John Cole, one of our most prolific observers of the natural world, once described the flight of the rarely seen frigate bird I a way that reminds me of many who invest primarily in small and micro-cap stocks:

These birds are designed for flight, nor perching; for gliding, not walking, running or scratching in the ground like wild turkeys. The air’s upper reaches are where the frigate bird lives most of its life, soaring, riding the thermals like a skier on invisible, airy slopes, finding hills in the sky, dipping along the rim of a great cumulus, then soaring suddenly higher on a windward thrust those of us watching from below will never feel, see or comprehend.

 Like the frigate bird, small- and micro-cap investors are not made for perching or walking, or even gliding. We are searching for those potential once-in-a-lifetime opportunities—the ten baggers, as Peter Lynch coined them—that will make life a bit easier if we are right about their prospects for soaring suddenly higher on a windward thrust of the thermals. We know the well-established companies, however, successful, will trade below those windward thrusts, their market values likely to continue appreciating year after year at a slow but healthy enough rate to assure comfortable wealth by the time we retire. Yet for the entrepreneurial investors, there is something missing in this traditional path. My interviews with micro-cap investors suggests that what makes individuals buy and sell micro-cap stocks often involves more than just monetary wealth. Part of the allure involves the process of discovering and participating in exciting business opportunities, a process that can stimulate our imagination and augment the psychological cement that holds our sense of self together.

    Investing in micro-cap stocks is not for everyone. It means taking losses in speculative stocks or small companies that never make it, while maintaining our convictions that creative research and intuition will pay off with enough large winners to far outweigh the losers. It requires the discipline to do more research than most are willing to perform, the capacity for assuming higher risk than most are willing to take, the balance to experience grandiosity yet keep it well controlled, the patience to endure the long time frame often required for innovative products and services to catch on, the confidence to eschew the investment community’s fixation on short term results and quarterly statistics, and a knack for viewing the world in a way that is both highly focused and expansive.

   Having said that, however, there are a number of reasons why small companies out-perform large firms by significant percentages over the long term — by about 2.5% per year according to the Chicago research bureau Ibbotson Associates. 2.5% may seem like a minimal amount, but consider the following numbers. If you invested $10,000 that compounded at 10% for 20 years, you would end up with $67,275. If you invested $10,000 that compounded at 12.5% for 20 years, you would accumulate $105,451. That’s a large difference.

    The Elimination of Group Think. The first reason that small caps outperform is that developing enterprises need to be innovative and nimble, and that tends to free them from the constraints of group think or herd mentality. Large institutions shy away from smaller stocks because they literally have too much money to invest and it is more efficient to spread their funds among fewer higher priced issues than thousands of lower priced ones. In addition it is impossible for institutions to buy or sell large blocks of small cap stocks without upsetting their market prices.

   While the elimination of institutional participation levels the playing field for us individual investors and gives us a better opportunity for substantial profits, it also means we have to act completely independently of the “conventional wisdom” of the Street.  As Bernard Baruch once said, most information reaches Wall Street through a “curtain of human emotions.”  With little institutional guidance, the small cap investor is left alone to distinguish fact from fiction.  Functioning in a virtual vacuum, our grandiose fantasies sometimes need only the slight stimulus of a friendly “can’t lose” tip to play havoc with rational decision making.  Thus the small cap investor must constantly guard against rumors and tips, and the fantasies stimulated by working in a more isolated environment.

    Pricing Inefficiencies.  The second reason small stocks outperform is the dearth of research coverage for emerging companies. Since institutions are generally disinclined to buy small cap stocks, most institutional analysts don’t conduct extensive research on their issuers.  Instead of the usual 10-15 analysts reports, we are lucky to find 1 or 2, and these are usually from the company’s investment bankers, who tend to be small outfits themselves and often have their own public relations agenda.  Without the typical consensus on earnings estimates, the potential for pricing inefficiencies (i.e. incorrect valuations) is greater, offering the individual investor a competitive edge.

Capitalizing on these pricing inefficiencies, however, exacts a psychological toll on the investor.  Exceptional opportunities, by definition, are rare, and uncovering them requires thorough financial analysis and sound understanding of the company, the industry, and the economic factors effecting the industry and the company’s products or services.  Doing the job the right way demands enormous time and energy, commodities that are usually in short supply when preoccupied with family and a full time job outside the investment field.  So there is a tendency to create our own ostensibly rational assessment of a company based on fantasies woven from incomplete facts and inordinate expectations.

   Lower Liquidity, Higher Rewards. The third reason for out performance is that small companies often have fewer shares outstanding and fewer buyers and sellers for their stock. In other words they are more thinly traded and not as liquid as large stocks. Combining this small float with a usually low price, individual investors can often gain much more leverage in small stocks. It’s much easier for a $2 stock to increase 300% than it is for a $60 stock to increase 300% in the same time frame. Because it can be harder to convert your holdings to cash at a moment’s notice, investors demand a higher reward for the increased liquidity risk.  Higher potential rewards, however, mean increased psychological pressure to tolerate uncertainty: the uncertainty of exiting stocks in the face of a sudden correction or bear market; the sense of doubt from realizing you cannot have all the information necessary for informed decisions; and the uncertainty that you have made a correct decision in purchasing a stock despite a temporary pull back in its trading price.  The more prolonged an investor’s uncertainty in the context of lone decision-making, the greater the likelihood of acting irrationally—selling at the bottom or chasing stocks and buying at the top.

    Volatility. Finally Small stocks possess more “company risk” than large caps.  For example, they often don’t have the financial strength to survive one poor year, whereas a Pepsico, IBM or Microsoft merely restructures and continues its corporate life after adjusting to bad times.  Volatility in this sense means that small companies have the capacity to disintegrate quickly.  The small caps of course also have more volatility in the market sense, and their stock can move precipitously and rapidly.

    The psychological pressures inherent in the volatility of small caps can compel investors, mistakenly, to make snap decisions more akin to stock and commodity traders than to long-term investors.  Quickly falling prices following a poor quarter or other disappointing development elicit an urgency to sell at what may well turn out to be rock bottom levels.  Rapidly rising prices can elicit a craving for short term profit taking, which calms the nerves but often at the expense of enormous up-side potential.  Because most brokers do not follow the small cap arena carefully if they follow it at all, they frequently join in the panic, encouraging their customers to sell at just the wrong moment.  Unanalyzed impatience is perhaps the most insidious psychological danger for the micro-cap investor.  The small and micro-cap markets are not for you if your self esteem depends on Mr. Market’s every day approval.  But if you can tolerate market pressures and risks on a long-term rather than a short-term basis you will give yourself a fighting chance for meaning rewards.

    Because micro-caps don’t usually have 5-10 years of financials to study, micro-cap investor must ask more qualitative questions about their prospective investments. Consider the following questions when investing in the micro-cap market.

 1) Does your company have a visionary product or service that could change forever the way large groups of people, or whole cultures carry on their lives?
 2) Will these products or services appeal to a niche market that are underserved by the existing products or services and that are willing to think in contrarian ways about new methodologies and tools?
 3) Can management drive the company to success? In a micro cap company, no matter how good the product, a poor management team will inevitably lead to failure. 
 4) Is this the right time to buy?  Ideally you want to buy at a point when nothing appears to be happening at the company, but your research has uncovered indications of positive developments.
 5) Does the company have effective financial and public relations support? The most common pitfall for small companies is under-capitalization. 
 6) Can the company develop valuable strategic partnerships?
 7) Finally, do you have the time to wait for small companies to become large companies? The average small company takes about 4-5 years to develop into a mature firm.