I've just added Resonance Health (ASX: RHT) to the long list of micro-cap companies I've looked at, decided not to buy, then watched go through the roof. Last Friday the hopeful biotech opened the day at 2.7 cents, and closed at 8.2 cents, a gain of over 200%. The catalyst was the announcement of approval for the company's HepaFat-Scan by the US Food and Drug Administration. Shares closed on Monday at 6.3 cents, giving the company a market capitalisation of $23 million.
The company is neither profitable nor cash flow positive, but is collecting revenue from its existing FerriScan product. FerriScan is a diagnostic tool that allows doctors to make a highly accurate measure of liver iron concentration. In particular, this is a useful tool for patients who have received multiple blood transfusions, as this can result in a build-up of iron in the liver.
As with so many of the small companies I look at, I decided not to buy shares in Resonance Health because it was neither making a profit, nor cash flow positive. I'm simply not yet at the level, as an analyst, where I'm able to accurately value a company before its even made a dollar. However, as the highly volatile share price shows, shares in pre-profit, speculative companies are often priced on sentiment, rather than logic.
On the other hand, I think it makes sense to keep an eye out for companies that are about to report their first profit (or positive cash flow). That's because when a company passes that inflection point, it is often in a position to grow profits rapidly, at least for one more year. However, sentiment often dominates pricing, so prepare for a bumpy ride.
One example of this is Atcor Medical (ASX: ACG). The company sells a medical device, SphygmoCor, which allows non-invasive measurement of central aortic blood pressure. Essentially, this is a more accurate measure of blood pressure than the traditional manual one that most of us have had around our upper arm when visiting the doctor. Atcor reported its maiden profit in FY 2013, although it did benefit from a grant, a research and development rebate, foreign exchange gains and interest on its cash holdings.
I picked up some shares in Atcor Medical at under 10 cents once it became clear it was cash flow positive in FY 2013, as there was a small window of opportunity before the market caught on. Shares rocketed up to a high of 23 cents in the subsequent months, but save your admiration: I sold for a far more modest gain, demonstrating the mismatch between my method of valuation and the sentiment driven share price. At the current price of 16.5 cents, I think the market is quite optimistic about the company's prospects.
I sold my shares (for less than the current price) because I had concerns about competition and whether the company will be able to market the product to GPs. At the moment, the most important source of revenue for Atcor Medical are the proponents of pharmaceutical clinical trials, who use SphygmoCor to monitor patients.
Instead, I've settled on Global Health (ASX: GLH) for the main micro-cap in my portfolio. The company provides record keeping and secure communication software (as a service) for the medical industry. Its main clients are hospitals and mental health practices.
I like Global Health because a substantial portion of sales create recurring revenue, so there is (theoretically) more security that revenues will grow from year-to-year. As with Atcor, Global Health reported its maiden profit in 2013 and as a tiny company is vulnerable to mishaps. Unlike Atcor group, Global Health didn't benefit from grants and research and development incentives.
Foolish takeaway
Resonance Health, Atcor Medical and Global Health are all interesting micro-caps that are firmly on my watch list. I would consider buying Resonance shares once the company becomes cash flow positive, but by then, the opportunity may have passed. Investors should be careful buying tiny companies, as it's easy to allow your excitement (or fear) to get the better of you. Foolish investors should focus on stable, profitable companies with proven business models and the potential for sustained growth at a reasonable price.
