A few thoughts on Microcaps

Friday, September 08, 2006 | 02:34 PM

NOTE:  This Trading alert was originally posted at Ritholtz Research & Analytics on FRI 9/8/2006 3:00 PM EDT by email.

This is posted here not as investing advice, but rather as an example of a trading call for potential subscribers. We expect to post future advisories in a similar manner -- after the call, but in the correct chronological location on the blog.

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Q. You mentioned Micro-caps recently -- Why? Some time ago you showed a chart showing that the market is shifting to big caps from small caps – why even look at smaller capitalization stocks?

A. I look at Micro-caps for a few reasons: 1) They are not well covered by Wall Street, and therefore opportunity exists; 2) They offer large potential upside; 3) I have had some pretty good luck with them over the past 10 years.

 
My prior mention of Micro-caps generated a surprisingly large response; This alone makes me nervous. Since subscribers have insisted, I am sending out these details about the pros and cons of these speculative issues.

There are a few small caps I am watching, and a couple I already own. Depending upon how these develop, I may end up recommending these --  HOWEVER: 

As a rule, I do not particularly like Micro-caps. They tend to be too thinly traded. They very often do not comply with reporting rules or Sarbanes-Oxley. They are heavily promoted, by both paid IR people and other less savory characters. My general take has been that outlandish percentage of micro-cap situations will eventually go to zero.

But as I mentioned last time, I’ve had a pretty good run with a handful of these. In particular, I like special situations. I want a good combination of factors – I look for insider ownership, strong intellectual property and a good patent portfolio, clean reporting, strong management and most important of all, a positive catalyst – a good story that can flower into a great stock.These incidences are exceedingly rare. Because of that infrequency, I have developed caveats about speculating in these companies:

1) Think of them as STUBS – an option that doesn’t expire. That means you only purchase in smaller lots than your stock buys. If you typically buy equities in $50k blocks, then you would only buy $5-10k worth; If its $10k, then you buy $1-2k.

2) Due to the combination of low prices and high volatility, stop losses do not really work on these. Swings up and down tend to stop you out prematurely. Without a stop loss, it is my working assumption that my purchase will get cut in half; Therefore, I only buy smaller amounts.

3) I would rather average up – buying more when the stock is working – than average down. I hate to add to losing positions;

With those caveats in place, here is a discussion of some winners and losers I have had in this micro-cap space. These are simply war stories to give you an idea of how these can trade. I’ve never put together an audited track record of my special situations buys – I’ve had plenty of losers to go along with my winners.

Even the micro-cap big winners have had dangerous track records. These are not recommendations, they are war stories:

Visual Data (VDAT):  In the late 90s, dot com madness, a firm I worked at had a banking relationship with Visual Data; The firm had an online library of videos; They were tryinjg to commercialize the space long before broadband.

The stock was stuck under $2; I discovered a prior convertible offering that kept issuing stock any time it got neat $2. I proposed the firm raise $3m to buy out the convert holders – thinking the stock could go to $3 or $4. It went to $46, and then back down to $1. Yes, lots of people made lots of money – and then gave much of it back.

NX Networks (NTRX) – another late 90s round trip success story. At the height of the internet, with Sycamore and Juniper chasing Cisco, this networker ran from under $2 to $30 – and then back down to zero.

Ampex (AMPX) the company that invented the VCR, had a big portfiolio of technology patents. They proved to a court that the digital cameras essentially used the same technology that put images on tape. The stock was about $5 when the first major settlement was announced, and on that news, I was a buyer between $5- $15. The stock subsequently ran up to ~$55 – before plummeting back to $16.

Burst (BRST) Long story short: I looked over this tech company as a favor to a friend (who owned too much too high) when its stock was in free fall in 2000. Bottom line: Loved the technology, hated the management. I told the founder to fire the CEO, get a new business model, and BTW, everyone is stealing your IP. I joined the Board of Directors when the stock was 3 cents, and helped to convince the firm to pursue a patent claim against Microsoft. The settlement in 2005 was for $60 million. The stock ran to over $3. The company issued a one time special dividend of ninety cents. It’s about a $1 and change today.

 

Those four were the winners – and in every instance, the stock eventually came down precipitously. Microcap losers look the same – they go pretty close to zero – only with out the spectacular run up first.

Final thoughts:

When I do make a micro-cap recommendation, my disclosures will include the following:

Ownership: If a special situation comes along, I expect to 1) own it personally; 2) own it in managed accounts I run; 3) own it in the fund. Yes, we eat our own cooking around here.

Pay for Play: Never. It may be borderline legal, but its totally unethical in my book. I had a boss some years ago who was dying to capture $25k plus in fees for each report he wanted me to write (I refused, and then quit a few weeks later). I thought the guy was a criminal – and from what I hear, he’s under NASD/SEC investigation. Can’t say I’m surprised.

More next week -- including the macro housing piece I promised a week ago . . .


-Barry Ritholtz
September 8, 2006

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