Taking the Risk Out of Microcap Stocks

Written By David Roberts

Posted July 31, 2018

Investors generally come in two varieties: the risk averse and the risk insensitive.

Most people, invariably, fall into the first category.

They’re the savers. They’re fearful of loss, which has the paradoxical effect of making them both wary of investing and wary of not investing at the same time.

Investing leads to the obvious exposure to risk, which people of this mentality cannot stand. At the same time, however, not investing exposes them to loss of wealth stemming from other variables — like inflation or housing market depreciation.

So they have to invest just to keep what they have, but in doing so, they put what they have at increased risk of erosion.


There isn’t a whole lot I can say to people like this, so I prefer to focus entirely on the second group of people: the risk insensitive.

These are the pros. The lifers. The gamblers. To them, the act of the trade and the potential for gains trumps whatever risks may be associated.

When they lose, they lose big, but when they win, they win even bigger. Their lives aren’t just made more secure or comfortable through investing — they’re defined by it.

To these people, the concept of the microcap is like a strong drug. It can bring near ecstatic pleasure when done right or can lead to some serious pain when done wrong.

When I first started studying the nature of microcap investing years ago, I quickly realized it doesn’t have to be an all-or-nothing kamikaze run that either yields massive gains or near-total losses.

Science, Not Systems

No, in fact, there is a scientific way to minimize your exposure to risk, while at the same time retaining the sort of upside potential that’s inherent to microcaps.

It took me some trial and error through some pretty expensive field-testing, but I came up with a five-step methodology to decrease the risk usually associated with microcap stocks.

And at the risk of sounding like some fool hocking another investing system, I will say that this filtration process has led to some pretty spectacular results.

Here’s my approach:

  1. Avoid the Dividends: Early-stage companies need to be reinvesting their cash, not doling out profits.
  2. Cash Reserves: This implies a healthy, stabilized debt-to-equity ratio. This means a company has the money to research and develop products, market itself, hire new staff, and buy new equipment. If the company is a body, the cash is the blood.
  3. Strong Profit Margins: A good profit margin isn’t essential, but it’s indicative of stability and future growth.
  4. Gross Margins of 50% or Better: This implies the business model works and will continue to keep the company profitable moving forward. 
  5. Tight Share Structure: Fewer shares for a small company means two things: First, individual shares will be valued higher and thus carry an appearance of stability. Second, positive news will have a stronger effect on trading volume as a percentage of total market capitalization. In short, good news will drive gains faster.

Now, this may not seem like a radical set of parameters, but the results from diligently applying these filters is fairly compelling.

When I initiated my last portfolio, it was exclusively with recommendations that satisfied all of these requirements.

Within five weeks, I’d closed two of the six open positions with 40% and 70% gains.

Moreover, three of the remaining four positions were up but still had gain momentum — thus remaining open.

Just one of the recommendations was in the red.

Who Would Want to Embrace Risk? Well, Sometimes I Do

So given these results, I made it a point to never stray away from the guidelines, right?

Well, not exactly… You see, while these filters do cut out about 90% of technical risk, they also cut out the one thing traders cannot live without: massive upside potential.

To tap into that, you need to remove the single most substantive parameter from the filtration process: profitability.

When a company with tons of long-term potential goes from negative net revenue to positive net revenue, it’s perhaps the most important transition it’s ever going to make — and it’s that transition that drives shareholder gains more often than any other.

For those willing to risk their money on a stock that has yet to prove itself on this basic level of feasibility, gain potential is magnified.

So what should be your takeaway here?

Well, as I tell anybody who seeks investment tips, it’s always the trader’s decision how much risk he decides to undertake.

That may seem like a foregone conclusion, but without being able to gauge risk properly, you simply cannot tell what you’re getting yourself into.

With this basic rule of separating the profitable from the merely prospective, now you can.