Pros and cons of an individual investor in the microcap space

One of the things that compelled me to first dip my toes in investing was reading Peter Lynch’s One Up on Wall Street. The straightforward prose of the book, as well as its key conclusion- that average investors can do as well as, if not better than the professionals inspired me. It is the first book I always recommend to friends who wants to learn how to invest in the share market. Of course, as many of you have experienced, the theory is a lot more difficult to practice. Especially in microcaps, individual investors have significant disadvantages to institutional investors. In saying that, there are some key structural differences that evens the playing field for the individual investors.

So, I have put together some pros and cons of individual investors in the microcap space.

Note: I am assuming that the investors here are long-only and invests with no margin.

Pros:

  • The biggest advantage as an individual investor is the lack of pressure to produce high annual return in the next quarter. This means that you can really take advantage of having a longer time horizon advantage (John Huber wrote a great article on this). What I mean by that is to take a longer term view than the short term view of most of the market participants. As John Huber wrote, some stocks “often get mispriced because there is a general perception that the next year or so is going to be very difficult for the company, and there isn’t any real near-term catalyst that will drive the stock price higher. This creates an advantage for those who are willing to deal with short-term underperformance.”

    Structurally, institutional investors have time horizon pressures due to monthly and some even daily performance reporting. While that reporting cycle has real transparency and accountability values, it forces them to at least think about how they will perform in the short term. At times of severe underperformance, this is a real concern as it may initiate big fund redemptions. Some investment funds have tried to reduce this pressure by locking in their capital by forming Listed Investment Company (LIC). As an individual investor, you are able to have a truly longer term horizon (3 years+) and capitalise on current market pessimism.
  • In microcap investing, fund size can be an anchor on investment performance. Large fund size prevents institutional investors from looking at lower-end of the market caps. This is the reason why many microcap listed funds close their funds off when they get to ~$100m mark. An individual investor on the other hand, can go all the way down to the nano-caps (although noting that nano-caps presents their own unique situation due to lack of liquidity).

Cons:

  • The biggest disadvantage to individual investors in microcaps is the lack of access to management. Management evaluation is crucial in microcap investing because they can disproportionately impact the company’s value. In a 100 staff company, the executive team and particularly the CEO has massive say in how well the company executes on its strategy, or even if they have the right strategy in the first place. The CEO of a small company is more often than not involved in most of the important decisions in shaping the company culture and its future. Ian Cassel, founder of Planet Microcap has said that “the key to successfully investing in microcaps is betting on the right jockey, or in other words, investing in the right CEO.” As an institutional investor, you generally get better access to CEOs through roadshow and conference presentations as well as when you ask for an investor meeting.

    This disadvantage doesn’t mean that individual investors CANNOT evaluate the management. You can try to call up or email management and some will be glad to talk to you. Other ways to evaluate management are:

    • Going back to previous guidance management has made and see if they achieved it or if they put a timeline for a project, whether they have met it or quietly swept it aside.
    • Looking at Key Management Personnel’s remuneration packages and evaluate the breakdown between the fixed part and the short and long term incentives
    • Evaluating announced acquisitions, whether it has expensive multiples and whether the acquisitions fit into the larger company strategy
  • Lack of resources and time to uncover informational advantage. Informational advantage is finding information that the market currently do not recognise. Due to the sheer number of Australian microcap stocks (>1800 companies), there are a lot more under-analysed companies than the medium and large caps. This situation presents opportunities where turning over more stones than the other investors can unearth favourable risk-reward investments. Such process takes time and institutional investors are able to capitalise on this more. Nevertheless, an enterprising individual investor should not be discouraged if he/she is willing to do the work.
  • Difficult to do activist-type investing, which can be effective in microcaps. Maybe it is just my experience, but I have seen quite a lot of microcaps that have lax corporate governance. This can be attributed to the concentrated nature of shareholdings resulting with companies that are effectively run as an individual or family type companies. In this situation, an investment thesis can rely on making better capital allocation moves- such as putting an end to irresponsible overseas expansions or questionable acquisitions. These types of investments are largely closed off to individual investors, and individual investors have to rely on the bigger shareholders doing the right thing.

Conclusions

While there are key disadvantages in microcap investing to individual investors, they don’t have to prevent the individual investors from achieving satisfactory returns. The key is to be aware of the limitations that you have and to stay in your circle of competence.

One thought on “Pros and cons of an individual investor in the microcap space

  1. Pingback: weekly wrap 06/10/17 – hidden value.

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