When is a micro-cap stock worth buying? Here’s how to tell whether it’s worth buying, or whether it’s just hype—with examples of micro-cap stocks to buy (or avoid) today.
Since launching Cabot Micro-Cap Insider last year, I regularly receive questions about which micro-cap stocks to buy and which to avoid.
Recently, Genius Brands (GNUS) had been a name of interest.
Because some are calling it “Netflix for Kids” and believe it has incredible potential.
Genius Brands is a content and brand management company that creates and licenses multimedia content for toddlers.
I decided to dig in to see what all the hype is about.
Luckily, it didn’t take me long to conclude this is a name to avoid.
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First, the company is overly promotional. This is a major negative. I much prefer a company that “under-promises and over-delivers.” It’s fine to publish a press release when something truly transformational has taken place. But Genius Brands publishes highly promotional press releases on a weekly or even daily basis. Despite announcing “breakthrough” new products over the past five years, the company has failed to deliver substantial revenue growth.
Second, the company has poor financial trends. As shown below, despite touting “transformational” new products and partnerships, the company has failed to generate net income over the past five years. In fact, its net loss has widened almost every year.
Third, the number of shares outstanding has grown exponentially.
This means that management has pumped up its stock price via promotional press releases and then sold additional stock, diluting existing shareholders.
Fourth, the stock is incredibly expensive. Currently, GNUS is selling at an Enterprise Value (EV)/Revenue multiple of 148x. Netflix (NFLX) sells at 8.5x. Thus, GNUS is over 17x more expensive than Netflix on an EV/Revenue basis!
When evaluating micro-caps, I’m looking for companies with 1) substantial growth, 2) conservative balance sheets, and 3) inexpensive valuations.
Let’s look at three micro-cap stocks that are better bets than GNUS.
Micro-Cap Stock to Buy: Medexus Pharmaceuticals (MEDXF)
Medexus Pharma (MEDXF) is a Canadian specialty pharma company that is growing at a rapid clip. Its drugs treat chronic conditions and, as a result, weren’t impacted by COVID. In the most recent quarter, revenue grew 94%.
While Medexus does have debt on its balance sheet, it is paying an unusually low interest rate on its debt, showing the lender’s high confidence in Medexus Pharma’s business model.
Despite incredibly growth and a high-quality balance sheet, the stock trades at an EV/Revenue multiple of 1.9x, a large discount to peers at 3.5x.
As more investors discover this stock, its valuation should expand, and I expect over 100% upside.
Micro-Cap Stock to Buy: P10 Holdings Inc. (PIOE)
P10 Holdings (PIOE) is an under-the-radar micro-cap stock operating in an extremely stable and profitable industry (private equity).
In 2019, revenue grew 57%. Over the next several years, I expect the company to grow free cash flow significantly as its private equity business grows.
The company has considerable debt on its balance sheet, but a large portion of it is attractive seller financing.
Despite its strong growth and reasonable balance sheet, PIOE trades at just 10x 2021 free cash flow, a significant discount to private equity peers such as Hamilton Lane which trades at 18.2x free cash flow.
Over time, I expect PIOE to continue to appreciate and wouldn’t be surprised if the stock traded at 15 or higher in a few years, significantly higher than PIOE’s current price of 7.50.
Micro-Cap Stock to Buy: Greystone Logistics (GLGI)
Greystone Logistics (GLGI) is a manufacturer of plastic pallets. It has historically grown revenue at a 34% compound annual growth rate and is profitable.
The company has some debt, but a significant portion of it is guaranteed by the company’s CEO.
Despite strong historical growth and an encouraging outlook, the stock trades at a P/E of just 8.0x.
Management and directors own 44.1% of the stock and are well aligned with shareholders.
GLGI is another stock that could trade at multiples higher in a couple years.
Avoid Liquid Micro-Caps
One final note on micro-caps.
Historically, micro-caps have performed incredibly well, but the most liquid micro-caps have performed poorly. See the data below.
As you can see, illiquid micro-caps (such as MEDXF, PIOE, and GLGI) generated a 15.4% average return from 1972 to 2017 while liquid micro-caps with hundreds of millions of shares outstanding (such as GNUS) have generated an average return of just 1.3%. I tend to look for stocks with 20 million shares outstanding or less, but it’s not a hard and fast rule; one of the stocks in my Cabot Micro-Cap Insider portfolio has 90 million shares outstanding. But in general, the less liquidity the better.
Remember this statistic when you are tempted to chase the next high-flying micro-cap!
Disclosure: Rich Howe owns shares in GLGI, MEDXF and PIOE. Rich will only buy shares after he has shared his recommendation with Cabot Micro-Cap Insider members and he will follow his own rating guidelines. To become a Cabot Micro-Cap Insider subscriber, click here.
*This post has been updated from an original version, published in 2020.