Investors consider the size of the companies they invest in for many reasons, namely because it has a role in expected risk and reward. Let’s look in more detail at what a microcap is and the advantages and disadvantages of smaller companies for investors.
Definition and Example of Microcap Stocks
A microcap is a publicly traded company with a market capitalization of less than about $250 million to $300 million. Market capitalization is the total value of all a company’s stock, and it changes as its share price or number of shares change. Microcap companies typically have fewer assets and trade in lower volumes than larger-cap companies. This leads to them being more volatile, so they are also considered riskier than larger-cap stocks. And they may be susceptible to fraud and market manipulation. It can be more challenging to get in-depth information on microcap companies because many do not file public reports with the U.S. Securities and Exchange Commission (SEC). However, the higher volatility of microcaps also means they have the potential to earn more significant gains. Applied Optoelectonics (AAOI), a provider of fiber-optic networking products, is an example of a microcap stock that trades on the NASDAQ exchange. In mid-November 2021, AAOI traded at about $6 per share and had a market capitalization of $163.8 million. The company’s share price has been as high as near $13 in the year prior, more than double the mid-November share price per share, which demonstrates the volatility of microcap stocks.
How Microcap Stocks Work
While all investments have some risk, microcaps and the smaller nanocap stocks are among the riskiest types of equities. Many of these companies are still in startup mode. They often have minimal assets, products that are still under development, no profits, and minimal revenue. Another reason microcaps are considered higher risk is because of their low volume of shares that trade daily. Lower trading volumes make it more difficult for an investor to sell shares at the price they want to. The lower volume of shares trading regularly means that any size trade can significantly impact the stock price. The SEC warns investors to watch for these red flags when investing in microcap stocks:
SEC trading suspensions Large assets but small revenue Insiders own large amounts of the stock Unusual auditing issues Financial statements with odd items mentioned in footnotes
Microcap vs. Larger-Cap Stocks
One of the biggest differences between microcap stocks and stocks with a larger market capitalization is that microcap stocks frequently have less publicly available information on them, particularly those that trade on the OTC markets. Companies quoted on the OTCBB or the OTC markets do not have to apply for listing or meet any minimum financial standards. Larger-cap stocks, in contrast, must file regular reports with the SEC. Larger stocks are more commonly followed closely by stock analysts who write about them regularly.
Pros and Cons of Microcap Stocks
For investors, microcaps have several potential upsides and downsides to consider.
Pros Explained
Greater opportunity for higher returns: Smaller companies tend to have more significant swings than larger companies, so they can offer the potential for larger profits. Diversification: Including microcap companies in a portfolio that is heavy on larger-cap stocks can help improve diversity. Lower share price: Shares of microcaps tend to have a lower barrier to entry because their share price is generally lower. Opportunity to find undervalued companies: Investors may find undervalued companies amid microcap offerings.
Cons Explained
Higher risk: Microcaps are typically less established companies with less revenue than even small-cap companies and significantly less than large-cap companies. They may not survive an economic downturn. Higher volatility: All stocks experience volatility, but microcap stocks tend to have significantly higher volatility, meaning their price can change more significantly in a short period of time. Vulnerable to fraud and market manipulation: Microcap stocks can be easily manipulated through “pump and dump” schemes and other fraud. The increased risk of fraud is due in part to the fact that there is less public information available about them. Many microcap companies have a limited historical record. Less public information available: Companies that have less than $10 million in assets do not have to file reports with the SEC. Microcaps are not covered as heavily by stock analysts, so it may be more challenging to get in-depth information about them. For many investors, microcap stocks have an important role in diversifying their portfolios. If you’re considering a microcap stock, be aware of the higher risk and volatility associated with them.
