Thanks @Wini and everyone

Many of the examples you list above largely listed a long time ago - or got to a decent size (say > 1-2b) a while ago

I haven't done the analysis re all the stocks you mention - but if I refine my 'hypothesis' / concern it would be go like this:

1. Today there is a lot more private equity and large enterprises looking to acquire unlisted or listed micro/small caps (than say 10-20 years ago). I dont know for sure that this is true - but feels right
2. Many micro/small caps have a small market cap under 500m for quite a while (or at least under 1b) - making them easier to fund takeovers
3. The last 5-10 years have been quite turbulent - making these companies more vulnerable (due to funding requirements and periods of low valuation)

So it feels a bit like these micro caps are like small turtles trying to get to the safety of the ocean - but they keep getting picked off before they get there

So to be successful you have to now get two things right:

1. Pick a winner with a good return - and hold it for the long term
2. Be lucky that it doesn't get picked off before you see that return (especially in a down market where it can be way undervalued)

@shearman good points, i suspect that PME AD8 ALU may make the grade. what would be really interesting are some stats that show how rare these companies really are, like winning lottery tickets. how many in the micro universe succeed to that extent? secondly can you pick them? doesnt stop people trying, but i think the odds are quite daunting. imo

I think your observation lacks nuance. Lets assume these rough definitions of Microcap to Large cap $ values are correct:

• Microcap = $50m-$250m
• Small cap = $250m - $2b
• Mid cap = $2b - $10b
• Large cap = $10b - $200b

So for a microcap to go to a large cap at the top end would have to 40-bag or more to become a large cap at the lower end. So, of course its very rare for a microcap to become a large cap. To become a midcap it would have to 8-bag or more still very rare. A $10m company going to a $100m company is still a microcap but now just 10-bagged. Successful investing should be irrespective of market cap space you play and more about finding the strategy where you have an edge and can consistently outperform. Putting yourself on a box of "i only invest in microcaps" or "microcaps never become mid-caps, so I never look there” or whatever, would be an ignorant and foolish thing to do in my opinion.

In any market cap sector, most people get average or less than average returns. That is not unique to microcaps. You are correct that in the microcap space there is bound to be more terrible companies because they mostly earlier stage. So, on average it might appear a bad place to play but if you know where to look the returns can be outstanding as proven by some of strawmans top members. The point of investing in microcaps or smaller market capped companies is that it reduces the chance of competition and increases the chance of mispricings. However, as you correctly point out, the hard part is finding and acting on these opportunities. I would suggest the opportunities for mispricings are far less obvious and don’t last as long the further up the market cap scale you go. 

No @shearman - you're not wrong - the odds are not generally in your favour, but you can improve those odds. Some of the examples given today of small caps that HAVE made it to be mid caps or large caps have one or two things in common, or they exhibit one of the following traits:

1. Large insider ownership, with those insiders having conviction to see the company fulfill its potential, so are prepared to block any takeover attempts; and/or
2. Substantial holders who hold at least 10.1% of the company who can and will block takeover attempts for the same reason; and/or
3. Companies where the respective Boards have knocked back takeover offers and the share price has risen meaningfully after the takeover offers have been withdrawn or have lapsed, so where the Board says that the offer meaningfully undervalues the company and its prospects and the market agrees with them over the next year or two; and/or
4. Companies that always look expensive, and remain so, and thus are far less likely to see opportunistic M&A attention.

As a general rule, #1 above (large insider ownership) is the best moat against low-ball takeovers before the company has reached its potential. If the insiders opt to sell into a takeover they clearly don't have the same conviction that us mug punters do - and they know the business way better than we do.

Where management who have plenty of insider ownership keep knocking back or refusing to consider takeover offers, I take that as a sign that the insiders believe in the potential of the company. It doesn't mean they are right, or that we are, but it's a good sign when it happens.

That's the takeover side of things. However there are HEAPS of things to look out for with microcaps that increase your odds of positive returns outside of M&A activity, including, but not limited to:

• Insider Ownership: Companies with high insider ownership, particularly company management, are a great place to start because it aligns management interests with shareholder interests and makes it far more likely that management will act in the company's longer term interests than try to satisfy the criteria for short-term incentives (like increased pay for themselves). We want management to be shareholders so that they have a longer term focus and are less likely to blow the company up or make bad decisions that decrease the long-term potential upside of the business;
• Management incentive structures. Obviously taking shares as part of their remuneration is positive, but also we need to examine what management need to achieve to earn their short and long term incentives. If it's just related to share price performance over set periods, that can result in overly optimistic guidance and/or announcements and other questionable behaviour from management. EPS growth hurdles are good. TSRs are good too. Combinations of those are even better. We don't want to see incentive structures that reward M&A activity just to grow revenue when it decreases margins and profitability, so Revenue/Earnings Growth by itself is not a good incentive from our POV if that could be earned by simply buying up other companies at over-the-odds prices. The late Charlie Munger said, “Show me the incentive and I will show you the outcome.”
• M&A: In the same vein, M&A must be strategically smart and priced right. Acquisitions should either be immediately earnings accretive (improves EPS) or else be very good strategically, but preferably both. The market doesn't always get that assessment right on the day of an acquisition announcement, but they generally work it out within the first year or two. We shouldn't just take the company's own statements as gospel; they are always going to paint the best possible picture; they're never going to say, "We do hope this one works out, and that we haven't overpaid, but it makes us bigger, so we reckon it's a good idea." Companies that rarely make acquisitions, and when they do, they are small and strategic, are often the best companies. Unless they're a roll-up strategy, and those always tend to unravel at some point, but they can be good for a while.
• Business Model: Firstly, management should be clear and constant with their messaging around their business model, not chop and change, and secondly we need to understand it if we're going to invest in the company. How do they make money? What could go wrong? What could go right? What are the risks? What is the potential upside? Could they go broke? What do you need to watch out for?
• Circle of Competence: This one is important, and it is about whether you really should have high conviction about a company where you are not well positioned to fully understand the risks that the company faces - the risks to their industry, to their business model, or even the Key Person risk that someone with valuable IP, expertise or client relationships leaves the company and takes the IP, expertise or clients elsewhere. Stay within your circle of competence for the most part. Risks you don't know about or don't fully understand are usually the ones that get you. Nothing wrong with expanding/extending your circle of competence - I'm always trying to do that, but you need to know where those boundaries are. In my case, I rarely invest in biotechs any more, for that exact reason. My experience and knowledge of that industry is far too limited and I don't fully understand the risks. When I do invest, they need to be largely de-risked already, so be selling their devices or drugs to the public, hopefully in multiple countries, but even then milestone payments and the expectations of when they will be paid is often outside of my circle of competence, as I found out with Acrux (ACR) and their Axiron testosterone replacement therapy when the addressable market was significantly downsized by the FDA and Acrux's global Big Pharma partner (Eli Lilly) stopped promoting Acrux (because they expected more bang for their bucks elsewhere) and then dropped it altogether in 2017 (see here: Eli Lilly, Acrux terminate license deal for testosterone product Axiron | S&P Global Market Intelligence (spglobal.com))
• Have an Exit Strategy: So, know what would make you sell before it happpens, or analyse new data ASAP and make a sensible decision based on the known facts. Don't allow your investment thesis to keep changing to suit delays and other bad news (thesis creep). Also, don't be afraid to take some money off the table if you're well in the green and the risks have increased in your view. Don't be a bag holder that watched the company you invested in multi-bag and then go all the way back down again without you locking in any of those gains. Also, don't be afraid to take losses, if in all likelihood those losses are going to get worse if you continue to hold. Once an investment thesis is busted, it's busted. You can make the money back in ANOTHER company - you don't have to make it back in the same company. Always aim to have your investable money in your very best ideas at all times, with the caveat being that you don't want to be swapping and changing investments every week, day, or hour, so this one is a bit subjective, but the point is don't ride these things into the ground. Be disciplined around selling, not emotional.
• Debt: Microcaps and small caps with debt are particularly risky. Those are the ones that go broke the most. A company without debt can still go to the wall, but only if their sales are less than their spending and they can't raise any more money. And remember that not all debt is always on the balance sheet or fully disclosed to us. The debt that took Forge Group and RCR Tomlinson to the wall was undisclosed until they were already in deep trouble because it was mostly completion guarantees and contract penalties such as penalty payments they had to pay under their EPC contracts for missed or late milestones. Those sort of liabilities are often not considered debts until they are called upon, so they are not liabilities at all as long as everything goes to plan, but they become very real liabilities when things go pear-shaped as they did for RCR and Forge (who both ended up in administration and had their assets sold off by the administrators with shareholders who didn't sell prior to the final trading halt losing 100% of their investment). That "hidden debt" usually only applies to contracting companies, particularly engineering and construction contractors, but there would be other examples in other industries. Point being that companies with net cash (no net debt) are much better than tiny companies with significant net debt. Lots less risk with net cash.
• Industry Position: Even tiny companies can have a good or great industry position, particularly if they are a cashed-up disruptor with first mover advantage and a good business model. It depends on their chosen industry of course, but where they sit in the pecking order within that industry is important and should not be underestimated.
• Sticking to their knitting: Many of my losses have come from staying invested in companies who changed their business strategy or direction significantly. Whether it was a gold explorer who went into lithium or uranium instead, or a company that ploughed headlong into what seemed like an adjacent industry to what they were already doing, but where they had limited experience and they started carving out a decent market share quite rapidly against experienced incumbent players. Two examples of the latter are RCR heading into Solar Farm construction, and Forge going into Power Station EPC work; both undercut the incumbents to win market share and then went broke when they couldn't cover the cost blowouts they experienced and penalty payments and/or completion guarantees were triggered and became payable, and they didn't have the cash to pay them, and their banks withdrew their support. But it happens across many sectors. You generally want companies to stick to what they do best, and if they decide to expand on their offering, they should do so in a measured way, not plough headlong into a new area at pace. This is again subjective, and each situation has to be judged on its merits, but its definitely something to be aware of. It often happens after a management change, and it's often an orange flag, and sometimes a red flag. One positive is if the new management who are behind the change have extensive experience in the industry that they are driving the company into; that would be less concerning, but still worth a close look to see if it's really in the company's best interests.
• Have a good idea of value, or future value, and not just based on the company's own promotional material, presentations, announcements and website. If all of our research is within the sphere of what the company is saying about themselves plus broker reports from brokers who have worked for the company or hold shares in the company or who have placed significant clients' funds into the company, then we need to expand our research beyond that. We need to look at their competitors, their industry position, the macro risks around their industry, etc., and what people outside of the company (not their broker mates) are saying about the company. I don't often use the formulaic company valuation tools that others here use, and I am well aware that many metrics such as PE Ratios do not work well on pre-earnings companies, but whatever method you use, have some conviction that there's significant upside from your buy price, and be able to explain that conviction to a 7-year-old without confusing them too much. So have a clearly defined investment thesis that makes sense at the current buy price, before you buy, and then check regularly that the investment thesis hasn't been broken (or blown up). I tend to try to come up with sensible price targets based on the known facts and likely eventualities, then compare those with the current share price. The PT has to be significantly higher than the SP and the risks have to be reasonably low compared to the upside potential - in general - for me to buy. And sometimes it's worth using the same test to see if you should sell, but my main mistake with investing is not allowing my winners to run long enough and capping my profits by taking profits (such as trimming positions) too early, so I have to work on that one.

You may notice that I have put the value (valuation or price target) last, because that isn't the first thing I look at. Have a shopping list, then decide where your buy zones are, but there's no point working out if something looks cheap if it's something that screams "Danger Will Robinson! Danger!" on a bunch of other factors, or if it's not within your sphere of competence.

Additional:

• Management that Underpromise and Overdeliver are usually better than companies who share aspirational targets and keep pushing out timelines for milestones they've been promising for years. Companies that are too optimisitic or overly self-promotional are often prone to a more volatile share price and selldowns tend to feed on themselves, so good for trading or finding some low entry points but not so good for restful sleep at night. Companies that always give conservative guidance and then consistently beat it tend to be among my favourites.
• Consistent Reporting is also important. Companies that keep changing their reporting metrics to suit their latest results are harder to trust than companies that tell you what to watch and then stick to those metrics. Both Geoff Wilson and Matthew Kidman (Geoff Wilson's first co-Portfolio Manager at Wilson Asset Management in its early days - and now running Centennial Asset Management) tell the story of why they invested in ABC Learning (was ABC.asx, now the ticker code for Adelaide Brighton Cement) - which was because ABC Learning was a successful and fast growing roll-up play that was arbitraging the value that the market was willing to pay for a listed childcare centre compared to the lower prices they were able to acquire private childcare centres for - and why they sold out of ABC completely in 2006 - which was after Matthew attended an analyst briefing with Eddy Groves at a big brokerage firm and Eddy told them not to worry about occupancy levels, those weren't important, it was some new metric that was the key metric to watch. Matthew went back to the office and reported this to Geoff and they fully exited ABC Learning shortly afterwards. ABC went into Administration in 2008 when the GFC hit - because they couldn't service their massive debt. For some time Eddy had been saying to ignore the mounting debt and the P/E Ratio and the earnings margins that were moving up and down - and to concentrate instead on the occupancy levels, because if their centres were over 90% full, they would make a lot of money. Then when occupancy levels in their US Centres fell into the eighties (below 90%) he said, don't look there any more, look over here. Big Red Flag !! (See here: Another Aussie Investing Classic. « ROGER MONTGOMERY). There will be times when a metric is no longer a suitable gauge of a company's progress and success, and that's fair enough, however be wary of management who change their reporting metrics regularly or start to avoid reporting (or refuse to disclose) stuff - stuff that they had highlighted previously when it was positive - because that stuff is now no longer positive for them - like ARR - not mentioning any names here...

So, on average it might appear a bad place to play but if you know where to look the returns can be outstanding as proven by some of strawmans top members. The point of investing in microcaps or smaller market capped companies is that it reduces the chance of competition and increases the chance of mispricings. However, as you correctly point out, the hard part is finding and acting on these opportunities.

Yeah!

A lot of people seem to overestimate the extent of the inefficiency in the smaller end of the market – especially for story based stocks. In most cases it's probably cheap for a reason or your estimates (which you based off that PP presentation management gave LOL) are way too optimistic.

The real driver of returns is low expectations. How do you find low expectations? You look where no one else is. Then you turn over rocks. The rest is mostly just pattern recognition. But you need a model or models of what it is you're trying to find – not dogmatic rules but some sort of framework – otherwise the siren song of the stock story can be overwhelming.

I've never really tested this theory, but my observation would be it's easier for a $100m company to get to $1b than it is for $10m company to get to $100m. Down at the $10m level it's mostly buying either a small cap on its way to Heaven or embryonic businesses stuck together with Gaffer tape, having not much more than an idea and a need for cash.

I agree with you @UlladullaDave that many overestimate the inefficiency of the market at the smaller end, but the market gets things wrong at both ends, it just seems to get things MORE wrong at the smaller end when it does get things wrong, and that could be because there's less broker coverage so less guidance from so-called "trusted sources" and more jumping at shadows, so I find that while the market overshoots in both directions right across the board on a daily basis, it does so MORE at the smaller end. I agree however that given time the market usually sorts out an appropriate valuation for most companies, but it's not always an immediate adjustment. I've seen announcements recently where a company announces an acquisition and the market sells them down, and then they end up well in the green by the end of the day despite releasing no further news. Admittedly one of those companies I'm thinking of has a $1.5 billion market cap, so not a microcap, but it sometimes takes the market a while (hours or days) to decide if a move by a company is a net positive or a net negative and asign a new valuation to that company - there are often (but not always) opportunities if you've already done your homework and have that company on your shopping list.

Good points there about having a good investing framework and also about not falling in love with the story. I agree also with your comment concerning the $100m company vs the $10m company and their respective chances of 10-bagging - the $100m company has likely got a much stronger business model and proven strategy compared to the nanocap that has not weathered many storms at all yet or faced many serious headwinds. If a company has grown to $100m, they are likely to be a stronger and healthier company, and such companies have superior odds to 10-bag in my view also.

As an aside, in the spirit of celebrating our small wins, Today was a rare day for me, as I hold a total of 26 different companies across 4 real money portfolios that I manage and 24 of those companies finished today with higher share prices than yesterday. Interestingly, of the two that did NOT rise, one fell by two tenths of a cent - AVA (currently valued at around $40m by the market) - and one was flat - GNG ($379 market cap) - both microcaps. Nine of the 24 that rose, rose by more than +5%, and 7 of those 9 were companies worth over $1 billion, one (NCK) was worth $970m (after today's +7.25% SP rise) and the other one, which was my biggest winner today, was EGL (the Environmental Group) which finished the day up +8.89% with a market cap of just $91.5 million, so a microcap. Microcaps at the extremes but lots of larger companies making big moves as well. My second best was NST ($14 billion market cap), up +8.12% today.

Mind you, every sector was positive today:

Still, not often I only have one company in the red in one portfolio, one company flat, and all the rest in the green - not often at all! Time for a celebratory lemonade...

Hope others here also had a really positive day!