Motley Fool Hidden Gems Investing - Intro to Micro Caps

Episode Date: March 15, 2025

How does a maker of pesto sauce become a 28-bagger? The recipe calls for profitability, focused management, and sustainable earnings, along with a few other ingredients. Ian Cassel is a micro-cap investor, the founder of MicroCap Club, and the author of two books. Motley Fool Senior Analyst Buck Hartzell caught up with Cassel for a conversation about investing in the smallest kinds of public companies. They also discuss: - How to evaluate companies with market caps less than $500M. - What makes an “intelligent fanatic.” - Why growing a stock position is like cultivating a relationship. Host: Buck Hartzell Guest: Ian Cassel Producer: Mac Greer, Mary Long Engineer: Chace Pryzlepa, RIck Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

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Whatever lies ahead, don't change your morning. Let your morning change you. Discover Coffee Plus on Nespresso.com. We define Meyercap as sub-500 million Meyercap. You know, I'm really looking to initially invest in something sub-100 million, which is really where there's no institutional ownership, there's no analyst coverage, there's nothing. And I think it's, is it a dangerous place to invest?

Yes, but it's a great place to invest to learn stock picking because you're forced to do the work. There's no analyst there that you can lean on. Like, you got to do the work yourself. And it's that independent mindset that is crucial to becoming a better stock picker. And so, you know, it's not a surprise that the best stock pickers ever came out of the microcap ecosystem. I'm Mary Long, and that's Ian Castle. He's a microcap investor, the founder of Microcap Club, and the author of two books.

Ian joined Motley Fool senior analyst Buck Hartzell for a conversation on microcap investing. They talk about intelligent fanaticism, a pesto sauce maker that became a 28-bagger, and why microcaps are like four-year-olds. I've been at The Fool for over a quarter of a century, and we fielded a lot of questions from investors that are excited about investing in this space. And what I've seen is a lot of them get off on the wrong track, and it kind of sets them up from failure, but this is an exciting part of the market. And I think you do things the right way. And we're going to learn some great lessons today about how you can be successful in micro

cap investing. But first, I want to just start it off simply. Can you define what we're talking about here when we talk about micro caps? Sure. I mean, when I'm talking about micro caps and talking about companies with market capitalization lower than 500 million, and I know it can vary based on your geography of where you're investing. But in general, I think most people use the definition of sub 500 million market cap. And when you're kind of sizing up the space in particular, if you're just looking at in North America, so the United States and Canada, there's approximately 23,000 total stocks that trade in the United States and Canada. Around 56% or 13,000 are microcap companies. So they make up a majority of the public companies that trade are these small

kind of obscure microcap companies that don't have analyst coverage, that a lot of them don't have any institutional ownership. They're mainly kind of owned by retail investors. And that's also the opportunity in microcap. Right. And that's interesting. If we go back, you know, several decades, the entire stock market was kind of ruled by retail investors. and today as you say it's it's all institutional it's a new institutional game so most of the investing and trading that goes on happens by big companies whether they be for passive indexes or actively traded funds now when you look at them i mean a lot of people will say hey there's some junk there's a lot of junk in some of those small cap companies right now how do you go about

kind of weeding what's your process for weeding through that and kind of getting the cream to rise to the top well i think to your first point um if i can digress a little bit you know i think a lot of people that when they do think about microcaps they do think about penny stocks and i do think it's sort of a derogatory firm or term that's used in the space and a lot of times you know people's entree into small stocks is you know through some hard mailer glossy marketing thing they get in their email or their snail mail and it's usually just some sort of paid advertisement for a company that has zero fundamentals, but claims to be the next Amazon, you know, and people buy that stock and the stock goes down and nobody wants to invest in these companies

ever again, you know, and that's probably 80% of people, they get their entree into micro cap investing that way. And they then think that this is just an awful ecosystem to invest in. And it's just not the case, especially when you look at the fact that most of the best stock pickers ever started their careers investing in micro cap stocks from Warren Buffett to Peter Lynch to Joel Greenblatt, they all started their careers investing in small, obscure micro-cap companies that had fundamentals. This is where they found their edge because of the inefficiency that lies in these small, obscure companies. And when you look at the best performing stocks ever, they all were basically micro-caps when they started. When you look at the best performing

stocks literally in the last 10 years, when you look at size up the global equity market, you screen out the companies that are up a thousand percent or more 87 originated out of the microcap ecosystem and guess what 91 of those companies that went up a thousand percent or more were profitable not profitable story stocks and so yeah and so when when we think about investing in microcaps a lot of people go invest in story stocks but when you actually look at the facts the evidence-based research that's done in this space, a majority of them are just simply a small business that can grow into a larger small business and do it profitably. Right. And I think that profitability is key because that weeds out a lot of those thousands of stock.

Like you said, you call them story stocks. I'm always a little bit hesitant when I see a small company and they say, I want to be the next Microsoft or the next big whatever. And you're like, wait a second, you're only a hundred million market cap. And those kinds of companies that over promise tend to under deliver. What I see in a lot of these really good companies is they tend to be run by really smart, but pretty humble people. They aren't out there saying I'm going to be the next whatever else. They're just kind of, you know, daily doing their job and growing the business. And I want to talk about some buckets of those stocks. I think so. Some stocks that end in the micro cap land, what types of businesses are these? And so like if we had to

bucket them are these just kind of new companies that are IPOing or these companies that have been around for a while and maybe had some hard time and now in a turnaround situation what type of companies do you tend to focus on if you have any bucket you know I think in general the companies that do really well are companies that dominate a small niche market that is expanding you know And I think if an investor can find a small public company that dominates a niche that is expanding, it proves out really kind of the most important thing that management is competent because they either created that market or they took market share, you know, and they're most likely profitable when they did so.

If the, some of these companies, fewer of them in the United States, I would be, I would call it rising stars. So, you know, new companies, a new management team doing something new in a new company. There are fewer high-quality companies going public small in the United States. We still see higher-quality companies going public in places like Canada, in places like Australia. But here in the United States, probably the biggest bucket would be a transformation type of situation where it's an existing microcap company that maybe was mismanaged. A new management team comes into that business. They inject capital. Hopefully they get skin in the game that way. And then something old becomes something new. And so the United States, which still represents

probably 80% of my personal investing, a lot of what I'm looking for is transformations. those when management a new management team takes over another company and you could look into that management past history and see that this isn't their first go at it they build up companies before and sold them or ipo'd them or whatever and you see these repeat winners taking over this small obscure company and just leads you wondering well they're not doing this to lose money they're doing this because they think they can make money and they're bringing the gang back together again to do it again, one more time, you know, and that's the type of qualitative setup that I like to find in a microcap company. Yeah. So I love that. So we got two buckets

right there. I mean, you talked about rising stars and I think we see that here, right? Companies that are new and exciting in areas are tend to stay private longer because there's so much venture capital out there. And then by the time they do come public, they call them unicorns. There's over a billion dollars and very large. And so you're saying we're seeing less companies here now like that, but more of transformational companies that may have had some difficulties likely due to mismanagement that have somebody that comes in and can kind of really turn things around. And I want to talk about management a little bit because that's something that's near and dear to our hearts here at The Motley Fool. We love founder run businesses, but we also just

love and appreciate great operators and use the word kind of term intelligent fanatics. I don't know if that captures what you're kind of looking for, but can you describe that? Sure. No, I co-authored two books on the subject of intelligent fanaticism. And intelligent fanatics is a term Charlie Munger used to basically describe a great business builder, somebody that created a business from scratch, grew it up to a point where it dominated its niche, its geography, its industry, and did so over a period of decades, not just one or two years. And me and my co-author, Sean Eddings, we kind of went back and looked at some of these entrepreneurs that were intelligent mathematics that Charlie Munker mentioned. And we wrote two books on them and kind of pulled out some valuable insights and, you know, tried to come up with a framework or blueprint that you kind of look for.

And, you know, my main goal in that whole project, which lasted, I guess, four years, you know, was really to kind of fine tune my lens for finding these great leaders in small, obscure microcap companies. You know, because, you know, if you want to find great companies early, you've got to find great leadership early, you know, and so yeah, I mean, you kind of hit on one, you want to find founders, but kind of getting back to the transformation stuff we just talked about before, they're not always founders, you know, sometimes it's simply a new management team kind of taking over. And I guess we could say that they are the founders of it's a new strategy. But oftentimes we find them where they do own like four or five or 6% of the company, not 25%, which is all what we all like to find. But, you know, maybe it's the number two in the organization that comes up and steps up that to be number one in the organization. he was overlooked for many years and he has he has just as much fire in his belly or her belly as the the founder of the company did they have something to prove you know and you know you find kind of that bucket of an individual that can also be defined as an intelligent fanatic as well and you know really i guess i should start off by saying if it's a microcap company i don't call the person a intelligent fanatic until they grow the company up and out of the microcap

ecosystem let's just be clear i'll be i'm trying to find potential intelligent for that potential right yeah and so does it have to be a five bagger once it's a five bagger they're an intelligent fanatic if they if they can do that i i like to say once they reach escape velocity out of microcap so out of you know 500 million bar cap that's usually what i'll define them as an intelligent fanatic you know something there where it's a sustainable move built on fundamentals and you see you see them in all walks of life i mean the you know to give you an example of what i would say a traditional multi-bagger looks like in microcap you know it's not the next google it is a company um and i'll mention one i don't own it and you shouldn't go out and buy it but a

company like armonino foods which is the symbols amnf it trades on the otc markets it's not even the nasdaq and they're the market leader in pesto sauce in the united states you know and all that company did was go from $30 million in sales to $60 million in sales over 14 years. They went from earning $2 million to earning $10 million over 15 years. And that's a 28-bagger. And there's nothing sexy about making pesto sauce. But they did that without diluting. And so earnings per share continued to increase. And that's really what drives sustainable multi-baggers, which is what I'm looking for because in the microcap space, you can find a lot of flash-in-the-pan successes that work out for one or two quarters because they have the right product or service

that hits a fad or theme in the market at a specific period of time, but they come right back down. You know, you want to find these real high-quality businesses that can sustain that trajectory. And here in the United States, you know, out of those kind of 13,000 microcaps in North America, 7,500 of them are on OTC markets. And so that's a significant amount of companies. I mean, that's more companies than that trade on the NASDAQ and New York Stock Exchange combined. The sandbox, if you will, microcap companies, it's a lot of them to kind of sift through. And yes, there's a lot of them that no one should buy, but you could say the same thing about any small business universe, whether it's small private equity or venture

capital they have just as much failures as we have in small public companies they're just private their failures aren't public ours are and that's why we kind of get a bad rap too as microcat yes yeah absolutely and so so far we're talking about you know we said hey let's start with profitability let's look for profitable companies that are run by really good people it could be a change of management bringing in people with a track record that also have some skin in the game maybe they own three four five or six percent of the business and then you want a sustainable growth and earnings. So you can get that exit velocity, like you said, so they can kind of compound those earnings and you can get really good results. Are there any other kind of

quantitative factors that you might look at that says this is a really good candidate to be a good microcap stock? I would say it's just a combination of profitability, growth, and leadership and the a potential intelligent fanatics history in business you know that they do this before you know they repeat winner you know kind of those combinations and when you when you kind of add all those things together it doesn't mean you're going to have a thousand percent batting percentage but it's kind of like it takes your your batting percentage from you know 200 percent or 20 percent you know to 40 or 50 or 70 you know and that's the hall of fame that's better than the hall of fame right yeah yeah exactly exactly the difference between getting a hit 25 percent and

30% is about $10 million a year. Right. That's a big, that's a big difference. And so I want to move on to some qualitative things. We call those intangibles, you know, here at the Motley Fool. And for everybody listening, those are just things that don't show up on the balance sheet, right? It could be, hey, this is a brand and it's really, we think of pretty good, but it's

been mismanaged or it could be other things. Are there intangibles that you may look at besides leadership? You kind of already talked about looking for somebody who's competent, that's leading the business. are there other intangibles that get you excited when you look across the microcap universe it's a good question um one of the things that i do look for and again the way i invest probably shouldn't be the way you invest you know because we're all different we're all kind of like fingerprints where we look the same but when you zoom in we're all different you know that's the

same thing for every stock picker um but you know for my strategy i am looking for high organic growth businesses because i do think about who is going to buy this stock from me you know three five seven years from now hopefully 10x higher you know and the one thing that everyone is attracted to whether you're a value investor or hyper growth is growth you know it's why bengram himself kind of throughout his career went from cigar butt investing by the time he died he was basically a growth investor you know because he realized like this is a better way to invest when there's some organic growth attached to it. You don't have to worry about, you know, some value investor that thinks it's worth 2% more than you, you know, to reversion of the mean. I want to talk about

also some other important things for people here. They're managing their own portfolios out there. Microcaps are a little bit different. What do you do as far as position sizing and holding period for these stocks? Is it the same? You know, it's going to be different, I would assume, than buying an index fund and just averaging into it your 401k over three decades. you probably treat microcaps a little bit differently yeah and you have to i mean i wish i could just come on and say you know just find some 10 great stocks coffee can them in the portfolio and you know wake up in 20 years and yeah you'll be rich yeah that'd be a lot easier but they they just these are small evolving businesses they're small businesses they evolve

in good ways and bad ways you know it's sort of similar to where i don't let my four-year-old stay at home by themselves, you know, or else they're going to burn my house down. I got to watch them, you know, I got to watch what they're doing, you know? And so it's the same thing with the portfolio of my air caps is maintenance due diligence, meaning the diligence you do after your initial purchase is crucial, you know, because that's going to decide if you're, you know, buying more holding or selling. And I would say the normal shelf life of a position, even in my portfolio, and I've been doing this since I was 19, now 44, I'm getting old, um, has been around two years, probably the average shelf life in a portfolio of mine. And so when you think

about that, it's like, okay, I'm, I'm usually in about a dozen companies at one time. And I've probably owned, let's say 60 or 70 companies over the last six or seven years. You know, when I think about how many of those 60 or 70 companies over the last six or seven years that I still own today, it's about three or four, you know, that, and a lot of times people get turned off by that, but it actually aligns with the greatest stock pickers and investors of our generation. You know, like Warren Buffett, when you look at his public portfolio, he's, I think he's owned about 300 stocks over his career. And he has about a dozen companies that are there that zone for 12 years or more. So the greatest investor ever had to own hundreds of stocks

to find a handful that are worthy of holding. And just think about layering on, okay, now I'm investing in small businesses. Of course, there's going to be turnover there. So I would say the average hold time for me is around two years. There's some I've owned for 10 years and there's some I'll own for three months. And it's not because I'm, my intention with every purchase is to hold forever but very few earn that right right and so you mentioned the buy sell or hold it determines can you give us some examples um like what is the situation where you're like okay i need to cut ties with this company what is that to maybe help our investors at home make that decision if you're kind of actively monitoring it uh the position yeah i mean i would say that

there's kind of four main reasons why you would sell the first two are good reasons and i would just say that you know the first one would be you find something better than your worst idea in the portfolio and i say that's a good reason the second good reason is something goes up too far too fast and usually i define that as kind of pulling forward five years worth of returns into a single year you know and what i found in those circumstances just through my experiences 95 of the time that situation happens because a lot of people will say well you should still hold it because i still have room to run 95 of the times that where i've experienced that type of huge win in a single year where something goes from 10 times earnings to 100 times earnings is

95 of the time there's they're going to stub their toe in an upcoming quarter and the stock's going to get cut in half or more and then it's going to spend the next five years backfilling fundamentals or not before it reaches new highs again. And so it does make sense to take some off the table in those circumstances. The last two reasons are obviously more bad where something bad happens with the business. Either the business evolves in a bad way, you need to sell. Or the fourth reason would be, I've just found management to be untrustworthy or incompetent. And I don't care what the valuation is, I'm going to sell it immediately. That's great. And we all make mistakes. You know, we think we get excited. Somebody news in here. They have a great track record. And I think what's important for folks at home and maybe you agree with this or not. I have an idea in my head what I'd like to see management do like this is what they should do. And usually they'll say the right things and you're on board and then you start to see them deviating from that course. And it's like, oh, what are we doing here? So you do have to hold them accountable. And and so maybe that happens for you as well.

to make sure that not only they're saying the right things, but they also have to do the right things. Well, and it kind of relates back to your position sizing question. I think one place where I've evolved the most in the last 10 years was, you know, 10 years ago, if we were having this conversation, I'd be telling you, you know, if I'm not putting 10% of my money into something initially, then I don't have the conviction to own that. You know, where today it's more like, I'm okay taking on a smaller position size and averaging up even less times when you're actually averaging up in something and you kind of grow with the position you grow with the company and it's a more natural way to grow a position because that's how we all grow relationships and i think

building conviction is like building a relationship where it just it goes better over time and i love that and we we say buy in thirds and sometimes i joke buy in 15ths or 20ths yes because we love to add the winners at the motley fool and we also realize that maybe the day that we bought the stock or recommended. We did a lot of research. We may have put months of research into it, but after we own it for a year or two or three, we know it a lot better than we did that day. And so sometimes even though the stock has gone up, we think the business value has gone up even more because it hasn't been recognized yet. And as you know, once institutional gets large enough, you know, where that market cap is, where institutional investors can get into it,

that can push the stock quite a bit higher as well. Yeah. That discovery move, when institutions discover something is what I'm trying to get on the left side of, you know, especially, especially in my type of investing. And, you know, I, we defined my air cap as sub 500 million market cap. You know, I'm really looking to initially invest in something sub 100 million, which is really where there's no institutional ownership. There's no analyst coverage. There's nothing. And I think it's, is it a dangerous place to invest? Yes. But it's a great place to invest, to learn stock picking because you're forced to do the work. There's no analysts there that you can lean on. Like you got to do the work yourself. And it's that

independent mindset that is crucial to becoming a better stock picker. And so, you know, it's not a surprise that the best stock pickers ever came out of the microcap ecosystem. Right. And I want to talk a little bit about valuation because you kind of said, you know, when something runs a little bit, you know, too much and it gets a little bit too excited, 95% of the time you see that come back down or stub the toe. So I want to know, like, how big of a role does valuation play in the work you do? I have a colleague, Bill Mann, and I love his analogy, so I'll take it. He calls it the awesomeness continuum. I think this applies to Ben Graham and certainly Warren Buffett and Charlie Munger as well. Munger talked Buffett into saying, hey, it's better to pay a fair price

for a wonderful business than a great price for a below average business. And so how important is valuation for you? And is it a sliding scale? Are you willing to pay more for some businesses and less for others? I would say that when I, I'm very valuation focused when, with my initial purchases. And after that, I'm very execution focused on my subsequent purchases. You know, I'm really trying to find these management teams that can consistently execute over quarters and over years and when you find them you can't be afraid to average up because these are small businesses if they continue to continue to execute these things can go up you know a thousand two thousand five thousand percent you know so whether i'm buying at fifty percent higher it's not that

big of a deal to me i'm really just trying to find these management teams that can execute so you know price is my due diligence as buffett would say on the initial purchase more so. And then it's more execution focused thereafter. I try to underwrite what I, you know, in a perfect world, we would all find deep value stocks that turn into growth stocks. You know, you're finding them at five PEs and they turn into 30 PEs. And that's where you get the double lever of multiple expansion and earnings power, you know, and that's create these monster winners. And so I do think your initial purchase price matters. Yeah. And ironically, you know, probably the most profitable investment ever was Warren Buffett's purchase of Apple, which he made

it about 10 times earnings originally. And then this past year, he sold about 600 million shares of that. They were over 30 and close to 40 times earnings. So he had the benefit of the growing earnings plus buybacks, plus the expansion of the multiple. But he said, hey, this is better than any business we own at Berkshire Hathaway. But yet he sold a lot because he realized, hey, at some price even the best business maybe in the world is not a great investment and he's willing to kind of cut ties and pay some taxes and now he has 325 billion in cash sitting on his balance and it's funny too when you think about the maturation of multi-decade winning stocks i mean every single one of them was a deep value stock and a gross stock at one point in time and probably

multiple times during the journey you know and at any one point in time you know it attracts different types of investors that are deep value or value or growth or garb or whatever you want to call it you know and so we all kind of sometimes silo ourselves into a valuation like i'm a value investor and yet the companies themselves transcend you know they're going to go up and down they're loved and hated they're shorted they're not there's activists involved it's it's interesting when you look back the journey is that's absolutely true and i remember looking at one time with apple it was listed in a ton of growth etfs and then you looked it was also listed in all the value ETFs. We, the Motley Fool, we don't even really like the value growth dichotomy.

We're investors, right? Like people put names on things, but that was kind of funny to look over across all those ETFs. Basically, they all had Apple. Didn't matter what they called themselves. Apple was in there. Can you talk about a mistake that maybe you made in the past to help some of those that are just getting started today? Maybe there is a 19-year-old listening like you were, and they would like the benefit from some of your pain in the past. Maybe you can kind of share a mistake that you made um that now you're cognizant of more than you were when you started yeah i was a little bit i was a little bit different in that i find that people get into investing in one of two camps you either get into investing as a story stock investor or you get

into investing as buying cheap stocks and the difference is you know whether you got into invested before or after you took an accounting course you know and i started as a story stock investor which is kind of odd you know and then i kind of build up capital it's kind of a higher turnover momentum type strategy through my 20s and then i became a full-time private investor for 10 years i'm just living off my portfolio you know and i've evolved and grown and matured and you know i'm nowhere near the type of investor i was 10 years ago and i hope i'm not going to be i hope i'm different than i am today in 10 more years because i think that's a key to anybody's investing is just evolving and growing uh but uh so i i think one of the things that i would say

and we hit on it already but i'll hammer it home again is stick to the profitable companies you know there's 17 of microcap companies are profitable you will get rid of 98 of the pain and frustration if you just stick to that bucket of companies and once you learn from there then you can be free to move up and down the risk spectrum. You know, maybe you want to try to get them right before they get to the inflection point of profitability, you know, and that's kind of what I do too now. But I would start just, you know, sticking, doing a screen for trailing 12-month profitability on things sub-500 million. Pick an area that you're interested in. Maybe it's an area where you work, where you have some inside knowledge in that industry. That's a good place

to start, you know, and stick to the profitable part of that. And, and I think, uh, you'll learn and learn the right way and then you'll evolve from there. Yeah. And the fun part about that is it'll make you better at your job. You know, I told my, one of my children is into technology and that kind of stuff, software engineer. And I'm like, look in those places. Cause if you understand business and the technology, that's a great thing to bring. And everybody, as you said, we're all individuals. So everybody has their own strengths, uh, out there. And I want to give one more idea is so if there's resources do you recommend any resources for people who want to learn you mentioned some books that you have written any other things where people that want

to take this to the next level um can get more information we actually have a free youtube video that's up on youtube uh just talks about how to research a microcap stock you know and it's free up there there's no you know call to call to action to come join us or anything like that but I think that's a great resource because researching a microcap, small microcap company is different than researching Apple, you know, and probably the half of the way it's different is just looking out for red flags, you know, things like that when you're, when you're doing the analyzing businesses. And so I think that's just a really kind of simple, free resource I'd point people to.

Um, and, and obviously, you know, microcap club's a great resource too, but I think that's a good one. there's not i wouldn't point i don't think i can think even think of any type of specific book um just and i'd be hesitant to just because i do think it it gets back to the type of investor you are yeah my type of investing being concentrated even the types of companies i look for invest in are going to be different than somebody else you know and i i don't think it's right to kind of push people into investing exactly like me because i think the journey of investing is trying to find out how to invest like you. And that's just great advice. Once again, I mean, this is an exciting

space for people to enjoy. It's an area where they don't have to compete with the big institutional players, but you have to do your work. I mean, just like Ian Castle has, once again, founder of Microcap Club and Intelligent Fanatics. Thank you very much today for enlightening us and sharing some tips to make us better investors. We appreciate it. Thank you. as always people on the program may have interest in the stocks they talk about and the motley fool may have formal recommendations for or against so don't buy or sell stocks based solely on what you hear all personal finance content follows motley fool editorial standards and are not approved by advertisers the motley fool only picks products that it would personally

recommend to friends like you for buck hartzell and ian castle i'm mary long thanks for listening Fools and we'll see you on Monday.