Think big. That is the motto most successful investors live by. But sometimes, big ideas and big investment returns come in small packages. In this article, you will learn how you can find and evaluate a winner in the micro-cap market.

Micro-caps can provide significant diversification to your portfolio. This asset class typically has very low correlations with other U.S. equity classes (as low as 0.60 versus the S&P 500 for the period 1972-2006), as well as low correlations with international equity and fixed-income securities. As Figure 1 shows, however, micro-caps carry higher risks than many other asset classes.

Analyzing Micro Caps

Micro-cap companies dont generate fat investment banking fees for Wall Street firms, so they rarely enjoy regular research coverage by analysts. As a result, it can take more time and effort to analyze a small company than a large one, and fewer published reports means an investor must do more original research. The result, however, is that micro-cap stocks often dont trade at their full values, creating a price inefficiency from which savvy investors can benefit.

When it comes to analyzing a micro-cap company, the approach is the same as for a larger company; only what you emphasize in this analysis will differ. Like any potential investment, you might start out by assessing the current stock price against its 52-week high/low trading range. You might glance at valuation ratios, such as the price/earnings multiple or price/book multiple, to see if the stock looks cheap or expensive. Youll probably review the companys financial statements to learn how much net profit is being earned on revenues, how high debt levels are compared to the companys capital base and whether the company is generating cash or burning it .

Not Making Money?

What you may discover is that many micro-cap companies arent making money yet. Earnings are probably negative, so the traditional stock valuation ratios wont make sense. You may also notice a sizable deficit in shareholders equity, where a positive number ought to be. Dont be too alarmed! These may be signs that the company is in its early stages of fast-paced growth.

With a micro-cap company, how you spend your research time gets turned upside-down. Unlike with large cap companies, for which historical financial performance is a window to the future, non-financial information holds much more value when looking at a micro-cap stock. You should spend 80% of your effort understanding the companys business strategy and business model, ensuring the management team is the right one to pull it off, making certain the industry in which the company operates is sizable and growing, and judging how or whether it is better than its competitors. You should spend only 20% of your time looking at current financial results.

For a small, expanding company, financial statements are out-of-date the minute theyre filed. Be sure, however, that the company does file financial reports with the SEC, and that it does so on time. When an OTCBB company doesnt file timely reports, it is given a short grace period by the regulators but is then removed from the exchange. Delayed filings, as well as unusual auditing issues, are major red flags.

It is critical to stay informed on consumer and industry trends, if you are to be successful in choosing the winners from the losers. Technological advances and changes in consumer tastes and lifestyles can make or break even the strongest companies. Future-focused studies, like the predictions of trend-guru Faith Popcorn. can clue you in to the latest brands, attitudes and ideas about to rock the world.

Questions to think about include:

• Has this company invented a compelling product or service that taps a unique niche in the market place?