One of the most common questions I get is probably the most basic: How do I pick the companies I like?

Well, before getting into it, I’d just like to say that there is no system for finding stocks — nothing that will result in a single pick or a list of picks that are guaranteed to profit and grow.

In fact, the only guarantee in this equation is that anybody who claims to have figured it out is full of it.

That said, there are ways to reliably slice big chunks of risk from your portfolio.

So while a system for picking stocks may not be realistic, a system for removing companies from consideration is quite realistic.

When it comes to microcap companies, we know the primary source of risk arises from four basic characteristics inherent to smaller companies:

• Lack of revenue
• Untested business model
• Lack of cash
• Untested product

We know these factors are the main sources of risk because these problems are the first ones to vanish when a company leaves its early, volatile phase and positions itself for long-term growth.

So it follows that effectively minimizing these shortfalls in companies still in their early stages would therefore increase their chances of reaching higher market capitalizations.

No major revelations yet, but then we add just one more variable to squeeze a bit more firepower out of our microcap vetting mechanism…

We forget dividends. Because a small, profitable company looking to grow shouldn’t be giving its profits away as a carrot for shareholders — it should be reinvesting in research and development, expanding payroll, expanding infrastructure, etc.

The Filter

So to address those needs, I’ve broken down these risk-canceling characteristics into four requirements:

• No Dividends: Early-stage companies need to be reinvesting their cash, not doling out profits.

• Strong Profit Margins: A good profit margin isn’t essential, but it is indicative of stability and future growth.

• Gross Margins of 30% or Better: This implies the business model works and will continue to keep the company profitable moving forward.

• Positive Cash: This is the lifeblood of young companies. It means if all else fails, they can still afford to open their doors tomorrow.

The next step: Apply these parameters.

The Process

If you do a raw search across all markets for companies with market capitalizations of $200 million or less — the standard definition of “microcap,” you’ll be overwhelmed with 19,700 results.

However, take away dividends, and that count is down to 18,900.

Add gross margins of at least 40%, and that count falls to 1,780.

Add a net profit margin of at least 8%, and you’re now down to 290 companies.

Finally, add a positive cash-to-shares ratio, and that list is down to just 90 companies.

That takes you from almost 20,000 to a very lean and highly de-risked 90 — a reduction of 99.5% of the field.

However, that still leaves you with 90 companies to sift through — and it’s this remaining 0.5% that’s going to be the hardest to whittle down.

There’s No Shortcut to Thinking

And that’s where you need to start looking at every company individually and making judgment calls based on non-numerical factors like industrial and economic trends, product positioning, partnership agreements, and existing and impending legal battles.

Is this company involved in a business that has a future, or is it on its way out?

Does this company have a product that is about to make all of its competitors obsolete?

Put all that together, and you’ll get your shortlist.

Now you have to ask yourself if this method for eliminating risky stocks is really loyal to the spirit of microcap investing. Aren’t high risk and high volatility the telltale signs of high profit potential?

Well, I’m not going to get into philosophical questions, but I will say that yes, if you want to hit that five-figure gainer, you’ll need to dial back on all that de-risking.

And yes, I have a method for that, too.

But you’ll have to wait until another time to get that.

– John Peterson