Microcaps risky but sometimes pay off

Investing in microcaps seems like searching for a needle in a haystack.

There's sometimes scant public information. Many don't meet listing standards of major exchanges and trade on the over-the-counter market. They tend to be newer firms with greater risk.

If you're bold enough to invest in the stock of one of these companies, you must do your homework. If you put money in a fund specializing in them, you must expect volatility. Lately, overall performance hasn't exactly shot out the lights either.

While the Russell Microcap Index has a five-year annualized return of about 13 percent and three-year annualized return of more than 11 percent, it gained just 2 percent in the first four months of this year. The index includes market capitalizations of $50 million to $500 million, with its average company under $300 million.

But microcaps do offer opportunity to latch onto innovative new companies with a potential for eye-popping returns.

"Microcap stocks tend to be thinly covered by Wall Street analysts, so you're not competing with a slew of really smart people with MBAs," said Christopher Graja of Argus Research Corp. in New York, co-author of "Investing in Small-Cap Stocks." "The challenge is that you have to do your own research, which takes time, commitment and a little expertise."

Management is crucial, Graja said. Look at whether it has invested in the firm's shares and has interests aligned with shareholders. Determine whether larger competitors with more resources and capital could encroach on its territory.

"It was true in the 1970s, 1980s and still true today that small companies are far more agile and adaptable to the environment than large companies," said Marcus Robins, president of the Robins Group LLC in Portland, Ore., which provides research and brokerage services for small and microcap companies. "The reality of life is the small-cap arena is where the greatest amounts of innovation are created."

Robins sees the cup as half full, not half empty, in research.

"Small companies are much easier to analyze because they only have one or two business lines, and the reporting is far easier," Robins said. "Since they have the least amount of research, one can do a tremendous amount of research and create value more easily than with a company followed by 15 analysts."

Robins likes the shares of: