Microcap stocks, consisting of the bottom two deciles of stocks ranked by market capitalization and often with a market capitalization of $50m-$300m, present an intriguing investment opportunity. The Russell Microcap Index, comprised of the smallest 1,000 companies in the Russell 2000, plus additional qualifying companies, represents less than 2% of the US equity market capitalization. The index predominantly includes Healthcare and Financials with average and median market caps of $858m and $235m respectively.

While large cap stocks typically dominate diversified portfolios, microcap and small cap stocks offer unique traits such as lower trading liquidity and limited international sales. These smaller companies, often perceived as more susceptible to interest rate hikes and macro-economic shifts, historically demonstrate higher market performance volatility. Unlike heavier, established firms like Google or Microsoft, smaller companies have the potential for rapid, exponential growth within a shorter timeframe, albeit with accompanying volatility.

The lure of microcaps revolves around potential “asymmetric information” advantages, premised on the belief that the market is not entirely efficient. This advantage stems from the notion that smaller, lesser-known companies might harbor unforeseen, undervalued market potential, unlike larger, well-researched entities like Apple or Meta.

Under this premise, Zacks Investment Research highlights three under-the-radar microcap companies with no current Wall Street analyst coverage. Innodata Inc. (INOD) is positioned as a versatile player in the AI domain, with its products catering to various AI technologies. Red Violet Inc. (RDVT) operates as a high Gross Margin (adj. GM~80%) software company, providing identity verification and fraud detection products across multiple verticals. Lastly, HF Foods Group Inc. (HFFG) distributes food products to the dispersed Asian restaurant industry in the US. These companies, though lesser-known, show promising potential in their respective niches.

Finance academics perceive small stocks as generally outperforming large stocks over the long term, albeit with augmented volatility, hinting at a possible market anomaly. Despite extensive academic studies addressing this phenomenon, newer research suggests that a “size premium” still exists, particularly among microcap stocks. However, this premium is bolstered when combined with other factors such as defensive/quality traits, bolstering the screening process and uncovering the “diamonds in the rough” among small-cap entities.

Yet, caution is warranted, particularly regarding trading friction associated with the more illiquid microcap stocks. Institutional investors seeking extended stock allocations and individual investors pursuing modest shares both encounter the impact from wider bid-ask pricing spreads due to scant share availability. Consequently, Zacks underscores its potential value addition through a proprietary microcap ranking system detailed in “The Microcap Ranking System.” The approach aids in navigating the microcap landscape, steering clear of potential pitfalls while capitalizing on promising opportunities.

*The Journal of Portfolio Management, Volume 45, Number 1, Fall 2018, “Fact, Fiction, and the Size Effect”

From thousands of stocks, 5 Zacks experts have chosen their favorite investment options predicted to skyrocket +100% or more in months to come. Among these, Director of Research Sheraz Mian hand-picks one with the most explosive upside.