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The Micro CapInvestor
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The Micro CapInvestor
Strategies for Making Big Returns in Small Companies
RICHARD IMPERIALE
John Wiley & Sons, Inc.
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Copyright © 2005 by Richard Imperiale. All rights reserved
Published by John Wiley & Sons, Inc., Hoboken, New JerseyPublished simultaneously in Canada
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Library of Congress Cataloging-in-Publication Data:
Imperiale, Richard, 1957–
The micro cap investor : strategies for making big returns in small companies / Richard
Imperiale.
p. cm.Includes index.ISBN 0-471-47870-9 (cloth)1. Small capitalization stocks—United States. 2. Securities—United States.3. Portfolio management—United States.
I. Title.
HG4971.I47 2005332.63'22—dc22
2004018701
Printed in the United States of America
10 9 8 7 6 5 4 3 2 1
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Contents
Preface
Acknowledgments
CHAPTER 1 Characteristics of Micro Cap
The Nebulous Micro Cap (What Is a Micro Cap Stock?)The Micro Cap Dilemma (Why Do They Exist?)
CHAPTER 2 The Information Advantage
Understanding the Information Advantage: 
Efficient Market Theory
Weak-Form Efficient Market Theory
Semi-Strong-Form Efficient Market Theory
Strong-Form Efficient Market Theory
The Random Walk Theory
The Practical AnswerVenture Capital Theory
The Public-Private Bridge
Conclusion
CHAPTER 3 Micro Cap Stocks as an Asset Class
Investment Performance: Small versus Large StocksA Survey of Modern Portfolio TheoryAsset Allocation and Modern Portfolio Theory
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Contents
Asset Allocation and Micro Caps
Economic Linkage
Venture Capital and Private EquityMicro Cap versus Venture Capital
CHAPTER 4 The Micro Cap Asset Class and Portfolio Construction
Micro Caps in the Portfolio Asset Allocation
The Portfolio Contribution of Micro Caps
Conclusion
CHAPTER 5 Using the Information Advantage
Methods to Evaluate Principal Agent Actions
Management, Management, ManagementWho’s Doing What: Insider InformationManagement StyleStrategy and Planning SystemsManagement ChangesManagement ReputationHow the Company Develops and Promotes EmployeesConclusion
CHAPTER 6 Corporate Governance
The Company’s Social RelationshipsInformation Resources
The Company
Competitors
Customers
Suppliers
Trade Associations
Industry Professionals
Legal Documents
Public Company Federal Filings
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Contents
SEC Reports
Annual Report Form 10-K
Quarterly Report Form 10-Q
Material Current Events Form 8-K
Not All Reporting Is Equal
CHAPTER 7 Micro Cap Stocks and the 
U.S. Domestic Economy
Why Micro Cap Stocks Appear Cheap Relative 
to Large Stocks
Fundamental Valuation Techniques for Micro Cap StocksBasic Financial Analysis of Micro Cap Companies
Price-to-Book Ratio
Price–to–Free Cash Flow Ratio
Low Price-to-Earnings Ratio
Conclusion
CHAPTER 8 Micro Cap Case Study: A Company with All the Indicators
Smart-Money Owners
Cheap Valuation
Skin in the Game
The Transaction
CHAPTER 9 Consolidating Industry Case Study
Case Study of Suiza FoodsOther Opportunities
CHAPTER 10 Gehl Company Case Study
CHAPTER 11 Pozen Company Case Study
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CHAPTER 12 Private Investments in Public Equities
(PIPEs)
Tracking PIPE TransactionsA Brief Case Study of a PIPE Transaction: Ptek Holdings
Contents
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CHAPTER 13 A Framework for Investor Action
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CHAPTER 14 Micro Cap Fund Investing
Index
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Preface
This  book  is  an  explanation  and  analysis  of  micro  cap  stocks.These very small companies have endured a checkered history. Ingeneral  terms,  micro  caps  are  large  in  absolute  numbers  but historically  have  been  a  small  and  misunderstood  sector  of  theinvestment landscape. In this world of efficient markets and indexfunds, this perception has started to change. Many micro cap com-panies are well-managed, high-quality businesses that present anexcellent  investment  opportunity.  In  addition,  micro  caps  are  aviable and competitive investment option for those who are look-ing to broaden and diversify their investment portfolios.
As a professional investor in micro cap stocks, I noticed thatthe  average  investor  largely  misunderstands  these  companies.Many professional investors and portfolio managers also have lit-tle knowledge or interest in micro caps. In addition, there are veryfew  books  or  other  resource  materials  on  the  subject  of  microcaps.  Those  books  that  are  available  are  either  very  simpleoverviews of the subject or highly complex academic treatmentsof  the  topic.  And  most  books  do  not  address  the  fundamentalresearch issues that underlie the basics of micro cap investing nordo they address the concept of how to integrate micro caps intoan investment portfolio.
The Micro Cap Investor: Strategies for Making Big Returnsin Small Companies is an attempt to address these very issues.The book begins by defining micro caps and reviewing why microcap investors might be in a position to gain an information advan-tage. This is followed with a general discussion of micro caps asan asset class, an analysis of how micro caps behave as an invest-ment  class,  and  an  explanation  of  how  they  are  best  integratedinto an investor’s portfolio.
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The next three chapters of the book describe the fundamentaleconomic issues that affect micro caps in general and attempt toanalyze these issues in the context of the micro cap investmentvehicle. The book continues with a series of case studies and areview of specific methods for analyzing and screening for microcap  investment  opportunities.  The  final  three  chapters  of  thebook use the theoretical constructs developed in the case studiesto build a framework for investor action as well as reviewing thegrowth of PIPES, or private investments in public equities, a newcapital financing opportunity for micro cap companies.
Micro caps are an emerging asset class. As in any new assetclass,  there  is  a  limited  amount  of  quality  data  available  fromwhich to draw conclusions. This book offers a practical and use-ful  overview  of  the  limited  data  that  bridges  theoretical  con-structs  with  practical  investment  knowledge.  In  addition,  thebook provides the reader with some practical statistical data rel-evant to the general analysis and valuation of the micro cap assetclass.  This  appears  in  the  numerous  charts,  tables,  and  graphsthat summarize key micro cap data into a usable format.
My intention is for this book to fill a void in the available cur-rent literature about micro cap investing and to help supply a bet-ter understanding of an emerging asset class.
Richard ImperialeMilwaukee, WisconsinSeptember 27, 2004
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Acknowledgments
Although  the  author  ultimately  gets  credit  for  writing  a  book,there is an army of others who contribute to the process. I’d liketo recognize them here.
This book is dedicated to my wife, Sue, and our two daugh-ters, Emily and Mary, who put up with my absence at family andschool  functions  and  during  many  evenings  and  weekends.Their support and encouragement made the completion of thisproject possible. Every day they make me realize how fortunateI really am.
I’d  like  to  thank  my  good  friend  and  mentor,  Dr.  JohnKomives, from the Marquette University Business School. For thepast  20  years  we  have  worked  together  with  a  great  sense  ofadventure  on  many  business  and  academic  projects.  We  haveoften discussed potential projects over a cold glass of beer on Fri-day evenings and this book is in part a result of those conversa-tions.
Of course, it’s not a book without a publisher. My friend andcolleague Jerry Twedell, who is the author of several investmentbooks,  was  kind  enough  to  introduce  me  to  his  publisher,  JohnWiley & Sons. Through that introduction, I met David Pugh, whois now my editor at Wiley. In the middle of a less than favorablegeneral investment climate, he was open-minded enough to listento my ideas about micro caps, give me critical feedback, and go tobat for me on this project. David has been an excellent coach andcritic,  who  helped  me  shape  this  book  into  a  much  better  andmore useful text. I now consider him a good friend and thank himfor all his help.
I thought the writing was hard. But that was easy compared tothe copyediting. For helping me get through that phase of the proj-ect I want to thank Ginny Carroll. When the writing was finally
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Acknowledgments
complete, the book was behind schedule. Ginny’s talent and skillhelped to get the project back on schedule. Through the editingprocess she also patiently taught me many useful lessons aboutediting  and  publishing  that  will  make  me  a  better  writer  in  thefuture.
Much  of  the  data  in  the  book  is  compiled  from  academicpapers, company reports, and industry trade associations. Muchof that data was processed by my assistant, Rochell Tillman, andmy  research  associate,  Farid  Sheikh.  Their  diligence  and  hardwork have helped to provide consolidated data not found in anyother single place.
I’d also like to thank Lyn Woloszyk, who transcribed many ofthe chapters and case studies for the book. She often did the tran-scriptions  on  short  notice  and  with  tight  deadlines,  which  washelpful  in  keeping  the  project  on  schedule  due  to  my  time  con-straints. And thanks to my business partner, Ed Jones, who cov-ered for me at many meetings and on many projects while I wasworking on the book.
My sincere thanks to all of you.
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CHAPTER 1
Characteristicsof Micro Cap
This chapter will attempt to answer the following questions:
• What is a micro cap stock?• Why do they exist?
THE NEBULOUS MICRO CAP (WHAT IS A MICRO CAP STOCK?)
Investors often refer to “the market” when speaking about stocksas a group. However, knowledgeable investors will agree that notall stocks are created equal. Different investors will often focuson more narrowly defined segments of the market. When lookingat the composition of the market as a whole, these investors willnormally classify stocks by certain characteristics. The two mostfundamental  characteristics  of  classification  within  the  invest-ment community are those of value and of growth stocks. Mostinvestors  are  familiar  with  the  concepts  of  growth  and  valueinvesting, although agreeing on the definition of either is often atopic of debate among informed observers.
Taken further, the growth and value styles can be divided into
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THE MICRO CAP INVESTOR
subgroups that categorize the investments by market capitaliza-tion. For example, there is large cap growth and mid cap value.These capitalization ranges are typically broken down into largecap,  mid  cap,  and  small  cap  when  referring  to  the  size  of  theunderlying companies. These style and market cap definitions arethe  most  basic  categories  of  classification  when  referring  toinvestment managers and the stocks they own. But when dividingthe  market  of  stocks  by  capitalization,  a  very  large  number  ofsmall  public  companies  virtually  disappear  from  the  investorradar screen. These are a segment of companies often referred toas micro caps. It should be no surprise that, like the definitions ofvalue  and  growth,  the  threshold  sizes  for  large,  mid,  and  smallcapitalization stocks are also subject to debate.
The market capitalization of a company is arrived at by multi-plying the number of outstanding shares of common stock in thatcompany  by  its  current  market  price  per  share  to  arrive  at  thetotal value of all shares outstanding.
Market capitalization = (shares outstanding 
× current market price per share)
To some degree, the demarcation of market capitalization isinfluenced by the many widely published market indexes such asthe  Standard  &  Poor’s  (S&P)  500  or  the  Dow  Jones  IndustrialAverage. The threshold sizes for market segmentation are oftenrelated in some ways to the relative market capitalization of thestocks contained within a popular market index.
For example, the S&P 500 Index is considered to be a largecapitalization index. The smallest stock in the index has a marketcap of $414 million, with the largest having a market cap of $286.6billion. The 500 stocks that constitute the index have an averagemarket  capitalization  of  $17.9  billion.  The  index  has  a  medianmarket cap of $7.5 billion as of June 30, 2004. (June 30, 2004 is thedate of all market capitalization data throughout this book unlessotherwise noted.) These types of statistics will lead market par-ticipants to general ranges that define the boundaries of marketcapitalization  segments.  Currently,  most  market  participantsagree that large capitalization stocks are those that have a marketcapitalization of outstanding shares in excess of $5.0 billion.
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Characteristics of Micro Cap
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Another way to approach the issue of defining market capital-ization boundaries is to study the market cap distribution of allpublic companies. Using a standard distribution of market capi-talization values, the market cap of all public companies can bedivided into groups based on the range of market capitalization inwhich they appear. The Center for Research in Securities Prices(CRSP) at the University of Chicago maintains an extensive data-base  of  stock  prices  often  used  for  this  type  of  market  capresearch. The CRSP produces a database of market performanceindexes  that  are  broken  down  by  market  value.  The  index  thatrepresents  the  smallest  20  percent  of  publicly  traded  commonstocks  is  typically  used  as  a  proxy  for  the  micro  cap  market.CRSP ranks the top 20 percent of the market in terms of capital-ization as large cap, the next 30 percent of market capitalizationfollowing that as mid cap, the following 30 percent is a proxy forsmall  cap,  and  as  mentioned,  the  smallest  20  percent  is  consid-ered micro cap. In addition, there have been those who segmentthe top 10 percent of companies by market cap and consider themto be mega cap companies. Conversely, the quantitative researchgroup  at  Merrill  Lynch,  led  by  Richard  Bernstein,  has  dubbedstocks with a market cap of less than $100 million the “nano cap”sector.
The many academic studies of market cap segmentation cou-pled  with  the  growth  in  the  investment  consulting  professionhave resulted in the definitions of capital markets becoming morestructured.  Institutional  investors  now  segment  the  investmentmarkets  into  narrow  sectors  ranging  from  nano  caps  throughmega caps. This segmentation of the public investable market hasgiven rise in part to the micro cap asset class.
As mentioned, there have been a large number of academicstudies that explore the market cap segmentation of public com-panies.  The  outgrowth  of  one  such  study  was  the  Russell  2000Index,  published  by  Frank  Russell  Company,  of  Tacoma,  Wash-ington. Each year, this company reshuffles the universe of U.S.-domiciled companies by total market value and selects the 3,000largest  U.S.  domestic  public  companies.  They  then  create  theRussell 2000 from the bottom two-thirds of the 3,000 largest com-panies.  The  new  universe  contains  stocks  with  share  pricesgreater than $1 that are publicly traded as of May 30 of each year.
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In addition, Russell must receive documentation from each com-pany that includes a company description and confirms the num-ber of shares outstanding in order for the company to be eligiblefor inclusion. The Russell 2000 Index has become the most popu-lar small cap benchmark against which the performance of smallcap portfolio managers is measured.
With the introduction of the Frank Russell Company Russell2000  Index,  small  cap  stocks  finally  had  an  index  of  their  own.The Russell 2000 was introduced in 1985, and by the early 1990sthere was a proliferation of small cap mutual funds benchmarkedagainst the index. The Russell 2000 is now the most widely quotedindex of U.S. small cap stocks. Prior to the creation of the Russell2000,  micro  caps  were  often  grouped  with  small  cap  stocks.  Inaddition, as mentioned earlier, the boundaries of where micro capstocks  ended  and  small  cap  stocks  started  were  often  debatedwithin the financial community.
It was not until the early 1990s that micro cap stocks began todevelop their own identity and their characteristics evolved suffi-ciently to separate them from the small cap segment. This was inpart  the  result  of  the  large  and  growing  number  of  micro  capstocks in the public arena. It was also due in part to the continuedrefinement of market segmentation within the professional con-sulting and investment community.
Currently,  the  Russell  2000  has  a  range  of  market  caps  thathas fallen for three years in a row, as of the most recent rebalanc-ing on June 30, 2003. The largest stock in the index has a marketcap of $1.2 billion, whereas the smallest stock has a market cap of$117 million. In comparison, the range in 2002 was $1.31 billiondown  to  $131  million.  The  rebalancing  pushes  the  weighted-average market cap down to about $646.9 million versus $696.6million when the index was rebalanced in 2002. The average mar-ket cap for stocks in the newly rebalanced index is $443 million,while the median capitalization is $350 million. This index clearlyreflects the definition of small cap within the investment commu-nity. Currently, most market participants agree that small capital-ization stocks are considered those in the range of $500 million to$1.5 billion. Thus, if large cap is $5.0 billion and up and small capis $500 million to $1.5 billion, then by elimination mid cap stocksare those that fall in the $1.5 billion to $5.0 billion ranges. This stillleaves the definition of micro cap as an unanswered question.
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Characteristics of Micro Cap
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796 stocksOver $5.0 billion —
 11%
878 stocks$1.5 billion to $5.0 billion — 12%
4,174 stocksUnder $500 million —
58%
1,303 stocks$500 million to $1.5 billion —
18%
FIGURE 1.1 Distribution of reporting public companies by market capitalization, June 30, 2004.
These commonly accepted descriptions of market capitaliza-tion leave out one very large segment of the public markets. Cur-rently  there  are  more  than  4,000  stocks  listed  on  the  New  Yorkand  American  stock  exchanges,  and  the  Nasdaq  and  over-the-counter (OTC) markets that have a market capitalization of lessthan  $500  million.  Some  observers  might  argue  that  micro  capsbegin  at  below  $400  million,  or  even  below  $300  million,  but  inany  case  the  absolute  number  of  these  micro  cap  companies  islarge. For purposes of this analysis, a market cap of below $500million  will  be  considered  a  micro  cap.  Wherever  the  line  isdrawn, these small company stocks are generally known amongprofessional  investors  as  micro  caps.  In  absolute  number,  themicro cap universe of 4,000 stocks has roughly twice the numberof stocks than the universe of companies with market capitaliza-tion of over $500 million! (See Figure 1.1.)
THE MICRO CAP DILEMMA (WHY DO THEY EXIST?)
In the world of professional investing, micro cap stocks are oftenoverlooked simply because of their small size. To a large degree,this  is  the  result  of  the  growing  size  and  scale  of  professional
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investment  management.  For  example,  small  cap  investmentmanagers who offer a good performance track record often findthemselves with a billion dollars or more of investment capital tomanage on behalf of their clients. A simple search of the Morn-ingstar universe of small cap mutual funds yields over 1,450 smallcap funds with an aggregate of over $900 billion under manage-ment in these funds alone. It does not consider the separate pri-vate accounts of these institutional money managers. In addition,it does not consider the hundreds of private institutional moneymanagers who don’t manage a public mutual fund.
In the Plan Sponsor Network (PSN) database of money man-agers published by Thomson Financial, there are over 1,900 smallcap managers listed with an estimated $850 billion of small capassets under management. This creates a situation where, for thepurposes of liquidity and efficiency, professional investors mustfocus on small company opportunities that provide the scale andliquidity required to invest these larger pools of funds.
Professional  investors  also  have  limited  resources  availablein terms of research capabilities to analyze and screen the thou-sands of smaller companies. In many instances, they rely on WallStreet research analysts to provide basic coverage of small com-pany opportunities. However, Wall Street research is often hesi-tant to focus on small companies if those small companies don’tappear  to  provide  investment  banking  opportunities  for  theresearch firm or if the companies don’t have sufficient market li-quidity to allow for easy trading in the stock by larger institutions.This creates a situation where many small high-quality companiesthat are not seeking additional investment capital or have limitedtrading volume go largely uncovered by Wall Street firms and arelargely unnoticed by small cap portfolio managers.
The  world  of  small  cap  stocks  is  also  where  many  researchanalysts begin their careers in the investment business. This is notto say that all analysts covering small cap stocks are new or inex-perienced; however, a large number of analysts often begin theircareer paths in the small cap arena. This new analyst phenome-non  often  leads  to  research  that  is  of  lower  quality  than  theresearch published by more seasoned analysts who are focusedon the mid cap and large cap investment arena. From a businessperspective,  it  makes  sense  that  the  resources  of  better,  moreexperienced  analysts  are  allocated  to  opportunities  of  the  size
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Characteristics of Micro Cap
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and  scale  that  are  more  meaningful  to  large  institutionalinvestors. Large companies tend to be more complex, too. In addi-tion,  these  larger  companies  often  provide  more  active  invest-ment  banking  opportunities  for  the  sell-side  brokerage  firm  aswell. So it’s easy to see why many small and micro cap companiesare  either  undercovered  or  not  covered  at  all  by  Wall  Streetresearch firms.
In addition to these burdens, small and micro cap companiesare often considered riskier by institutional investors. This notionof high risk may run contrary to the professional investors’ fidu-ciary duty, which is often prescribed as limiting risk in the contextof their portfolio management. So in the face of fiduciary respon-sibility, a typical professional investor would feel more comfort-able  owning  Anheuser-Busch,  with  a  market  capitalization  of$42.6 billion, than Samuel Adams, the small microbrewery basedin Boston, Massachusetts, with a market capitalization of $217.0million.  Without  regard  to  the  idea  that  the  smaller  brewery  isgrowing  at  a  much  faster  rate  (and  makes  better  beer,  in  thiswriter’s opinion) and also carries a generally lower valuation thanAnheuser-Busch,  professional  investors,  because  of  their  fidu-ciary  obligations  and  their  perception  of  risk,  would  likely  ownAnheuser-Busch over Sam Adams.
When considering an investment, many institutional and pro-fessional investors equate a low share price with low quality orhigh  risk.  A  share  price  of  below  $5,  or  even  below  $1,  oftenbrings  to  mind  the  notion  of  “penny  stocks”  with  professionalinvestors. Penny stocks are generally low-priced stocks normallytrading below $5 and often trad