Three red flags of microcap investing

Despite the increased risks, Emanuel Datt, chief investment officer at boutique Australian equities investment firm Datt Capital, believes there is a formula to increase investors’ success in the volatile microcap market.

According to Datt, a successful microcap investment strategy demands a long-term view and investment in internal research “over many years”.

Whilst offering significant opportunities for outperformance, Datt said, with the potential for higher returns against better-researched big cap stock, microcap equities do come with significant risks.

For investors seeking to diversify their portfolios with microcaps, Datt has warned investors to look out for three red flags:

• Inappropriate corporate governance practices. “Even small companies should have appropriate independent boards in place as they are essential for compliance and shareholder protection,” Datt said.
• Extensive related party transactions. “If a company wants to grow and achieve larger market sizes it needs to develop its own internal capabilities which can grow as the company grows.”
• Inadequate management expertise. “Management needs to be skilled and hold relevant experience in the company’s sector.”

By focusing on long-term research and relationships with microcap companies whilst they are still small, Datt said investors “can reap big rewards”.

Datt added that significant idiosyncratic alpha can be generated from microcaps by “actively working with management teams to enhance value for all shareholders as well as improving governance and capital allocation decisions”.

With institutional investors leaving microcaps in droves, microcap stocks are currently trading at historically low valuations, creating an attractive prospect for those investors who can bear higher-risk stocks.

Microcaps represent Australian Securities Exchange (ASX) listed businesses with a market capitalisation of less than $300 million.

The investible universe of microcaps on public markets outside the S&P/ASX 300 totals around 1500 shares.