3 myth busters and 3 micro-caps you wish you'd heard of

The world of micro-caps is riddled with mystery. But when you find that stock that's right for you - bam - you've struck gold and it will truly reward you.

Its labyrinthine qualities are in part because there is so little broker coverage of this end of the market. The likes of Netflix, Amazon and Apple all began as micro-caps under US$1 billion (Spheria's global micro-cap universe is a bit broader than some domestic equities which are capped at $500 million.) But like the FAANGs, micro-caps have large-cap potential with supercharged returns to be made along the way.

I recently spoke with Gino Rossi, portfolio manager for the Spheria Global Microcap Fund to break down some of the myths and mysteries around micro-caps. He provided some illustrative case studies and the best tips for diving into this complex world. 

First up, here are three myths that need busting: 

#1 You need safety in numbers

If it's not covered by brokers, it must not be a good investment, right? No. 

More than half of all micro-caps have no sell-side coverage on Bloomberg, according to Spheria, while the average S&P500 company has 21 investment recommendations. 

The reasons for this are varied. On one hand, there is a vast universe of micro-caps, but only so many analysts who largely choose to cover safer, simpler and more popular stocks. 

"We've got 15,000 stocks in our market cap range, which we would define between around US$50 million to US$1 billion, and that's in developed markets alone. We don't invest in emerging," he said. 

Sometimes, said Rossi, the company just doesn't need the capital and so they don't actively seek coverage. 

"We spoke to the CFO and said, 'Well, nobody covers you.' And he goes, 'Eh, we'll get around to it.' You know, he wasn't too fussed. That's the irony here, many of these companies are going so well, so they don't actively seek coverage because they don't need it," he said. 

If you want to avoid the crowded trades, take a look at microcaps. The only catch is DYOR (do your own research). 

#2 They're too volatile

Better to invest in something "too big to fail", surely? Well, not necessarily. 

"The dot-com experience shows that micro-caps are particularly appealing during a period of heightened market valuations since they typically trade at a discount to larger stocks. However, the drawback of microcaps can be a heightened sensitivity to economic shocks," said Rossi. 

However, they're also sensitive to economic rebounds, which if it's anything like COVID-19, can be exceptionally powerful. 

"During the GFC, World micro-caps declined 61% in USD, slightly more than the World Large Cap Index decline of 58%. However, from the trough on 9 March 2009, micro-caps had recovered fully by February 2011. The large-cap MSCI World Index did not break even until December 2013," said Rossi. 

#3 They're too risky 

Being at the smaller end of the market means they are more susceptible to failure. Ahh.. not so fast. 

If you put all your eggs in one basket at any point in time you're taking a risk. Similarly, if you're adequately diversified, you can spread that risk. The same is true of micro-caps. 

"Our biggest fear is that we buy at the top," admitted Rossi. 

But he said he handles the macro-economic environment and all the levers you can't control by simply using good diversification. Nor does he invest in thematic trends. They're even style-agnostic, preferring a blend of value and growth stocks in the fund. 

Rossi appreciates that micro-cap investing is a part of a bigger portfolio construction story. But even so, surprisingly, he found that a micro-cap contribution can complement and even lower the risk of a large-cap fund. 

"We think this really compliments large-cap equities. So if you blend our portfolio with, say, a Vanguard ETF, since inception that would have boosted your returns, but also would have lowered the risk of the portfolio," he said. 

What does a good micro-cap look like? 

To help illustrate all these thoughts, insights and lessons, Rossi has provided a few examples of top performers: 

Collectors Universe (formerly NASDAQ: CLCT) 

Collector's Universe is one of only two coin-grading companies in the world. It also covers the collectibles market from your Pokemon cards to signed sports memorabilia. And this was a stock that you would have wanted to collect. 

"We were attracted to the numbers. So when we looked, the market cap was US$200 million -  quite small, but we had a business where the margins were at 20% EBIT margin pretty consistently," said Rossi. 

"The return on capital was north of 50%. That free cash flow conversion we talked about was 110%. So 110% of the earnings went through the cash flow. Net cash balance sheet and revenue growth of 7% per annum, CAGR of two years," he said.

"So you look and go: 'wow, must have something'. And then you dig and you do the work. And what you find is, firstly, that industry structure is amazing ... It's been around a long time. ... (But) what you also find is that it's actually a great leverage play to e-commerce," said Rossi. 

Rossi said while the asset fundamentals were astounding, he was helped along by a bit of luck. When COVID-19 came along and everyone was stuck at home with the decades of memorabilia (read: junk) they've collected over the years, Collectors Universe took off. 

Spheria acquired the stock at around $20 per share, and held until it was taken over by a consortium at around $92 per share. Outstanding. 

ChannelAdvisor (NYSE:ECOM) 

"It's a little bit like a Shopify. It's really there to help companies manage their online channels. In particular, for a big brand, they need to protect their process architecture. They need to know where their inventory is going. So ECOM helps them do that, whether it's through Amazon or eBay or any other online channel." 

BML Inc (4694:JP) 

"One of our most recent acquisitions is a Japanese pathology company and it was a massive surprise to me to see how far behind in COVID testing they are. 

"Up until not that long ago, their main point of diagnosis was CT X-rays of the chest. New South Wales was doing more tests per day than the entire country's capacity to do PCR COVID testing, you just learn all this, and then you dig into why that's been the case and what's changing," he said. 

How to invest in micro-caps

Patience is a virtue, but that doesn't mean you have to wait for all eternity for a micro-cap to hit the big leagues. 

For Rossi, the joys of investing in micro-caps are more than just inflated returns (although that certainly helps). It's partly the thrill of the chase and partly perfecting the strategy.

"I'd say the first step is just being clear on what you're looking for. And then second is hopefully having the tools to implement it," said Rossi.

What you should first and foremost look for is cash profit, he said.

"More simply than that, we just look at free cash flow conversion. So how much does their profit and loss convert to cash profit? And if the cash profit is strong, then that means it's free cash flow to fund their growth. So that's step number one really," he said.

"We also look at how many acquisitions they've made to see if they are serial acquirers, which we typically take a dim view of," he said.

The second thing to have is the right tools to find these wretched, analyst-free micro-caps.

"For us that that's really screening. We have some really powerful screening tools that help find companies with these characteristics when you look at the history of these companies. 

"The beauty is we can play out through this 15,000 stock universe and look for the companies that we identify as having these good fundamentals. So that screening is something that we've invested a lot of time and money into. And the nice thing about it is we can find companies before others do so we don't rely on brokers to find stocks. We find them ourselves," said Rossi.

Doing your own research is easier than you think

But for the rest of us mere mortals? Rossi said there is plenty of research out there.

"It's amazing how much an annual report has to disclose particularly in the US. So I would always encourage people to do their own research," said Rossi.

Interestingly, Rossi doesn't ascribe himself to a Lynch-like truism of "invest in what you know". Rather he truly believes you can learn enough to invest in anything if you choose to.

"That's all part of the fun of being a fund manager - constantly learning and finding how to run new businesses, exploring new industries."

Learn more about Gino's fund

Expand your portfolio diversity through exposure to a largely unexplored segment of growing microcap businesses with strong fundamentals. For more information, visit Spheria's website here.

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