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D. Murali

IF you are searching for `strategies for making big returns in small companies', here is Richard Imperiale's "The Micro Cap Investor," from Wiley (www. wiley. com) to offer some help. "Micro caps are an emerging asset class," informs the preface. The author defines micro cap stocks as very small companies that have endured a chequered history.

Though these are `a small and misunderstood sector of the investment landscape', and `quality data' to draw conclusions from are absent, many micro cap companies are well-managed, according to Imperiale.

"When dividing the market of stocks by capitalisation, a very large number of small public companies virtually disappear from the investor radar screen," and these are the micro caps, points out the author. Large caps are those with a market capitalisation of outstanding shares in excess of $5 billion, while Merrill Lynch calls the less than $100 million category `nano cap'. On these numbers, however, there is no unanimity.

The author cites the useful work of CRSP or the Center for Research in Securities Prices in the University of Chicago, which relies on the standard distribution of market cap values. Russell 2000 Index is `the most widely quoted index of US small cap stocks' and therefore worthy of your study.

To explain how share price has no relationship to market cap, Imperiale gives the example of Nortel Networks that boasts of large cap classification of $10.4 billion; though its share price was only $2.70 in June 2003, the company had 3.85 billion shares outstanding. Seaboard, an agribusiness company, is a micro cap stock with only $260 million market cap; though its share traded at $207 per share, shares outstanding were only 1.255 million. A few more statistics, though of the US, may be of interest. "In the year ended June 30, 2004, 554 companies graduated from the micro cap to the small cap arena simply due to price appreciation... The average 12-month return of the graduating class was 113 per cent. During that same year, 651 companies descended from the ranks above micro cap into the micro cap arena." A chapter on `micro cap stocks as an asset class' notes that most investors realise that small stocks outperform large stocks over the long term. Investors "don't seem to understand that this performance is achieved within significant cycles of underperformance and outperformance relative to bigger stocks", laments Imperiale. "It is the very instability of this relationship between the performance of large and small stocks that creates the investment value of small and micro cap stocks in a multiasset class portfolio."

Though the efficient market theory (EMT) suggests that an investor can't outperform an index of stocks over a long period of time, the author is of the view that as the market cap becomes smaller, the EMT becomes more questionable. "In fact, it appears that a diligent investor can gain an information advantage when dealing with very small public companies." The opportunity that Imperiale wants to emphasise for investors is that this class "behaves like private venture capital but has the advantage of some amount of daily liquidity and market-based pricing". To gather info and thus gain an advantage, the book guides you with tips. For instance, "it can be very tempting to buy shares in a company that has recently had a major change in management," states the author, and cautions: "if a company has problems of the magnitude that required a change of management, it is likely they will not be solved quickly." Tangible impact of a management change may not show in operating results until several years have gone by, he says.

Look at corporate governance too, advises the author. That "customers are usually the most thoughtful and objective source of information about a company" is an insight worth testing out. In Imperiale's view, customers have the ability to "crystallise a large amount of information in a few sentences by answering the question of why they are doing business with that particular company". Legal documents are another helpful source, though these may be a laborious read.

Do you know that PIPEs are private investments in public equities? "A PIPE transaction is a negotiated private sale of a public issuer's equity or equity-related securities to institutional investors," explains the author.

"Both fundamental and technical investors like to purchase PIPEs because they efficiently and seamlessly help them obtain a large position in a small, illiquid stock without having a large adverse impact on the market price."

If you are by now sufficiently enthused to take a dip in the micro cap pool, the simplest way that the book suggests as a framework for action is through a micro cap mutual fund. Else, if you have the time and patience, the author's advice is to analyse and select micro cap stocks. The `holy trinity' of financial items to examine are: "price to book value, price to free cash flow, and price to earnings".

The book, though about what are too small, is worth not losing sight of.

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BookValue@TheHindu.co.in

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