk factor.


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Lastly, we point out HF Foods Group Inc. (HFFG - Free Report) . The company distributes food products to the Asian restaurant industry in the US which is comprised of over 90,000 restaurants which are fairly dispersed geographically. These restaurants often require quick delivery times for refrigerated products like seafood and produce. Most of these restaurants are independently owned, thus lacking the purchasing power inherent in larger chains and requiring utilization of a distributor. The Chinese restaurant industry is growing at a 5% annual clip. Commodity price inflation is arguably the largest risk factor.

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Finance academics generally agree that small stocks outperform large stocks over the longer term, but with increased volatility, suggesting a possible market anomaly. The understanding of this “size effect” has evolved over the years. The dissemination of multiple academic studies examining this phenomenon began in earnest in the early 80’s and culminated in the much-referenced Fama and French study of 1993. But more recent research, most notably Alquist, Israel, and Moskowitz-2018*, sheds new light on the issue. The researchers argue that a “pure” size effect no longer exists, most likely because it was arbitraged out after the release and discovery of these studies. They also find that the seasonal January effect disproportionately benefits small companies and contributes to the outperformance.

But not all is lost. The researchers find that a size premium does exist and “mostly comes from microcap stocks”, and is “made much stronger when looked at in conjunction with other factors (namely, defensive/quality factors)”. Such a screening process is euphemistically referred to as “controlling for junk”.  The “junk” among the landscape of small companies typically includes companies that are unprofitable, pre-revenue, debt laden, or have broken business models.  Please note that the trading friction associated with the more illiquid stocks needs to be considered within the microcap strategy. The friction results from wider spreads in the bid-ask pricing because of a scarcity of available shares. Obviously, this matters more to an institutional investor seeking a longer arc allocation of the stock vs. an individual investor trying to attain a modest volume of shares.

This “controlling for junk” process is where Zacks believes it can add value through a proprietary ranking system of microcaps, the discussion of which is the focus of our explanatory piece, “The Microcap Ranking System.”

*The Journal of Portfolio Management, Volume 45, Number 1, Fall 2018, “Fact, Fiction, and the Size Effect”




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