Rules For Successful MicroCap Investing

MicroCap Investing - An Overview

In today's market environment most investors define a microcap company as any stock with a market cap below $200 million. Market capitalization is determined by multiplying the price of the stock by the number of issued shares- this gives you the value which the market is placing on the company.

Microcap stocks do not lend themselves to traditional analysis. There is usually no history of revenues and earnings from which one can predict future performance. There are few if any analysts who publish formal financials and price projections on microcaps. There is generally very little information from which one can make a "logical" decision to invest in a micro cap stock. Investing in MicroCap stocks tends to be more emotionally driven.

Dr. Richard Geist, Harvard PhD in psychology, long time observer of the psychology of investing, and contributing editor to the OTC Journal, says there are four primary factors that contribute to success in the micro-cap market:

The most successful microcap investors make decisions more from the gut than the head. Investing in the unpredictable futures of companies with revolutionary ideas, but no history of success, requires a certain amount of intuition and luck. The rewards can be unparalleled when an investment pays off.

Before deciding to invest in a microcap stock, be certain you like the company. If you have no feel for the prospective company's business model, simply do not invest. Never invest on the basis of a hot tip or the advice of this newsletter. We will continue to come up with about eight ideas each year, but you must make the ultimate decision. It is your money, and you will suffer the consequences of any loss and enjoy the benefits of any gains. We already know we are going to be wrong about some of the companies we profile. Therefore, you should expect the same.

After reading the following section, if you determine you cannot adhere to these basic principles, please do not invest in microcap stocks. It is obviously not the proper investing arena for you. We recognize this is only one small corner of the entire investment world, however, it is one we believe every investor should be involved in with a small percentage of discretionary capital.

Basic Investing Rules For MicroCap Stocks

Here are several rules to which you must adhere to be a successful microcap investor:

• Never invest more than you can afford to lose. Since microcap stocks are highly risky, only a small percentage of your assets should be committed to microcap stocks. Consult a professional licensed financial advisor if you are unsure about a suitable amount to invest in this high risk end of the market.
• Be prepared to invest with at least a one to two year time horizon. Peter Lynch, one of the most successful fund managers of all time,  stated that he made his best returns starting the second year he held a stock, often waiting five years to fully maximize his profits. While one month might seem like an eternity to a short sighted investor, one year is a small fragment in the life cycle of a successful company. A specific example is Comverse Technologies (NASDAQ: CMVT). One of our editors traded this stock in 1987 at $.375. Today (July 28, 2000), the stock is trading at $78 ($234 split adjusted) after a 2:1 and 3:2 split. It would be interesting to learn if there are any shareholders who purchased this stock at $.375 in 1987 still holding it today.  A 10,000 share purchase for an investment of $3,750 in 1987 would be worth $2,340,000 today.
• Learn to accept losses. There is a much higher failure rate among microcap companies. Successful microcap investors have to develop the capacity to tolerate a loss. You must be secure in the knowledge that a few really large winners will result in success. Most unsuccessful investors become pre-occupied with their mistakes, blaming brokers, analysts, company management, or the OTC Journal. Successful investors expect mistakes. Most successful investors enjoy the process of investing as much as they enjoy making money. Stocks can go up infinitely, but they can only go down to zero. Therefore, whenever you invest for the long-term in a microcap stock, your upside potential is much greater than your downside risk.
• Learn to Tolerate Bear Markets. Microcap Stocks, as with all stocks, will always trade both higher and lower than you ever thought possible. We go through extended periods of time when market conditions are unfavorable for microcap stocks, which can be psychologically damaging to undisciplined investors. Because microcaps generally trade less volume than their bigger brethren, market makers can manipulate price levels in their favor in both up and down markets. The absence of buyers in microcap stocks during a bear market allows market makers to drop prices dramatically on very little volume. High percentage pull backs on light volume in a microcap stock can be excellent buying opportunities. However, in order to take advantage of such opportunities you must have capital, the courage of your convictions, and the patience to wait for an upturn in market conditions. You must discipline yourself against allowing the psychological impact of tough market conditions to affect your belief in the future of the companies you own.

Trading Strategies For MicroCap Stocks

Here are some tried and true trading strategies for microcap stocks, which have have proven to be successful over time:

• Never invest the entire amount you are willing to commit on the first trade. We have never profiled a company that did not trade below our profiled price at some point in time. Unfavorable market conditions can be excellent opportunities to add to positions. Also, small companies stumble in the execution of their business plans, thus leading to depressed pricing of their stock. If they right the ship at a future point in time, this can represent a buying opportunity. If the stock is trading in your favor, you can always add to a position at higher levels if the company is performing beyond your expectations.
• Always use limit orders. Market Makers in microcap stocks are in business to make money on your trade, and they are ruthless. Microcaps trade less volume than larger stocks and are therefore more easily subject to manipulation by market makers. We have often watched market makers fill a market order to the detriment of the investor. Even if you are willing to pay the current market price, please place it as a limit order. The next generation of direct execution brokerage firms will help eliminate the predatory practices of market makers. However, stocks on the OTC Bulletin Board do not trade within the electronic systems, which allow investors to bypass the market makers. We hope the regulators will make a change soon.
• Never Place an Order to Buy a Stock at the Market Price when it Gaps Open. A Gap occurs when a stock opens at a much higher price than it closed the previous day based on some news or event. When market makers have market orders for a stock at the open, they will often take the stock up and fill the market orders at an exaggerated higher price.  When shareholders sell into the newly established higher price, the stock will drop back down and fill the price gap previously created.  Market Makers have been using gaps to line their pockets with money from investors for years. Generally, if you want to purchase the stock that day, place a limit order at the previous day's closing price. You will nearly always get your order filled.
• Never Sell a MicroCap Stock At the Market When it Gaps Down at the Open.  Traders use the same tricks on bad news. If they have an excess of market sell orders at the open, they will fill those orders at a ridiculously low price. Always wait for the inevitable bounce before liquidating your position if the news is bad enough. You should always be looking to preserve your remaining capital.
• Don't Be Afraid to Add To Positions During Unfavorable Markets. If you have followed the rules and not committed the entire amount you are willing to invest, bear markets can be excellent buying opportunities. Microcap stocks will generally drift down in the absence of buyers and can drop to ridiculously low levels during bad markets. Profits can be made when you purchase during these periods of time when no one wants the stock. As a general rule, a microcap stock will make 90% of its move up in 10% of the time that it trades. Before adding to a position, make your best effort to determine that the company is still on track to execute its business plan. Try not to put good money after bad if you can get the information required to make an informed decision. Don't be afraid to pick up the phone and contact the company directly.
• Take Some Profits When the Stock Is Hot. Since microcaps tend to make 90% of their moves in 10% of the time there is nothing wrong with taking a profit when your stock is climbing the charts. One tried and true strategy is to sell 50% of your position after the stock doubles in value. This allows you to recoup your initial investment and hold the remainder for the long term with no risk. However, don't sell your entire position. You never know how high a stock will go.

Conclusion

There is a whole world of investment opportunities in securities, and microcap stocks are just a small part of it. However, they do represent the basic tenant of the American Dream. Hard working entrepreneurial management can use revolutionary ideas and technologies to make extraordinary returns for the average investor.

We have seen it happen hundreds of times- $2 stocks that go to $50, and $2 stocks that go to $0. Our challenge is to uncover the hidden gems amongst the 5,000 microcap stocks currently trading. This is the role of the OTC Journal- to uncover those hidden gems that have the potential to go from $2 to $50.

We are merely a provider of ideas - You are ultimately the one to decide if an idea we present, is right for you. We will have winners and we will have losers. However, we have already uncovered and profiled several huge winners. We can only hope you are informed and interested in our profiled companies, and are along for the ride on at least one of our big winners.