Best Buys Among Microcaps

06/11/2020 5:00 am EST

Focus: ETFS

Richard Moroney

Editor, Dow Theory Forecasts

If you’re an optimist on the U.S. economy and stock market, you may want to boost your exposure to microcaps, explains Richard Moroney, editor of Upside Stocks.

The smallest of small stocks tend to perform well in the early stages of market recoveries, especially when the Federal Reserve is cutting interest rates and adding liquidity to the economy.

Of course, microcaps are notoriously volatile, tough to trade, and difficult to research. Because analyst coverage is typically sparse, earnings estimates can be unreliable. A microcap fund is a good choice for many investors.

For investors able to tolerate the risks, individual microcap stocks offer the potential for big returns. Below are two that earn our highest "best buy" rating.

A financial software provider, Mitek Systems (MITK) focuses on mobile solutions for remote banking. More than 6,500 financial institutions use Mitek’s customer-identification technology for smartphones, a space seeing higher demand during the pandemic.

Mitek could attract takeover interest from potential suitors, given its market position, positive free cash flow, rising profit margins, solid balance sheet, and reasonable valuation. March-quarter earnings per share rose 86% to $0.13. Sales advanced 16% to $23 million.

Although operating momentum will ikely slow over the next couple of quarters, the consensus still expects sales growth to exceed 5%. With net cash equaling 7% of its share price, Mitek is a Best Buy.

UFP Technologies (UFPT) makes custom components and packaging from specialized foams and plastics. Its four biggest markets are medical (65% of 2019 sales), automotive (10%), consumer (9%), and aerospace and defense (7%).

UFP has kept all of its factories open during the pandemic and has even begun to produce medical face shields. For the March quarter, earnings per share rose 4% on sales growth of 2%.

Strong demand for infection-prevention products boosted medical sales 16%, partly offset by declines of 23% for aerospace and 20% for automotive. The balance sheet contains $7 million of cash, versus $3 million of debt. UFP is rated Best Buy.

Our top fund pick is First Trust Dow Jones Select Microcap (FDM), an exchange-traded fund. Especially with microcaps, avoiding likely losers is crucial. That is the premise behind our this pick.

The fund screens for actively traded microcap stocks, then eliminates those with the worst earnings growth, profit margins, price/sales and price/earnings ratios, and six-month returns.

The fund, which has outperformed the Russell Microcap Index over the last five and 10 years, ranks among the top 2% of small-value funds based on 10-year returns.

The fund, with an 0.60% expense ratio, mirrors an index designed by Horizon Investment Services, a sister company of Horizon Publishing, publisher of Upside Stocks. Horizon Investment Services is compensated for creating the index.

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