Have you ever received emails promising quick returns of 1,000% or more from stock investing?  I know I have. Most of these emails tout high-risk, hugely volatile micro-cap stocks.  

#-ad_banner-#The majority of investors simply discard these emails as nonsense — but the funny thing is, returns of 1,000% or more are indeed possible in the micro-cap sector. What’s important to keep in mind is that these huge gains are accompanied by equally gigantic risk — the kind that can quickly wipe out your entire investment.

Fortunately, there’s a way to profit from this market while greatly reducing the risk. To be sure, this technique does not allow for outrageous returns, but it did return over 50% during the past year and has a history of market-beating results. 

Before I get into the specifics of this low-risk method of investing in the micro-cap market, let’s look at what exactly a micro-cap stock is. The SEC’s definition of a micro-cap stock is one issued by a company with less than $300 million in market capitalization.  

These tiny firms often do not file financial reports with regulators, making research and due diligence very difficult. This lack of freely available fundamental information, combined with generally low trading volumes, makes this market ripe for illegal “pump and dump” trading scams. 

In a “pump and dump” scheme, fraudsters spread false or misleading information about a stock to entice investors to buy shares. This buying drives the stock price higher, prompting the fraudsters to suddenly sell all their shares. This selling from the “insiders” sends the price plunging, wiping out unsuspecting investors in the process. Of course, there are many other types of schemes perpetrated in this market.   

Another risk factor is that there are often no minimum listing standards on over-the-counter exchanges. In contrast to the disclosure requirements and high capital standards required to be listed on the NYSE or Nasdaq, companies don’t need to have a minimum level of net assets, number of shareholders or even proof of an actual operating business to be traded on OTC exchanges.

However, there is an exception to this rule: Companies listed on the OTCQX exchange, the OTC market’s highest tier, must meet minimum listing requirements.  

Most individual investors lose in the micro-cap market because they typically take chances only on stocks that are being promoted. In contrast, the secret to savvy micro-cap investing is to take advantage of the services of a team of professional investors by buying shares in one of the two funds that specialize in this niche.   

Not only does this approach reap the benefits of a team of investing professionals, it also creates a diversified micro-cap portfolio with one transaction. Let’s take a closer look at these two micro-cap funds.

Founded in 1999, the Lord Abbett Micro Cap Growth (LMIYX) mutual fund invests 80% of its assets in stocks within the parameters of the Russell Microcap Index. Lord Abbett Micro Cap Growth returned an astounding nearly 79% in 2013, earning it top honors in The Wall Street Journal’s Winners’ Circle. These returns were no doubt created by a heavy bias toward biotechnology combined with a sophisticated fundamental screening process.

Excited by these returns, I called the company to verify the investing criteria — but I was told the fund is currently closed to new investors. In addition, it required a million-dollar minimum investment, which precludes everyone but the most well-capitalized investors. However, the fund’s representative said new investors can still gain exposure to LMIYX — through the Lord Abbett Alpha Strategy Fund (ALFAX).

Holding more than $1 billion in assets, ALFAX is a fund of funds that includes about 10% exposure to the micro-cap fund. The rest is distributed among small and mid-size U.S. equities, growth companies and value companies, as well as international equities (including emerging-market stocks). As its name suggests, this fund seeks alpha (returns in excess of the broader market’s) in a diversified basket that consists of six Lord Abbett funds. As you can see, AFLAX was no slouch last year, returning over 40%.

In contrast to LMIYX, the Oberweis Micro-Cap Fund (OBMCX) requires a minimum investment of $1,000 ($500 for IRAs). The fund invests a minimum of 80% of its net assets in what it considers to be micro-cap companies (which it considers any company with a market cap of $600 million or less or is part of the Russell Microcap Growth Index).

Oberweis uses an innovative fundamental screen to select companies for its funds. Called Octagon, this screen chooses stocks based on eight underlying factors, including rapid revenue and earnings growth, innovative services or products, rising profitability, and low price-to-sales ratio. OBMCX has an average five-year return of 26% and is up just over 3% this year. 

Risks to Consider: Investing in mutual funds exposes you to market risk. Although investing in micro-caps through funds is less risky than investing in individual stocks, multiple risk factors still remain. Always diversify and use stop-loss orders when investing.

Action to Take –> I like both the Oberweis and Lord Abbett funds. If you are seeking direct exposure to the micro-cap market, the Oberweis fund should be your choice. Both OBMCX and AFLAX are off their highs right now, creating an enticing entry opportunity.

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