Investors give themselves a better probability of success by having a thoughtful process of researching, analyzing, and investing in microcap companies.  Today, nearly 50 million visitors a year come to Las Vegas to enjoy what the city has to offer, which obviously includes gambling.  Las Vegas is a city built on a tiny statistical advantage in the games of chance offered by the casinos.   Small shifts in the risk reward outcome moves millions of dollars into the pockets of the shareholders of the casinos.  The same way casinos hold a small advantage in the games of chance, this article describes actions investors can take to strengthen their investment process and shift their probability of success for investing in microcap companies.

Let’s start by understanding the challenges of active investing in both the larger market and in the microcap arena.  According to a study by Hendrik Bessembinder of the W.P. Carey School of Business at Arizona State University, from 1990-2020, 2.4% of all the companies in the market accounted for 75.7 trillion dollars of the wealth created in the stock market. Essentially, one out of 40 companies do the heavy lifting of generating great returns. In the microcap area, the probability of finding one of these entities is even smaller, probably much smaller.  We know we are up against a difficult task, and it is probably why it is best left to specialists or those focusing on this chase full time.  Still, investors come to the microcap area because it is possible to find situations where the returns can be substantial, and in some cases, life changing.

The first recommendation is to only invest in industries and companies where you are excited about the prospects.  One way to do this is to eliminate all the industries you have no interest in investing in.  Personally, I will very rarely even look at the automobile, airline, cannabis, biotechnology, early-stage pharmaceuticals, leasing, and many manufacturing entities.  Industrial entities are probably not going to get much of a look, either.  It means you say no to 90-95% of most companies.  The filtering is important because the largest microcap conferences like LD Microcap , PlanetMicrocap Showcase, or investment banking conferences often have hundreds of issuers presenting.  Online conferences will have smaller numbers, closer to 10-20 entities, but narrowing your search to only those you are excited about helps focus your time.  A healthy number is 10-15 companies you really want to investigate.

The second piece of advice is to go to each web site of the company you are researching and learn about the individual members of both the board of directors and the management team.  You are looking at the backgrounds of these individuals for proof they have a historical track record of creating value for shareholders of the companies they have led.  You will find that a vast majority of microcap companies have executives which have not proven they are wealth generators.  While you are researching the board and executive team, you should find out what percentage of the economic and voting ownership of the company these individuals possess.  You can go to the proxy statement to learn this information.  I look for percentages of over 25% or more, and even higher is better.  You can find situations where the founder will own 20-25% of the company just by themselves.  As part of this research, you should discover if there is a dual class of shares and what voting rights each class of shares is entitled to.  With multiple classes of shares, you will find situations where the founder might own 5-10% of the company but has 50.01% voting control.  I want situations where the management team has a history of creating great wealth, high ownership, and if they have voting control you can live with it, but the first two criteria are mandatory.

The third area to research is analyzing the balance sheet of the company, specifically the capital structure.  Before looking at the liability piece, look at the total number of shares outstanding.  In the microcap area, it is too often the case the total number of shares outstanding is not symmetrical with the size of the business.  Typically, it involves a total number of shares outstanding of over 100 million or more, and the revenue (top line) of the business is 20 million or less.  In these circumstances, unless the business sees tremendous year over year growth for a long period of time, equity holders are burdened with too much supply of equity.  There are high profile investors who believe you should look for situations where the number of shares outstanding is less than 10 million.  The scarcity of the number of shares available is what you are concerned about, especially relative to the size of the business.

On the liability side, it is important to know the debt profile of the company.  How much debt does the company have?  In how many tranches are the debt?  What is the interest rate on each tranche?  When does the most immediate debt mature?  Most importantly, what do the interest and asset coverage ratios look like?

As far as assets are concerned, value investors are always looking for situations where there is a great deal of cash relative to the market value of the company.  It is very rare, but there are some companies with more cash on the balance sheet than the current stock price.  These are occasions where a closer look is necessary, but it is often the case that the operations are burning cash.  Comparing the quarterly and yearly burn rate to the existing cash gives you an idea of the time horizon before more cash potentially needs to be raised.  You often see this with early-stage biotechnology and pharmaceutical companies.  One other asset to pay attention to is any tax loss carryforwards and their amounts.  Larger is better, and combined with a cash generating business, these assets are a strategic and potentially valuable for a long period of time.

Fifth, let’s turn to the income statement and the size of the business.  For a company to begin to attract institutional sponsorship, the top line needs to be close to a hundred million and headed towards five hundred or a billion dollars.  From my perspective, I want to see businesses with a top line of at least 50 million dollars or close to it.  Anything less than twenty-five million is going to be relatively small versus what is needed to overcome the institutional barrier.  Interesting situations can be discovered where a business might be at twenty million on the top line, and they are involved with an acquisition which would double or triple the top line and immediately improve the cash generation capabilities.  Clearly, that depends on the specific situation and the ability to execute and integrate.  We also should mention looking at 2,3-, and 5-year comparisons of the income statement to look at top line growth and margins.  Clearly, higher growth rates and improving margins (shoot for at least 10% on the operating margin level).  Let’s turn to cash flow and capital expenditures.

Sixth, I want companies that are either generating cash, or are systematically moving towards operating cash flow.  I also don’t want to see a lot of capital expenditure so you can potentially have a high free cash flow generating entity.   Comparing the balance sheet to the cash flow statement gives you an idea of how the working capital, cash conversion, and timing of the receivables and payables is taking place.  Many investors use adjusted EBITDA, EBITDA, and EBIT as proxies for cash flow from operations.  It is important to look at capital expenditure as well.  I typically avoid anything that is capital intensive, but each company is unique in this regard.

Finally, every listed company on a public exchange is trying to improve their business.  Those which involve a big change, like a management replacement, business model overhaul, spinoff, exchange or sale of a division, or stock buyback, are potentially worth investigating further.  If you incorporate all of these points into your investment process, it will help improve your chances of finding a hidden gem in the microcap area.  Like the casino in Las Vegas, improving your risk reward is potentially a source of value.