Editor’s Note: Today we’re continuing our special holiday series. Below, microcap expert Chris Wood shares the “lazy” way to access the superior returns of microcaps. His answer may surprise you…
***
Superinvestor Warren Buffett admits we have an edge on him.
At Berkshire Hathaway’s 1999 shareholders meeting, he said: “I have to look for elephants. It may be that the elephants are not as attractive as the mosquitoes. But that is the universe I must live in.”
“Elephants” refers to large-cap stocks. These are stocks with a market capitalization over $10 billion.
“Mosquitoes” refers to microcaps. These stocks have market caps between $50 million and $300 million.
Put simply, Buffett can’t invest in microcaps because he manages too much money.
Berkshire Hathaway, Buffett’s investment firm, is worth about $650 billion. It must invest huge sums of money to grow profits in a meaningful way.
In Q4 2020, Buffett added four new stocks to Berkshire’s portfolio. He invested $364 million in The E.W. Scripps Company (SSP), $499 million in Marsh & McLennan (MMC), $4.1 billion in Chevron (CVX), and a whopping $8.62 billion in Verizon (VZ).
In other words, Buffett’s smallest investment ($364 million) was bigger than the largest microcaps!
Meanwhile, Buffett knows the truth: Microcaps offer superior returns.
According to investment research firm Ibbotson Associates, microcaps returned an average of 16.2% annually from 1926 through 2018. That was more than four percentage points higher than large stocks.
In 2019, the top 10-performing stocks were all microcaps.
And earlier this year in Project 5X, my microcap advisory, we closed out winning trades of 422%, 399%, and 177%.
The bottom line is Buffett wishes he could invest in microcaps... but he can’t.
Fortunately, we don’t have the same size limitations as Buffett.
We can access the superior returns of microcaps.
But there is a catch…
You can’t buy microcaps the same way you might buy other stocks…
More specifically, you can’t buy a basket of microcaps with a click of a mouse. Let me explain…
If you want to own large stocks, you don’t have to do the hard work of picking individual ones.
You can simply buy the SPDR S&P 500 ETF Trust (SPY)—which is the largest and most popular ETF in the world. It owns stock in 500 of America’s largest companies.
SPY has zero microcaps in it.
So… you’re probably wondering if there’s a microcap ETF out there.
The short answer is: yes.
You may be surprised to hear that.
Because some popular ETFs claim they’re focused on microcaps.
The biggest one is the iShares Micro-Cap ETF (IWC).
It’s got “microcap” right there in the name.
But as one of our eagle-eyed subscribers pointed out, this is misleading.
Let me show you what I mean.
A large percentage of stocks in IWC have market caps above $300 million.
In other words, they’re not microcaps.
And it gets worse. The fund puts the most weight on the largest stocks it owns.
Here’s a snapshot from earlier this year. It shows what IWC’s three largest holdings were on May 25:
GameStop (GME)… Digital Turbine (APPS)… and Magnite (MGNI).
At the time, GameStop’s market cap was around $12 billion… about 39X the size of the largest microcap! How did that stock ever make it into the fund?
Digital Turbine’s market cap was $5.6 billion… not even close to microcap range.
Magnite was a microcap when I first put it on my readers’ radars in Project 5X.
But when we cashed out in February for a 422% gain, it was a $5+ billion company.
That’s well over 10X the size of the largest microcap.
And these three aren’t anomalies...
In fact, the average weighted market cap of all the companies held in IWC is over $600 million... more than double the size of the largest microcap!
It’s the same story with all the other so-called “microcap” ETFs.
First Trust Dow Jones Select Microcap Index ETF (FDM) and AdvisorShares Dorsey Wright Micro-Cap ETF (DWMC) both have “microcap” in their names.
But the average weighted market cap of their holdings is $714 million and $682 million.
The point is, don’t be fooled…
You can’t buy microcaps the “lazy way” by simply buying an ETF.
Because true microcap ETFs don’t exist!
The main reason for this is very simple.
When a microcap is successful, its stock price grows fast.
When a microcap’s stock price grows fast... it doesn’t stay a microcap for long.
In essence, microcap ETFs can’t keep up with the rapid changes that are always taking place in microcaps.
So, there’s no “lazy” way to access the superior returns of microcaps.
You can’t buy microcap funds.
You must buy the right individual stocks.
In my Project 5X microcap advisory, I identify microcaps that check these boxes:
When you find a microcap that checks those four boxes... you may have a big winner on your hands.
Regards,
Chris Wood
Editor, Project 5X