Market cap is short for market capitalization, and this number portrays a company’s valuation as determined by share holders. The number is calculated by multiplying the number of outstanding shares by the share price. The implications of the market cap are much different for bigger stocks than they are for penny stocks. After trading penny stocks for some time now, here are my thoughts on market cap.
Why Market Cap Matters
A company’s market cap is important because it represents the valuation of a company. If the market cap is $100 million, than the company is valued at $100 million. As a diligent investor, I always look at the market cap to see if I believe that it accurately reflects the company’s true value. Since I also invest in, build, and sell my own private companies, I have a basic understanding of what a company should be valued at. So, if a company is valued at $100 million dollars, I have to ask myself whether or not I would pay that price for the company in a private transaction. More often than not, when researching penny stocks, the answer is no. Companies with zero revenues are often valued at millions of dollars. Unless the company is in the biotech industry, or some other field where revenues come later in the business life cycle, this makes absolutely no sense. Contrarily, some companies are valued at only a few million dollars when they already have a few million dollars in revenues/profits. When I am trading based on market cap, I look for companies that are undervalued and avoid companies that are overvalued. This tactic has helped me find some undervalued companies at their bottom prices. Some of these companies eventually run 1000-2000% in a matter of weeks. By looking for undervalued companies, you can gain a competitive edge by investing in these companies before the rest of the market catches on to the true value. You can also avoid investing in overvalued companies that are due for a crash. Keep in mind, that a companies market cap, be it overvalued or undervalued, will not always dictate the future price action, which is why I will be discussing why market cap does not matter.
Why Market Cap Does Not Matter
When I started investing in penny stocks, I assigned a lot of weight to the market cap of a company. I would avoid overvalued companies, and buy into undervalued companies. Considering that my investing roots are planted in small cap and large cap stocks, this seemed like a sound strategy. I was always baffled when the market would allow terrible companies to reach multimillion dollar market caps. Eventually, I realized that a company’s true value is not as important in penny stocks.
Most people are not “investing” in these companies, they are just trading them. When price action shifts upward, new investors jump on board. When stocks are breaking out, no one is taking the time to look at the market cap to ensure that the company remains properly valued. This is most apparent in the runs of marijuana stocks during early 2014. Penny stock traders sent marijuana stocks surging by 1000-2000% without thinking twice about the market cap. These investors didn’t care that the companies had no revenue or anything to justify their new market caps. They saw a hot sector and they played it accordingly.
On the opposite end of the spectrum, I have found quite a few undervalued companies that never reached their full potential. Some of these companies had revenues and product inventories that exceeded the value of their market cap, yet the companies never experienced any breakouts because there was no hype surrounding them. Simply put, penny stock traders go where the hype is. They follow the price action. If an undervalued company trades sideways for months, there is not much incentive to invest in it.
Looking at a company’s market cap is part of doing thorough due diligence, whether the market appreciates the company’s true value or not. Personally, I try to find undervalued companies that may be prone to a future breakout. I either invest in these companies or add them to my watch list. When these companies run, I increase my positions significantly. In this aspect, I use a market cap as somewhat of a safety net. If you buy into an overvalued company that starts to run, you are exposing yourself to a lot of risk. At one point, investors and traders could get bored and the stock could return to its true value. If you buy into an undervalued company during a breakout, you have a lot less risk, as the breakout may be responsible for taking the company to its true value. Of course, nothing is ever certain in investing, especially in penny stock markets, but strategies like this have helped me experience some great gains.