Micro-Cap Stocks: “Call Options” With No Expiration

Last week, I mentioned that you can think of micro-cap stocks as perpetual call options. Unlike call options, stocks do not have an expiration date, so there’s a limitless amount of time for the stock to rise (assuming the company does not go out of business).

Plus, like an option, micro-cap stocks usually have a low price. Some could be bought for under $1 a share. Keep in mind, “low priced” is not the same as “inexpensive.”

To find out if a stock is inexpensive, you’d need to analyze the stock and the company beyond the market price. But in any case, for the same amount of money, an investor can buy more shares in a low-priced stock, for large percentage gains. For a $1 stock to double, it would need to gain just $1. For a $100 stock to double, it would need to go up $100.

Easier for the Small Fry to Grow

Along the same line of reasoning, it’s easier for a company bringing in $5 million in sales a year to double the number than it is for a big company generating $50 billion in sales to do the same.

Thus, it is easier for tiny companies to grow fast. In addition, tiny companies are on fewer people’s radars, so there are more future potential stock buyers left if the company gets positive attention. Of course, the reverse side of that is that small companies are much riskier. The trade-off between risk and reward is what an investor has to consider.

Today, let’s highlight a few things to look for when deciding whether a particular tiny company is worth taking a chance on. By no means is this a comprehensive list, but it’s a few important things to find out.

Who’s In Charge?

Compared to blue chip companies, it’s harder to perform due diligence on small companies. There isn’t as much information, such as company track record or analyst research reports.

However, one helpful factor to consider is the company’s leadership. See what you can find out about the company’s executives and board of directors.

Are they people with a history of successfully building businesses? Do they have a good reputation? Are they paying themselves an excessive salary? Having good leadership team doesn’t guarantee success for a company, but having strong leadership is very important for realizing a young company’s growth potential.

For example, Amazon (NSDQ: AMZN) probably wouldn’t be where it is today without CEO and founder Jeff Bezos. Strong insider buying also is a sign that the people in charge feel stronger about their company and their interests are aligned with those of shareholders.

Check the Capital Structure

Another important factor is the company’s capital structure. As the saying goes, it takes money to make money. A major risk for shareholders of small companies is that the company runs out of cash.

Each time a company issues new stock to raise capital, it dilutes the value of existing shareholders’ shares, so you don’t want the company to do this often. If a company issues debt, it increases interest expense. And if the company borrows too much, it could even lead to default and bankruptcy.

If a company has a history of frequent equity and debt offerings but without much sales or cash flow growth to show for it, that’s usually a good sign that the company is wasteful and not particularly well run.

Financial numbers will probably fluctuate if a company is relatively new, but look for trends that reveal good (or bad) factors. For example, operating margin trends can also tell you if the company is improving the operating efficiency or if it’s going the other way. Changes in cash flow can also tell you about the company’s financial health.

What Will Bring in Revenue?

Also important are the company’s offerings. You could have the best business people in the world running the company, but if there’s no good reason why customers would want its products and services, then it will be hard to grow.

How does the company differentiate itself from competitors? Ask yourself why you would choose to be that company’s customer. If you would choose that company’s product for reasons other than low price, that’s a sign of differentiation. When there’s differentiation, that company is less vulnerable to a price war, and it can likely charge higher prices than competitors. A prime example would be a health care company that has or is developing a drug or product that serves an unmet need. Such a drug/product would have little to no competition and could be quite lucrative.

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