Holding a microcap that makes it all the way to mid-cap, or big-cap territory, is how you get a ten-bagger, or even a hundred-bagger. The odds are low of course, though it happens more frequently than you may realise and arguably often enough to justify the risk. 

To provide you with a roadmap for the sector, we sat down recently with two professional microcap investors, Shane Fitzgerald from Monash Investors and David Keelan from Ellerston Capital. 

We discussed how the experts sift through the 1400 stocks that make up this part of the market, some of the red flags to watch for, valuation methods you can use, and some areas the experts like right now. 

Because as Paul Kelly famously sang... ‘From little things, big things grow’.

Image: Shane Fitzgerald from Monash Investors needs to see a unique and significant opportunity before he will consider investing in microcap stocks.

Narrowing the universe of opportunities

Depending on who you ask, the definition of a microcap will vary, and it's a topic our panellists discussed off camera before shooting this video. For some, micro means very small, think sub $100 million market cap. After some deliberation, a consensus was reached that stocks of $500 million market cap or below could be classified as micro caps for this discussion.

The opportunity for investors is to find those small packages that can go on and become substantial businesses. However, the risks are elevated as these smaller companies are less established, they often require additional capital, and most fail to deliver on their ambitions.

With over 1400 stocks to filter through we asked our panel for a few of the ways that they narrow down the universe to a manageable size. Fitzgerald says that conducting face-to-face meetings is vital but the reality is that you're not going to be able to do that with every stock.

"You can't look at everything. So, you've got to look at what you have access to, compare them against one another and work out what's best to spend your time on. That's the key."

Keelan says that he runs a screen every week to identify those stocks that have broker coverage and those that don't. His preference is for stocks with coverage from one broker rather than none and says it helps him to gain a faster understanding of the business.

Once he has narrowed down the universe, Keelan says he likes to drill down into some of the key financial metrics. A clean balance sheet (no debt) and good cashflow are essential ingredients for stocks in his portfolio. He also wants to have a sense of where earnings are headed and see that management is aligned to the success of the business.

"Our portfolio is net cash. There are only one or two companies that have debt, and it is for a very specific reason."

It's all about the growth

When you're looking at microcaps, it really is about the growth story and finding stocks that can become small caps and potentially large caps over time. Keelan warns that the microcap landscape is littered with value traps – something to keep an eye on. "If it doesn't have growth, then it's a perennial microcap," says Keelan.

Fitzgerald agrees that growth is critical and says that there needs to be the prospect of a step-change in the company outlook for the team at Monash to even get interested.

"The reason you hunt in the microcaps space is that you're really on the hunt for something that can be a multi-bagger, otherwise what's the point given the risk?"

So, what does that look like? He says you need to find companies that are attacking a significant market that nobody else is chasing. Once you've done that ... it all comes down to management, says Fitzgerald. "Execution is everything and the management team is obviously what drives that," he says.

A unique set of risks for small companies

There are a plethora of risks that are commonly cited when you look at the microcap market, most of these are already baked into the price. The one risk that Fitzgerald believes is often overlooked is 'time.'  Significant opportunities can take years to be figured out, and that usually means that there will be a requirement for companies to tap the market for additional funds.

To that point, Keelan says that he keeps a close track on turnover of key management such as the chief financial officer (CFO). Having someone in the business that deeply understand the capital requirements of a company and the cash flows is critical, he says.

"We want them staying, we want them locked in, and we want the CFO and the CEO to have a very good 'brotherly' or 'sisterly' relationship."

Another risk that is specific to this end of the market is liquidity. Perhaps, this risk is more pronounced for people managing larger amounts of capital; however, if things go wrong (and they do go wrong) it can be hard to get out of a position.

Fitzgerald says he keeps a limit on the number of microcaps that are in the portfolio to about ten and he manages the risks by keeping them as small bets until the businesses start to prove themselves out.

A couple of ideas

As always, we like to get the fundies to nominate a stock that passes their filters, note these are not recommendations so do your own research or speak to an adviser.

Dave Keelan from Ellerston nominated PointsBet Holdings (ASX:PBH) as his pick. PointsBet is a recent listing in the online gambling market and has nearly doubled since the IPO in June. The company is the 4th largest player in the US$17 billion online gaming market. Keelan reckons they're doing a good job in the land grab that is taking place as new States open up the market for online gaming.

As many Australians confront water shortages due to drought conditions, it seems like the timing for water stocks has never been better. Fitzgerald chose to put the spotlight on a company called Fluence (ASX:FLC), a significant player in the water purification and desalination market. The company has revenues of around $200 million. However, Fitzgerald says the stock is approaching a significant inflexion point and expects it to be cashflow positive shortly.

"And you know what happens to small stocks when they go through major inflexion points …"

You can read more about Shane's views on Fluence in the microcap collection linked below.

6 unique microcaps under the radar (for now)

Click on the player below to access the video.

Watch more 

If you enjoyed that, in our previous episode we discussed the famous WAAAX stocks, which have stumbled in the last few months. 

You can access that here

Mark G

Great points made, certainly some lessons in there that would have saved me pain over the years. Would be interested in understanding the process for getting face time with companies and recommendations for retail investors on approaching management without being a nuisance.

Mark Dawson

Sorry, I prefer Tabcorp (TAB:ASX) over Pointsbet. Tabcorp is better diversified pays dividends and is well managed where as Pointsbet is a higher risk and the horse has already bolted. Though I guess if you like gambling, then go for it.

James Marlay

Hi Mark G, I would say getting face time with companies is probably the one thing that fund managers regularly discuss that is really hard for direct investors to replicate. I had a think about it and here are a few ideas... 1) All companies are required to hold an AGM, it is a guaranteed opportunity to get face to face with management once a year and is an opportunity to ask your questions. 2) Many small companies have to actively promote themselves. This means they often participate in conferences that take place. You could contact the company and find out if they are presenting at any conferences and attend. 3) Write a list of questions that you want asked. You can try giving them a call and asking the questions over the phone or if that doesn't work you can send them an email and see if they will respond. 4) Run a search on Google and scan their website for video and audio interviews. Not perfect but you still get a sense of the people you are dealing with and see how their story has changed over time. Ultimately it will depend on the company and individuals running it. Personally, I find the interaction that you have with a company and how they deal with individual investors to be a good indicator of the culture inside the organisation. I'm sure other Livewire readers will have some suggestions.

Carolyn Hatton

Using Paul Kelly's song is inappropriate. He glorified Gough Whitlam's soaring rhetoric in regard to land rights and self determination. Plenty of cash burn there, tax payers teat has been well cracked and burned.