How to Hunt for Winning Stocks Where Index Trackers Can’t Follow (and 3 Charts I Like Now)

An exceptionally tight circle of mega-cap stocks dominate the benchmark averages. Because the passive indexing craze automatically funnels trillions of dollars right into the top of the S&P 500 Index ($SPX), the vast majority of the equity landscape has been completely starved of liquidity.

In my never-ending search for a road less travelled, I have spent more time this year becoming familiar with a part of the stock market I always thought of as “my father’s” – micro-cap stocks. Not because they are some old-fashioned way to invest. But because my late father, who taught me to chart when I was just 16 years old, treated them as his playground. Mostly stocks priced under $10 a share, and often with weird names and market caps under $2 billion. Sometimes well below that level.

While I’m not looking to replicate that high-wire act of the last Isbitts generation, I am taking more of an ETF wonk’s dive into the micro-cap segment. In part, because I’m sick and tired of a market fixated on a small number of mega-cap names. And as I said, I like to think of myself as an investing contrarian.

A clean vehicle to monitor this arena is the First Trust Dow Jones Select MicroCap Index Fund (FDM). Unlike traditional small-cap portfolios, FDM focuses strictly on the lowest market-cap deciles. The fund filters its universe based on explicit value and liquidity metrics, including price-earnings ratios and operating margins, offering a great layout to spot individual companies that have been entirely thrown out with the bathwater.

Check out that table above. I compared assets under management (labeled as “Market Capitalization” for ETFs) of FDM, the First Trust Capital Strength ETF (FTCS), and the Vanguard S&P 500 ETF (VOO). 

FDM has just $250 million in assets under management, compared to VOO, which is about 3,700x larger! I think it is fair to say that microcaps are quite a contrarian market area. In that case, count me in! And if the full ETF is priced at under 13x trailing earnings, I like my chances of finding some individual winners among its constituents. 

Why the Micro-Cap Space Matters Right Now

The beauty of the micro-cap space is its near-total insulation from the index mania. These businesses are typically too small to be picked up by the giant passive funds that dictate the daily movements of the broader market. When a multibillion-dollar algorithm rebalances, it ruthlessly buys or sells the mega-caps, while micro-caps sit quietly on the sidelines.

This creates a highly opportunistic environment for factual stock selection. They are detached from mega-cap hype. While the large-caps trade at extreme multiples priced for absolute perfection, micro-caps frequently trade at massive discounts relative to their actual cash flows and book values. And, because the passive crowd isn’t pumping or dumping these names based on thematic trends, individual stock pricing is driven almost entirely by the business’s standalone operational execution.

The ETF’s chart itself is encouraging. It looks better to me than many industries and sectors do.

The index tracker itself serves as an excellent shopping list. By checking the holdings inside FDM, you can pinpoint companies with real balance sheets that are trading at single-digit multiples simply because the market has ignored them.

Here are a few charts from within those holdings which look higher to me. As a reminder, if you simply click on the Flipcharts feature here, you will be taken to a page where you can quickly fly through the charts. 

Take a look at Deluxe (DLX), a $1 billion stock that used to be in the check-printing business. Today, it is a micro-cap selling at less than 7x trailing earnings. Plus, it has a chart chugging toward what I’d call attractive. 

Business First Bancshares (BFST) is a Baton Rouge, Louisiana-based bank, and it appears to be setting up to ride the coattails of a larger bank stock rally. Why? The increasing tilt toward lower interest rates, as per the U.S. Treasury bond market. 

LSI Industries (LYTS) is a sub-$1 billion market cap stock that just broke out to a new high level. 

When you move away from the massive indexes and target this micro-cap space, your stock-picking process has to evolve. You cannot treat these names with the same long-term complacency you might apply to a giant utility or consumer staple.

Because micro-cap liquidity is structurally thinner, the price action can be highly erratic. To capture the upside without exposing your capital to unnecessary risk, keep your position sizes tightly equal-weighted and focus on shorter tactical horizons to harvest gains when a specific company hits its turning point. Let the passive crowd chase the over-concentrated heavyweights at the top of the cycle, while you use the data inside FDM to locate the true mispricings.

Rob Isbitts created the ROAR Score, based on his 40+ years of technical analysis experience. ROAR helps DIY investors manage risk and create their own portfolios. For Rob’s written research, check out ETFYourself.com.