If there is any such thing as a free lunch in finance, diversification would be the closest investment principle to it. A well-diversified portfolio provides investors with a good balance of reducing risk but still enough exposure to capture profits. When dealing with microcaps, it is critical that investors understand this concept. Given that most opportunities in this space can promise astronomical rewards, many undisciplined investors tend to forget or disregard the risks involved.
This week, Equities.com discussed the art of diversification in microcap investing with Stephen Kann, an industry veteran and expert in this arena, to gain some insight on this topic.
EQ: One of the most important rules in your methodology is to diversify your exposure when dealing with microcaps. Why is diversification so critical in this space?
Kann: Microcaps, by definition, carry higher risk. They're small companies where relatively minor issues can be highly impactful, whereas larger companies can endure the hits such as lawsuits or some negative PR issues. Small companies are less able to withstand that. So given that the risk profile is greater, it is more speculative by nature, and therefore diversification is key.
EQ: A common pitfall for average investors is to put all their eggs in one basket and hope that investment pays out big. Can you talk about the dangers of doing this?
Kann: I would consider myself a real expert in this space, and I, with all my research and all my access to management and all my experience, still don't get it right every time. In fact, it is at a virtual truism that the ones I'm sure will do the best are the ones that usually don't do the best. Conversely, the ones that I like but don't love are the ones that really outperform - where management really executes. These companies are the ones that usually become huge scores in the portfolio.
When I was writing for a newsletter about eight years ago, there were nine companies that I initiated coverage on. I loved them all, but there were two in particular that were, ironically, the two largest companies in the portfolio. They were both trading in the teens and trading on the NASDAQ, and were sort of out of character for what I typically look for because they were larger, which supposedly meant that they were more "stable" and "less risky." Well, those were the two of three worst performing stocks out of the nine that I covered. The two I was sure that were going to do well if all else failed, did poorly. One of the companies saw its share price cut in half, and the other was a wipe out. Had I succumbed to gut instinct and not followed my own rule of putting equal amounts into every company regardless of how you feel about it--as long as they pass your methodology and meet your metrics--I would've been overweighted on the ones that did the worst. That would have had an overall detrimental effect on the portfolio.
EQ: What would you recommend in terms of allocation and the number of positions an investor should have when building a well-diversified microcap portfolio?
Kann: In general, and depending on your own risk tolerance, you should never have more than 20 percent of your portfolio's assets allocated in microcaps. Whatever that number is, you then have to diversify that. For example, let's say you have $100,000 that is liquid and allocated to equities, and 80 percent of that is used for more conservative investments like ETFs, mid-caps or large caps. That means no more than $20,000 should go into microcap stocks.
In my opinion, you want to have at least five different microcap companies to get any diversification, but the more the better. Of course, there's the point of diminishing returns, so I'd say 20 or more microcap positions is no good because that's too many. So I think the sweet spot for diversification is between five to 10 stocks.
EQ: Do you also recommend diversifying the types of microcaps held by other categories, perhaps such as by sectors, growth drivers or some other metrics?
Kann: It's critical not to outsmart yourself and think you know more than the market does. Keep those allocations relatively even across whatever number of stocks you're able to buy with the money you've allocated for microcaps, and remember that discipline is key. Since my whole methodology seeks to uncover undervalued stocks relative to current conditions, I don't think there is a particular diversification among drivers or among catalysts. I'm not looking only at things that drive the fundamentals of the business; what I'm really looking for right now is mispriced fundamentals. As an example, I discussed HyperCom (traded NYSE:HYC) last week. I found the company when its shares were trading at $1.35, and when I compared it to its larger peers on a one-for-one, apples-to-apples basis, I felt that the stock at the time was worth $4 per share, which I subsequently felt was worth $6. It was ultimately acquired for $11 within 18 months. I look for those opportunities, and by following that methodology, and looking for stocks that are undervalued now in terms of fundamentals, I'm always going to win.
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