Why Micro-Cap Stocks Should Be Part of Your Portfolio

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Every investor should devote a portion of their portfolio to micro caps. Here’s why.

Before they were world famous investors, some of the best investors in the world started investing in micro-cap stocks.

Consider Warren Buffett, the undisputed greatest investor of all time.

Before he controlled Berkshire Hathaway (BRK-B), he ran a hedge fund for high net worth individuals. During the 13 years that Buffett managed his hedge fund he generated annual returns of 31.6% mainly because he started with a relatively small capital base ($105,100), which allowed him to invest in micro caps.

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When Buffett first invested in Berkshire Hathaway, it had a market cap of $18 million. When he purchased See’s Candies for $25 million, the company was effectively a micro-cap stock.

After shutting down his hedge fund in 1969, he switched his focus to Berkshire Hathaway. From 1965 (when Buffett made his first investment in Berkshire Hathaway) to 2019, Berkshire has generated a compound annual return of 20.2% Pretty amazing, but still significantly lower than his hedge fund’s track record.

In recent years, Buffett’s track record has further declined. Over the past 20 years Berkshire Hathaway’s compound annual growth rate has only been 9.1%.

Why has Buffett’s track record deteriorated?

It turns out, it’s hard to generate superior returns investing in large-cap stocks, even for the greatest investor of all.

Peter Lynch was also a fan of micro caps. While he managed billions of dollars, he invested in over 1,000 companies, many of which were micro caps.

In his book, One Up On Wall Street, Lynch writes.

“The size of a company has a great deal to do with what you can expect to get out of the stock. How big is this company in which you’ve taken an interest? Specific products aside, big companies don’t have big stock moves. In certain markets they perform well, but you’ll get your biggest moves in smaller companies. You don’t buy stock in a giant such as Coca-Cola expecting to quadruple your money in two years. If you buy Coca-Cola at the right price, you might triple your money in six years, but you’re not going to hit the jackpot in two.

 “If you find a stock with little or no institutional ownership, you’ve found a potential winner. Find a company that no analyst has ever visited, or that no analyst would admit to knowing about, and you’ve got a double winner. When I talk to a company that tells me the last analyst showed up three years ago, I can hardly contain my enthusiasm.”

Micro-cap stocks helped Peter Lynch generate his 29.2% compound annual return track record while he was running Fidelity’s Magellan Fund.

3 Advantages to Micro-Cap Stocks

There are three main advantages to investing in micro caps.

First, historic performance has been incredible. Data is a little hard to come by because there are no indexes that adequately track micro-cap stocks (most are too small to be included in the index). But from 1927 to 2016, the smallest decile of stocks in the U.S. generated a compound annual growth return (CAGR) of 17.45%, according to the Center for Research in Security Prices ($114MM avg. market cap). For context, the second smallest decile generated a CAGR of 12.5%, while the largest decile generated CAGR of 9.2%.

Second, their business models are simpler and easier to understand. Most micro-cap companies have one business line and are pretty easy to understand. Further, it’s usually easy to get management on the phone to run through questions that come up during your diligence process.

Third, it’s one of the last areas of the market where it’s possible to develop an informational advantage. With most stocks, prices adjust instantaneously for breaking news, whether negative or positive. Hundreds of highly paid buy side and sell side analysts are scouring financials and press releases to profit from the latest news. At the same time, high frequency traders are making thousands of trades per day profiting from tiny market anomalies.

In the micro-cap world, there are no institutional investors or high frequency traders.

A company may release a positive press release, and its share price won’t react for a day or two. You may be the only investor at the company’s annual meeting or the only attendee on its quarterly conference call.

This allows you to develop an informational edge.

Of course, micro-cap stocks are smaller than their large-cap counterparts and have less diversity, making their business models more volatile. As such, it’s prudent to invest only a portion of your portfolio in micro caps.

Nonetheless, if they were good enough for Buffett and Peter Lynch, investors should consider allocating a portfolio of their portfolio to micro-cap stocks.

And if you want some help identifying which micro caps to invest in, you can subscribe to my new Cabot Micro-Cap Insider advisory, which every month publishes an issue with fresh micro-cap stock ideas. We just launched this investment newsletter last month, and our portfolio already has six micro-cap stock recommendations.

To learn their names, click here!

Timothy Lutts

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