Buy and Hold Strategies for Micro-Cap Stocks

The thought of developing strategies for buying and holding micro-cap or penny stocks may seem strange.  After all, most micro-cap traders are swing traders who don’t usually hold any stock for more than a couple of days.  There are plenty of good reasons for this strategy.  Swing trading suits the kind of technical analysis that works well with penny stocks; it keeps investment funds fluid and available; it allows for profit-taking on relatively small, short-term fluctuations in stock prices; and it minimizes risk.

Swing trading, then, is clearly an intelligent approach to most micro-cap investing.  However, more and more players in the micro-cap world are recognizing that it can be a smart idea to supplement their swing trading with a more traditional buy and hold posture for a segment of their investment portfolio.

Why a Selective Buy and Hold Strategy Makes Sense

There’s a very simple reason why savvy micro-cap investors are developing buy and hold strategies: the promise of very large returns on investment.

Of course most penny stocks don’t show much volatility or price fluctuation at all—and that is why profit-taking on small shifts in price is generally the order of the day where they are concerned.  However, there have been plenty of micro-cap stocks that really made good and rewarded investors with substantial returns over the long term.

Some believe that the high-yield micro-cap stock is a myth— that it’s the El Dorado of modern times.  Others believe that if such a beast ever existed, it breathed its last with the end of the dotcom explosion.  But the high-yield penny stock is neither a myth nor an extinct creature.  The New York Times recently challenged its readers to identify bona fide penny stocks (i.e. not stocks trading under $1 due to a split) that had really taken off.  The responses came fast, and included examples like: Imclone (Nasdaq: IMCL), Nutrisystem (Nasdaq: NTRI), Mylan Labs (NYSE: MYL), Titanium Metals (NYSE: TIE), and plenty of others.

Obviously these kinds of cases are the exception rather than the rule.  But they are not the only cases and they won’t be the last.  There are other opportunities of this kind in the market today, and if you’re relying exclusively on swing trading you’ll miss them.

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What Counts as Holding?

There aren’t any hard and fast rules about the length of time that an investor should plan to hold any given stock.  Some of the examples mentioned above took off fairly quickly and others rose in value steadily over a period of several years.  Generally speaking, however, experts agree that, if you are going to adopt a hold-posture at all, you should plan on sitting tight for at least six months.  Any shorter period of time doesn’t give a position enough time to develop sufficiently to off-set the increased risk associated with holding or the inconvenience of taking a portion of your investment capital out of play.

Challenges of Adopting a Buy and Hold Strategy

While adopting a buy and hold strategy with some micro-cap or penny stocks can make sense and yield large rewards, there are also significant challenges to be faced.  The single greatest challenge concerns locating the type of information required to make wise choices about which stocks to hold.

Most short-term trading relies solely on technical analysis of market action such as price fluctuations and trading volume.  In effect, when you’re relying on technical analysis the actual nature of the company (its product, market, financial position, competitive position, leadership, etc.) is ignored and buy/sell decisions are based on complex algorithms predicting patterns of price fluctuation.  Longer term investing, however, tends to be built on fundamental analysis—that is, analysis of exactly those features of a company that technical analysis ignores.

But this kind of information can be unavailable, difficult to obtain, or very sketchy with regard to micro-cap companies.  While analysts with large brokerage houses will offer reports on larger stocks, these analysts generally ignore penny stocks.  And while micro-cap companies must submit SEC filings (10Qs and 10Ks, for example), these tend to be very minimal and bare-bones.  What’s more, very few micro-cap stocks have what would traditionally be considered “good fundamentals.”  They are generally newer companies, have low market capitalization, they are thinly traded, represent generally high risk, and they are almost never profitable.

Alternative Fundamental Analysis and Overall Strategy

The fact that most micro-cap companies do not have traditionally good fundamentals does not mean, however, that they are not excellent investments.  Nor does the fact that the traditional type of fundamental analysis is not always very helpful in researching these companies mean that traders cannot engage in fundamental analysis.  What it does mean is that traders will need to adopt an alternative type of fundamental analysis.

Instead of relying on traditional measures of a company’s strength—such as year-to-year profitability—a micro-cap trader will need to investigate a company’s potential for achieving profitability in the future.  The factors informing this judgment will include the quality and experience of the management team, the nature of the company’s product or service, the competitive landscape, and whether the company has an aggressive and intelligent marketing plan.  Micro-cap traders will also engage in so-called “front page” analysis—paying attention to general economic/political/social trends that might affect the company and to any buzz concerning the company.

Using this type of information, it’s possible for savvy micro-cap traders to make informed and intelligent decisions about which penny stocks they may want to hold.  This will allow them to adopt something like the type of mixed overall strategy that is common when investing in any other type of stock.  Some micro-cap stocks will be kept for the long haul (i.e. at least six months) and some will be swing traded.  And if there are stocks that show signs of immediate growth as well as potential for longer term growth, savvy traders will split the investment by swing trading half of their position and keeping the other half for longer-term gains.