As a follower of and investor in micro-cap stocks, I often am asked where they should fit within an investor's portfolio. For most investors, they should be a small satellite portion of the portfolio at most and not the core. Owning too many micro-caps can bring more significant risk than most investors can or should tolerate. Not only can these names be more volatile, they also can be of lower quality and much less liquid than your average larger name, sometimes with bid/ask spreads that you could drive a truck through.
In addition, while taking an initial position can be difficult to do in a cost-effective manner without pushing the ask price too high, exiting a position also can be a challenge. If you are in a hurry to exit and trading volume is low, as it often is, you run the risk of selling at levels well below the current price. In general, limit orders, not market orders, should be used whenever possible. With trading costs so low these days, taking a position over several trades over time can be less costly than going all in at once.
I also am asked about income generation from micro-caps. It is possible, as evidenced by some of the names mentioned here; indeed, running a screen of dividend-paying companies with market caps between $50 million and $500 million reveals a list of nearly 500 companies. That may be a surprisingly large number, but it encompasses a group of companies that may be unfamiliar to most investors. I will explore this investment area more in future columns.
It takes time and an iron stomach to build a portfolio of these micro-caps for income-generation purposes, and with good reason. Beyond the aforementioned liquidity issues, many of these names will have little if any analyst coverage, so you are on your own in terms of information gathering.
However, there are ways to gain exposure to the asset class in an inexpensive manner without building your own portfolio. There's the Royce Micro Capital Trust (RMT) , a closed-end fund that holds more than 311 names, with an average market cap of about $395 million as of March 31. RMT currently trades at about an 11% discount to net asset value. Perhaps more importantly for income investors, it currently yields about 7.2%. This is certainly not a trading vehicle, but could be interesting for the income-seeking investor who has carved out a small piece of the portfolio for micro-caps and intends to hold them for the longer term.
There are also a handful of micro-cap exchange-traded funds, but only the PowerShares Zacks Micro Cap (PZI) has provided a yield above 4% over the past 12 months. Other micro-cap ETFs include the First Trust Dow Jones Select MicroCap Index Fund (FDM) , the iShares Microcap Index ETF (IWC) and Wilshire Micro-Cap ETF (WMCR) . In addition, there are a couple dozen mutual funds that specialize in micro-caps, but we'll save that discussion for another day.