MicroCaps 101: Defining 'Ground Floor'

Even if the use of the phrase 'ground floor opportunity' may have become a little stale, it's still one of the key criteria many investors consider when selecting a small or micro cap investment. The challenge - as we all may know - is in finding such companies in the first place. Even within the micro cap world, true start-up stocks don't exactly present themselves, especially when older, more-established companies have a foothold in the publicity arena. 

Though the situation isn't likely to change (ever), simply being alert - with a dose of skepticism - can be of significant help to an investor seeking out solid micro cap names.

Being alert just means noticing the less-than-obvious things most investors don't. Take for instance a major auto manufacturer opening a new plant in a new location. Most investors may focus on that company's stock as a result. However, odds are this yet-to-be-built factory is going to outsource things like the interior/fabric work to other businesses in the region. Is a national bank growing the top line through aggressive acquisitions? If so, are they paying a premium for regional and local bank stocks? Did a biotech outfit finally get an FDA approval they needed to start selling a drug? It may be interesting to see if one supplier has the in-road to become the sole materials provider once the big pharmaceutical company ramps up production. 

The point is, look at things in a way other investors won't. There are more smaller companies feeding off of a big company's success than the other way around. 

Skepticism? Just think of it as your internal policeman. Every company will describe themselves as the 'next big thing'. Some of them are, and some of them aren't. If it seems too good to be true, it may not be. On the flipside, don't cast out that one-in-a-million company just because the business plan feels aggressive. As long as there's consumer demand out there, at least some smaller companies have a shot at scoring. Distinguishing between the two may require some serious study, but it's time well spent when the opportunity is solid. (Keep in mind the 80/20 rule though.....only a few of your small caps may be home-runs, but those winners should ideally more than offset weaker positions.) 

With this is mind, you may want to look for these general qualities in a viable small cap 'ground-floor' opportunity: 

• The type of business is not new 
• The company in question has a proven way to outperform other competitors (price, speed, quality, etc.) 
• The infrastructure or capacity is in place - no licenses, patents, or equipment needs to be acquired 
• Any financing commitment isn't more than the enterprise can bear
• The company has a tangible, achievable plan 
• The organization communicates well with investors 
• The company is not yet doing much business (if any), but can and will in the near future 

Aren't some of the best stocks rooted in companies that pioneered an industry? Certainly there are cases where creating an industry by default leaves its creator in the dominant spot within the market. However, by and large, when an industry doesn't exist, it usually doesn't exist for a reason. In other words, the risk of trying to cultivate a new market rather than breaking into an existing one can be tremendous. There may be fewer barriers to entry within an established industry.....like doing something better than everyone else in the same space. 

One of the other issues well worth examining closely (more so than most investors do) is new company financing. How is the company planning on staying afloat if things are going to be lean early on? However, do recognize that the books and capitalization for a smaller company - and for start-ups in particular - are not likely to be great-looking. Most small business start out losing money, so ask yourself where your particular company is in its time-line? If it's the first three months of operations, it may be too soon to expect net earnings. Or, perhaps the company is selling stock to raise funds? Yes, that dilutes the float, but the potential upside has to be wigged against that. If a 10% dilution now could mean a 20% appreciation in price later, that's not necessarily a bad trade-off. 

On the other hand, if it's been three years since the product hit the market, yet the company still can't seem to make ends meet, then it may be time to cut bait. 

Ultimately, don't assume a young organization will be profitable right out of the gate....nor should you assume you can't make money by being a stockholder of an unprofitable company. Current demand is driven by future potential, and the demand may be firm well before profits are made. 

The take-away here is straight-forward.....it's critical that one be able to distinguish between a ground-floor opportunity and merely a new company. There are are new companies formed every day - viable ground floor opportunities really worth considering are few and far between though. Again, that's how skepticism may prove fruitful when sorting through the myriad of ideas that have all been self-labeled as a ground floor opportunity. Thorough study and plenty of observation will help you hone this skill.

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