The Risks of Microcap Investing
Success is anything but guaranteed. This is high risk, high reward investing.
If you’re unfamiliar, a microcap stock is a company with a market cap of $300M or less.
The term is used synonymously with penny stock, which are stocks that trade at $5 or less per share.
Calling them penny stocks, even when they’re worth multiple dollars per share— has never made any sense to me… but that’s what it is.
Regardless, this is the smallest decile of companies listed on stock markets.
Given their smaller size, many of these stocks are:
Still trying to scale
Testing new technologies
Unprofitable, low or no revenue
Working on unproven business models
Highly volatile (losing 50%+ of your investment isn’t uncommon)
Point being, many of these companies are inherently “riskier” to invest in.
The possibility that these stocks will fail is higher, by nature.
If these concerns were resolved, their market caps would likely be higher.
Outright scams aren’t necessarily as prevalent as the broader financial industry would have you believe, but those are certainly something to look out for as well.
I’m not trying to scare you, but I want to make it clear that success isn’t guaranteed when investing in these smaller companies. Blue chip stocks aren’t guaranteed to perform well either.
At the same time, there are inherent advantages to investing in microcaps:
Because most investors won’t touch microcaps, mispriced assets aren’t hard to find. The efficient market hypothesis doesn’t exist here.
Most institutional investors either can’t or won’t invest in stocks with a market cap under $100M. Even if they could, their position sizes would be too small to have any meaningful impact on their returns. As the market cap of a microcap rises over time, institutional investors who want to establish a position will have to pay higher prices.
As I went over in my investing checklist, on average, illiquid microcaps have been found to provide the highest returns of any market cap decile.
So, you could consider this investing style: high risk and high reward.
While the rewards can be high when correct…
If you’re not prepared to potentially lose a significant portion of your investment, you should avoid investing in microcaps.
All of the investments I make are in these smaller companies.
I try to minimize the chances of failure as much as possible by thoroughly researching any stock I buy and maintaining a relatively strict set of criteria…
But at some point, I will invest in a company that will fail.
If you’re investing in individual stocks, that’s inevitable. Not every company is going to be a winner.
So, I want to emphasize that you must thoroughly research any stock you buy! You will ultimately have to take responsibility for any wins or losses you take in the stock market!
That’s why you should never rely solely on someone else’s information when making investment decisions!
When you have the final say on what you buy and sell, you can't blame anyone else when an investment goes wrong.
And sometimes, it isn’t even necessarily anyone’s fault that a company failed.
An Unfortunate Example
Carbon Done Right Developments (KLX) is a developer of nature-based carbon credit projects. They’re particularly focused on forest reforestation, which is exactly what the market participants in the voluntary carbon markets want right now.
Carbon offsetting corporations have prioritized buying carbon credits from these types of carbon removal projects. They commonly get pricing premiums compared to other project types.
BP’s carbon trading arm was even a partner in their first project.
Unfortunately, as I write this post, none of this generated enough interest in the stock, as the carbon markets are facing incredibly negative investor sentiment.
It doesn’t help that reforestation projects take a significant amount of time to monetize in any real way. As you can imagine, it takes time to grow trees.
According to an investment report from Shard Capital, KLX wasn’t going to be EBITDA positive until 2027-2028. That’s simply too long to expect the average retail investor to wait when the broader industry is going south.
Running out of capital, KLX announced a desperation private placement at C$0.05. Even at bargain bin prices, they seemingly couldn’t close that financing. So, there’s a total lack of interest in carbon credit stocks at the moment.
The company has a market cap of just C$2M and is searching for alternative ways to raise money to survive.
While they did make some strategic mistakes to end up here, the company generally positioned itself well… it was just in the wrong place at the wrong time.
These are the types of situations we can find ourselves in when investing in microcaps.
I never invested in this stock, but I’ve been watching these unfortunate events unfold.
TLDR:
Just make sure to understand the risks you’re taking on before buying microcaps, or any investment in the stock market.
If you don’t like investing in these types of companies, you probably won’t like any of the stocks I’m investing in.
Disclaimer
The owner of Green Investing is not a licensed investment professional. Nothing produced under the Green Investing brand should be construed as investment advice. My content is made for entertainment and educational purposes. Do your own research.