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 earlier this year, I regularly receive questions about micro caps that have caught investor attention—people want to know which micro-cap stocks to buy.
Usually, the interest is driven by a soaring stock price.
In early June, several investors were interesting in Genius Brands (GNUS).
These are the ones to buy.
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Just look at the 2020 stock chart through early June!
I dug in to try to decipher if the stock was worth buying.
Genius Brands is a content and brand management company that creates and licenses multimedia content for toddlers.
Day traders and retail investors got excited about the stock following its press release in early May 2020 that promoted a “Netflix for Kids” type offering called “Kartoon Channel.”
After reviewing Genius Brands’ financials, strategy and fundamentals, I quickly concluded that it is a stock to avoid.
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 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 EV/Revenue multiple of 96x. Netflix sells at 10.0x. Thus, GNUS is almost 10 times more expensive than Netflix on an EV/Revenue basis!
As expected, GNUS has come crashing down to earth since early June.
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 to buy that are better bets than GNUS.
Medexus Pharma (PDDPF) is a Canadian specialty pharma company that is growing at a rapid clip. Its drugs treat chronic conditions and as a result, its business will have limited headwinds from COVID-19. It just completed a transformative acquisition which is accretive and has been completely ignored by the market.
In the most recent quarter, revenue grew 27% on an organic basis.
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/EBITDA multiple of 6.4x, a large discount to peers at 25.6x.
As more investors discover this stock, its valuation should expand, and I expect over 100% upside.
Finally, the company bought back 5% of shares last year and insiders own 15% of shares outstanding, providing solid alignment with investors.
P10 Holdings Inc.
P10 Holdings (PIOE) is an under-the-radar micro-cap operating in an extremely stable and profitable industry (private equity).
In 2019, revenue grew 36%. 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 balances sheet, but a large portion of it is attractive seller financing.
Despite its strong growth and reasonable balance sheet, PIOE trades at just 9.2x 2020 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 10 or higher in a few years, significantly higher than PIOE’s current price of 2.50.
Greystone Logistics (GLGI) is a manufacturer of plastic pallets. It has historically grown revenue at a 34% compound annual growth rate and is on pace to grow EPS 140% this fiscal year.
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 6.6x.
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 shown above, illiquid micro caps (such as PDDPF, PIOE, and GLGI) have generated an 18.4% 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 5.2%.
Remember this statistic when you are tempted to chase the next high flying micro-cap stock to buy!
Disclosure: Rich Howe owns shares in GLGI, PDDPF 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.