Most independent investors shy away from small- and micro-cap stocks believing that shares in these newer companies are riskier than buying so-called quality stocks. Blue chips. We’ve all heard the expression “the rush to quality” when large stock markets turn choppy. Institutional investors move assets out of “riskier” stocks (foregoing the potential rewards these smaller stocks can deliver) and take positions in better known companies.

What is a Micro-Cap Stock?

There’s no clear definition. Each trader and each trading platform describes micro-caps differently. However, there are some points that all investors in these companies can agree on:

• Micro-caps are small companies, usually with a market cap of less than $400 million. The average capitalization of the Russell Micro-Cap Index is $391 million.

• Some micros are growth stocks (early bloomers that grow to profitability over time).

• Some micro-caps are value stocks – under-priced by the market compared to book value, products in the pipeline and other real world factors.

• Typically, micro-caps have low P/Es, especially when compared to the high-flyers that make headlines each day in the WSJ. The average P/E of a micro-cap is 15.8 times earnings. For comparison, well-known computer game maker Electronic Arts sports a P/E of 180 times earnings. Warner (Brothers) Music Group, as of this writing, was selling at 459 times earnings – and these are well-known, highly-liquid companies with routine high share volume.

Any stock selling at premium prices like these is destined to fall like a house of cards. Warner Music Group has a long, long way to go to get that PE down to micro-cap levels.

Price/book value compares a stock’s share price to its book value – the total value of the company and its assets including equipment, property, patents and other things of value. Now, you might assume the small- and micro-caps would have a high price to book ratio – share prices that far exceed actual assets of the company. Not so.

Micros have an average price-to-book ratio of just 1.4 times earnings. For comparison purposes, let’s look at everybody’s favorite online shopping destination – Amazon. This cyber success story had a book value of $550 million in ’07 with a market capitalization (the value of outstanding shares) running at $35 billion – with a b! That gives Amazon a P/B ratio of 64. We’re talking in the stratosphere, here, folks. But no one seems concerned about Amazon’s chances for future success. It’s etched in stone.

A stock’s beta is a measure of share price volatility. A beta of 1.0 is a neutral beta. A beta of .8 is lower than average, indicating a stock with better than average share price stability in active markets. A company with a 1.2 beta will react more than average, rising higher in good times, sinking lower in bad times.

These market ups and downs make some investors seasick so they opt for stocks that hold share price – stocks with neutral or better betas. Here’s a surprising stat: the Russell Micro-Cap Index averages a 1.0 beta – neutral.

That means that these small cap companies hold share value in good times and bad.

Take the company’s net earnings, divide by the number of outstanding shares and you get the EPS of a stock. While big oil kicks out big dividends (great for those living on fixed incomes), EPS in small and micro-caps is usually turned back into the business to expand operations.

But here’s something that will surprise you: the average EPS of a Russell Micro-Cap is 17.2%. That’s not bad when, historically, the NYSE has kicked out slightly less than 10% per annum.

Low P/E. Good EPS. Neutral beta. Reasonable P/B ratios – when you add it all up, you discover that micro-caps actually present some excellent buying opportunities in any market – even when uncertainty prevails.

Small-caps and micros aren’t risky. You just have to do the homework.

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