I believe the biggest risk to microcap investors is share dilution. One of the keys to successfully investing in microcaps is finding companies that don’t need to constantly raise capital to survive.
So right off the bat, be very careful of capital-intensive industries like mining, energy, and biotech. In many cases these companies need to spend $50m-$100m- even $1 billion on R&D, FDA trials, permitting, exploration etc before they produce one dollar of revenue. Obviously, even in these industries there are those rare situations where great microcaps can be found, but for the most part it’s a crapshoot.
To illustrate this point further, all you have to do is look at this two-year chart of the TSX Venture Comp Vs S&P 500. The TSX Venture Comp is 85% junior energy and mining companies who have to constantly raise capital to survive.
These capital intensive industries are especially hard for retail investors because institutions know these companies are going to have to raise money, so the stocks normally can’t ever get out of their own way. Institutions just wait for the next capital raise, which will be done at a discount, and short the common stock while they wait. Soon enough you have a company with a bloated share structure spiraling lower and lower. The only way I invest in these particular industries anymore is if I’m investing at the founders level (aka the lowest valuation possible).
Obviously, serial money raising companies can be found in every industry, so you just need to be careful. If a company isn’t profitable, make sure they have enough cash in the bank to get them to profitability. When management says they have enough cash, don’t believe them. It always takes more time and more money.
Now, story time…
Talking about winners is a great ego boost but offers little value. “I picked the right stock, it went up, let me pat myself on the back”. I’ll leave that to the gurus trying to sell you something.
I really like to talk about my losers. Why? Because I hope that someone somewhere can learn from all the mistakes I’ve made through the years. It also lets me reflect back on these experiences and learn to be a better investor.
From 2008 – 2011, I was fortunate enough to have large positions in two companies that went up 600%, and 1200% respectively. [Please read, “After a big win, take time off”]. I felt very smart, which is normally the first sign that I’m about to do something very dumb. I let my guard down and invested in a biotech company near an all time high that was a serial money raiser.
In 2010, I was pitched the iBio (IBIO) story from some fellow investors and was completely mesmerized by the technology. The company could produce vaccines and biosimilars in 10% of the time and at 10% of the cost of traditional methods. The company also had a big brother comp in Protalix BioTherapeutics (PLX) that pointed to a high valuation after proof of concept.
I met with management and visited their pilot plant in Delaware. I got to see all these green plants producing vaccines and other things. It was all very impressive.
The company was burning $5-6 million per year, which wasn’t a lot of money in biotech standards. My deranged thought process was that there was no way the company wasn’t going to get several licensing deals over the next 12 months with major pharma. These deals would likely include upfront payments which would be more than enough to fund the company on an ongoing basis.
Again, I just came off two major winners, so I obviously knew what I was talking about in an industry where I had no experience (sarcasm)….and I didn’t stay at a Holiday Inn Express the previous night
I bought stock, a lot of stock around $2.75-3.50 per share. The stock quickly raced to $5.50, but that was short lived. Licensing deals didn’t come, and the stock dropped from $5.50 to below $1 in 10 months. The company ended up raising capital at $0.65. Luckily the stock had a dead cat bounce, and I sold my position at $1.25(ish). I lost several hundred thousand dollars.
Fast-forward to today, they recently raised more money at $0.42 per share. The fully diluted share count was 35m in 2010, and now it it has ballooned to 95m today. Again, this isn’t a bash of iBio, this is common place in biotech. I still think the technology is amazing, but the constant dilution has destroyed shareholder value. iBio could still go on to be a real winner, but I’m not in the hoping game.
Here is another example…
I’ve followed Oncolytics Biotech (ONCY) for almost ten years. Oncolytics is another great technology whose management team has been successfully developing its lead product REOLYSIN. The company is now enrolling patients in six Phase 2 trials, and a Phase 3 trial. Even though I believe the management team has been successful in advancing the technology, very little shareholder value has been created. In ten years the market cap has gone up 300% but that is because the outstanding shares has gone up 300%, not because the stock price has gone up.
In conclusion, be careful.
Investing in microcaps can be very fruitful if you stick with a proven strategy and have discipline. Certain sectors like biotech and basic materials are very capital intensive and shareholder dilution is commonplace. When companies have to constantly raise capital, it is like an anvil tied to a runners foot. It makes it extremely hard for a stock to appreciate. Invest in companies with good share structures that don’t need to raise capital.
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How true. You nailed it.
There’s an art in investing in a nanocap right AFTER they have turned cash flow positive.
Time and constant dilution can destroy an investor’s percentage ownership..
Exactly Scott. Got to find those that won’t dilute you and those with good share structures so they go up when investors buy it.
Due diligence for Oncolytics Biotech comes down to making predictions about the chance that Reolysin actually works– not making simplistic blanket statements about company financials.
Indeed, the clinical trials of Reolysin are now predominantly funded and conducted by the national cancer institutes of the USA and Canada, making the corporate management almost irrelevant. (The 167 patient phase 3 in head & neck cancer is company-funded, but the 6 roughtly 100-patient each randomized phase 2s in the much larger indications are externally funded.)
The ratio of the market size for a broadly-active cancer drug to the current market cap is enormous. If Oncolytics Biotech’s drug works then the shareholders are set to make a ton of money.
If the drug doesn’t work then the shareholders will take a bath.
Of course, a little extra institutional growth capital can go a long way sometimes. 😉
I would expect that form you Albert 🙂