Don’t Worry About Illiquidity, Worry About Being Right

Ian Cassel Blog, Educational 26 Comments

I’m a full time microcap investor and I make my living exclusively from capital gains in microcap companies.  I’m not any smarter than anyone reading this blog. My only advantage has been my passion for microcaps started at a young age. This has been beneficial since it has allowed me to lose lots of money early in life. I continue to lose money in microcaps from time to time, but my win percentage has increased through the years. My goal with investing has always been finding great growth companies before the masses. Microcap investing is hard so it’s important to stack the deck in your favor.

I get asked quite often, What do you look for in a microcap company?

I’m looking for companies in an emerging trend with a great management team, share structure, with a unique product or service where there are few if any competitors and public comps. When the underlying emerging trend has emerged and the public and institutions are looking for an investment vehicle, I want this one company to be it. This is called scarcity and it’s one of the most powerful forces in any stock move where valuations are thrown out the window. Oh yeah, and I also want to find them very small, preferably sub $20 million market cap and the more illiquid the better. I want high insider ownership and no institutional ownership. I want companies that are profitable or have the cash runway to get to profitability.

Other than that I’m pretty open-minded.

Screen Shot 2014-03-26 at 8.48.42 AM

Scarcity can create some of the biggest gains in the market. Quepasa (QPSA), now MeetMe (MEET), in 2010 was the only public social network, and this scarcity value drove shares from $3 to $14 in less than a year. Volume also increased tremendously. When I started buying it volume was 10,000 shares per day, 9 months later it was 1 million shares per day. There were no alternatives and institutions had to own it and they didn’t care what they paid. MeetMe quickly dropped when alternatives in the social networking space came to market. What you want is scarcity as well as fundamentals. This is the dynamic I’m going after. It is rare and hard to find but they are out there. You combine this with a company that doesn’t need to raise money and it creates the perfect storm, as investors need to buy the stock in the open market.

Investing takes foresight, so you need to find these companies early, before the institutions…

There are 4,396 public companies on US Exchanges with market caps less than $50 million. The average dollar volume in these small microcaps (aka nanocaps) is less than $15,000 per day.  Most investors shriek like a vampire to a cross at the very thought of such illiquidity. But this is my playground.

Illiquidity is a beautiful thing. The more illiquid the stock the less known and cheaper the company normally is. I love it when it takes a month or more to buy a full position. My position sizing is unorthodox to most but I’m very comfortable holding a week to several months’ worth of volume.

Illiquidity is never a reason to not invest in a company. Why? If your investment thesis plays out and management executes liquidity will increase significantly.

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For example, 18 months ago BioSyent (RX.V) was a $0.60 stock trading $5,000 worth of stock a day. Management has executed very well and now it’s a $5 stock trading $250,000 worth of stock a day. A little over a year ago Plug Power (PLUG) was trading $50,000-$100,000 worth of stock a day, and just last week it was trading $1 billion of stock per day. So what this illustrates is as a management team executes and the market awakens to the story the stock rises and so does liquidity.

Small Retail -> Large Retail -> Small Institution -> Large Institution

(Dumb Money) ——————————————–(Smart Money)

When a company with a good share structure executes and volume goes from 10,000 shares a day to 100,000+ shares per day it represents not only increased liquidity but also a maturation of the shareholder base. Normally small retail investors find them first, what most would characterize as the “dumb money”.  Then larger retail buys, small institution and large institution. This maturation can be seen when you analyze a group of $20m market cap companies’ versus $100m market cap companies. The former have very little if any institutional ownership while the latter are usually 20%+ owned by institutions. Each wave of buyer has a greater appetite for shares and each one thinks they are smarter then the person they are buying from.  The small retail investor is always perceived as dumb even though they found the stock long before the institutions did.

The key is finding them and buying them early like small retail and selling them when the institutions buy them.  Be the dumb money and sell to the smart money.  You want to find them early when they are unknown and illiquid. I’ve made my living on finding them early and then selling to the smart money.  You want to find them at $10-20 million market caps and sell them at $100m+ valuation.

When an investment thesis plays out and the management team executes, liquidity often increases 10-100x.  So when you are searching for the next great microcap, don’t worry about illiquidity, worry about being right. 

MicroCapClub is an exclusive forum for experienced microcap investors focused on microcap companies (sub $300m market cap) trading on United States and Canadian markets. MicroCapClub was created to be a platform for experienced microcap investors to share and discuss stock ideas. MicroCapClub’s mission is to foster the highest quality microcap investor Community, produce Educational content for investors, and promote better Leadership in the microcap arena. If you are a passionate microcap investor, Join Us.

About the Author

Ian Cassel

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Ian is a full-time microcap investor. He is the founder of MicroCapClub, CIO of Intelligent Fanatics Capital Management, and co-founder of IntelligentFanatics.com. Ian started investing as a teenager and learned from losing his money over and over again. Microcap companies are the smallest public companies that exist, representing 48% of all public companies in North America. Berkshire Hathaway, Wal-Mart, Amgen, Netflix, and many others started as small microcap companies. Ian’s belief is the key to outsized returns is finding great companies early because all great companies started as small companies.

Comments 26

  1. Ian- great article, in one of the paragraphs I noticed that Share Structure is an important element, what should a prospective investor be looking for, in other words what is a attractive share structure of a microcap below 20 M in market cap? Total I/O and Float? Please shed your opinion on this aspect of your article.

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      Tony:

      I’m normally looking for companies with less than 30m shares outstanding where insiders own a meaningful amount of the company. The lesser the better really. The smaller the outstanding, the smaller the float the less it has to be turned over for the stock to increase.

  2. Ian,
    A great article,and almost a primer for foraging in this area of the mkt. You also put your finger on one of the reasons institutions don’t get into this area: they are basically lazy; they want to press a button and own a million shares of their new found love. It’s too much work to slowly accumulate a position. And heaven forbid having to work just as hard to get out of one that doesn’t pan out. When I find myself with a ton of a little bitty stock that rarely trades, I go to the mirror to see if I can detect a strange look in my eyes but once in a while it works out and so I keep up this strange passion. Keep up the good work, and hope not too many people take your advice. I don’t want to work any harder.
    John Gay

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  3. Ian,

    Thanks for the intelligent, well written outline of your microcap investing strategy. My experience in the microcap niche over the past 15+ years supports your thesis. While a strong stomach in the inevitable downswings is essential, done right your approach creates an opportunity for “dumb money” retail investors to crush the “smart money” on Wall Street.

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      Thanks Doug for the comment. As you know it’s also equally intriguing when institutions have policies of not buying stocks below $4 or not buying OTC stocks. When a company is successful it creates all of these waves of buying where they actually have to wait for the stock to go up before they can buy.

  4. Ian- great discussion. I am in agreement with all comments on this article. I wanted to add the following; I am now certain that institutional investors won’t buy stock below the $ 5 dollar mark, due to it being considered a penny stock per the rules. Also, noticed that they also seek stocks on the list of marginable securities. This usually happens when a stock graduates from a listing service like OTC-BB and to an exchange usually AMEX now the NYSE markets. Up listing. I use the below as an example only. I do not have any positions in ISDR anymore. For example ISDR, which 2 weeks ago graduated, but if you look at the charts and history just like Ian mentioned, trades by appointment and has a small I/O and float, also started out sub 1 dollar nice chart, now that they graduated they found real institutional funding, not your standard mega discount vultures on the OTC boards. Another thing I found encouraging is corporate governance, it costs a lot to maintain but they attempted to have standards even on the OTC-BB. I also liked the fact that they did not worry about the daily trading, they were busy running the company and if you look at the 10k they have fundamentals that mean something, EPS and P/E. When I look at microcaps, I look for how insiders tend to see the deal. In other words do they treat the treasury with respect or is it a printing press, that will tell you the story……I have a good 5 that have been super winners including ISDR.

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  5. Ian – Great article – Thank you.

    I appreciate the additional insights on share structure. This is where my questions were as well. One more if I may…

    Can share structure give you insights into the possibilities for dilution or is dilution something that is simply always a possibility; even with profitable companies?

    Thanks,

    Darren

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      Obviously some businesses will constantly have to raise money, and I’m normally not interested into those. Although I do have a one or two int the portfolio.

      Regardless, what helps is going back a few years, through the 10K’s and seeing how the company issued shares and how they financed the company. Did they do a bunch of very dilutive rounds or structured financings using preferred shares etc. The share structure normally tells you all the past sins so to speak.

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      If a management team is executing I can hold a stock for a long time. If they aren’t I will sell.

      In the good scenarios I use much more of a qualitative approach while also watching the market participants in the stock. These stocks will always go from illiquid to very liquid. When they get very liquid I start to think about taking some off the table.

  6. Ian what tools do you use for ferreting out stock selections you want to investigate. Can you share what search criteria you use.

    And, what is a good barometer to look at when evaluating management? Business plan execution? Return on assets/equity? others?

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      The Club was created to be an idea generator, and I’ve found quite a few great names on the Club. I also use CapitalIQ to do screens around earnings season. Evaluating management doesn’t happen over night but can take months to get a real feel for their abilities. It’s mainly why I don’t buy a big position early on. I scale in as management proves themselves.

  7. I am 20 years old, I started learning about trading three months ago now.
    I learnt how to figure out some good entry points during the day for couple stocks, I won some money here and there, though I believe that I can put a part of my savings in the stock market, as a long term investment. First to watch how it ends up and to learn how to do it in case I lose.
    You articles are helping a lot, it introduces the subjects awesomely, though you talk a lot about management which my business classes do as well, they focus a lot of that, but I can’t see how you can investigate the management within a company ? Is there any reports to read ? How can I know if the managements is well prepared to get the company to be a winners over time ?

    Thank you again.

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      Ben:

      Thanks for the comment. As it relates to evaluating management, you can get a hindsight perspective by looking at annual reports and filings. You have to literally talk to management, even meet them, and watch how they execute. It’s in many ways much more qualitative then quantitative. There is no book you can read as each management are unique which makes it difficult.

      Ian

  8. Ian,
    Great article. I couldn’t have said it better myself.

    “The key is finding them and buying them early like small retail and selling them when the institutions buy them. Be the dumb money and sell to the smart money. You want to find them early when they are unknown and illiquid. I’ve made my living on finding them early and then selling to the smart money. You want to find them at $10-20 million market caps and sell them at $100m+ valuation.”

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      Thanks. As you know, most people think buying these small nano caps as insanity, but those of us that do it think its insane not to. I can’t imagine only being able to buy liquid stocks.

  9. Ian,

    Thanks for your article – I basically agree with the general idea.

    If you haven’t read it already, there was a paper from Yale University that appeared in the Financial Analysts Journal last year that backed up your point – that portfolios of small, illiquid stocks outperform portfolios of large capitalization, liquid stocks. It was entitled “Liquidity as an Investment Style”, by Roger G. Ibbotson, Zhiwu Chen, Daniel Y.-J. Kim, and Wendy Y. Hu. You can read it online at http://www.ibbotson.com/us/documents/MethodologyDocuments/ResearchPapers/LiquidityAsAnInvestmentStyle.pdf

    Regards,

    Paul

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  10. Ian: Great article. I stumbled on ISNS, Image Sensing Systems, right in your wheelhouse of $10 – $20 million. Management is spending in R$D to build a SaaS web application to go along with its above ground detection systems. To that end, results will look weak through the end of 2014. Curious your thoughts about opportune time to invest when you know things are going to change at some predefined date.

    Downside limited by 100% gross margin royalty income — about $12.5 mil run rate.

    Cheers.
    Mike

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