Investing in tiny stocks can be extremely rewarding for diligent, patient investors. However, at times it can also be a volatile, frustrating, and slow strategy for building wealth. Even a solid, well-planned, research-driven investment approach will occasionally produce poor results. Investing styles go in and out of favor, and no single strategy is fail-proof at all times. Inevitably, even the best investors will suffer through periods where their philosophy generates sub-par returns. To compound matters, other techniques may suddenly appear to work more effectively. During those types of challenging times, it is imperative not to stray from your original strategy. After you formulate a well-thought-out investment plan, you should adhere to it regardless of current trends, because the frequent changing of investment methodologies will ultimately lead to dismal results.

With that in mind, I want to discuss one potentially profitable, but faith-challenging system that requires extreme patience -- buying and selling illiquid stocks. Investors in this arena should be prepared for an emotional fight, because the two powerful forces of fear and greed will always be present. History has taught us that these emotions, if not kept in check, can destroy a portfolio.

Many will likely remember the boom in dot-com and technology stocks that occurred in the late 1990s. Greed drove many investors to chase shares of these high-flying companies regardless of their valuation levels. However, when the grossly over-inflated share prices came crashing back to earth, the results were devastating.

During the height of the market bubble, many folks on Wall Street began to question whether legendary value investor Warren Buffett had lost his touch. To many, his stubborn avoidance of technology stocks seemed like old-fashioned thinking -- an assertion that was reinforced by his lagging performance during that period. However, when the bubble finally came to an end, Buffett's style was again vindicated. In the same way, we should all strive to develop a strategy that plays to our core areas of expertise. After doing so, we should remain committed to our strategy regardless of what the rest of folks on Wall Street are doing.

As the name implies, my weekly newsletter -- Undiscovered Micro-Cap Gems -- is dedicated to finding promising investment ideas among the market's smallest companies. I uncover many of these stocks with the aid of sophisticated data mining tools and financial modeling techniques. This process allows me to obtain and identify actionable investment information before the rest of the market catches on. In many cases, my research enables me to uncover attractive stocks that reside in the most neglected and illiquid of all sectors -- nano-caps. These tiny, thinly traded firms have market capitalizations under $50 million, and sometimes even below $10 million.

Throughout my weekly newsletter I sometimes profile companies that trade in a controversial corner of the investment universe -- the pink sheets. The pink sheet market is often maligned, and in most cases deservedly so. This exchange has historically been littered with fraudulent and bankrupt shell companies. However, amid the rubble, there are also a few diamonds in the rough that are worthy of inclusion in the portfolios of patient, long-term investors.

Increasingly, many small firms are being forced to de-list their shares because of the costs associated with compliance of excessive government regulations. Trying to stay compliant with new Sarbanes Oxley regulations can be a costly and time-consuming distraction for managers. After all, these managers are also trying to run and develop a successful business in a highly competitive global economy. As a result of these and other burdensome costs associated with being listed on one of the major exchanges, many small companies across the country are increasingly deciding to de-list their shares.

When a company de-registers its shares and becomes listed on the pink sheets, it is said to "go dark" because it no longer has any financial reporting or disclosure responsibilities to either the SEC or shareholders. Providing timely, audited financial statements is no longer required.

Many institutional accounts have bylaws that restrict them from making investments in pink sheet stocks. As a result, the shares of companies that are moved to the pink sheets are typically subjected to a wave of selling pressure. Often, this forced selling drives stock prices down sharply, allowing value-minded investors the opportunity to buy shares at unbelievable discounts to their intrinsic values.

Although companies that trade on the pink sheets have little or no transparency, most of them are still real businesses with employees, sales, and in some cases even earnings that can be purchased for pennies on the dollar. For those not caught up in getting quotes and seeing a certain level of trading volume every day, overlooked pink sheet stocks can be a profitable way to capitalize on the fear of others.

Now more than ever, investors willing to do their homework can uncover extremely cheap, quality stocks listed on the pink sheets. Patience and research are the keys to successful trading in this area. After all, the wheat must first be separated from the chaff, and even then it may take considerable time for the market to correct the prices of those stocks that have been grossly undervalued.

In my own personal investing, I generally purchase undervalued pink sheet stocks with the intention of holding them for a period of roughly 3-5 years. Because these stocks can remain inefficiently priced for extended periods of time and have very little volume, I've found that it is best to approach them with the mentality of an owner, rather than a trader.

Furthermore, the discrepancy between the bid/ask price -- or what the shares can be sold/bought for -- can be substantial, so entering a market order can sometimes be a mistake. Instead, I generally use limit orders in an effort to lock in more advantageous prices. Investors who use this strategy need to be prepared to wait, though, as it can sometimes take weeks or even months to accumulate a position.

In my recent analysis I've managed to uncover numerous examples of pink sheet stocks that may ultimately prove to be solid long-term investments. In the table below I've provided a list of 15 stocks that may serve as a good starting point for further research:

In a diversified portfolio, I believe it may be worthwhile to make room for illiquid stocks. Over time, a host of academic and market research has supported this view. For example, over the last forty years, studies have indicated that nano-cap stocks have outperformed the broader market averages by more than 2% annually -- a sizeable advantage over time.

In my opinion, this advantage can be magnified by careful stock selection and prudent timing. Ignorance and impatient, irrational speculation run deep with many who invest in thinly traded nano-cap stocks. Furthermore, all it takes is one individual or an institution to place a market order -- possibly just to raise cash -- and the market value of an otherwise sound business can be driven far below its intrinsic value. Take advantage of this overreaction by waiting patiently and then fighting to buy at the right price. Though it can take years for the shares to reach their true value, occasionally good news will cause a company to rally much sooner. In that case, don't be afraid to pocket some well-deserved profits!

Again, buying illiquid stocks is not for the impatient. Many simply get bored watching the shares of small companies go nowhere day after day. However, those who take on the mindset of an owner -- rather than the holder of a lottery ticket – shouldn't mind the lack of an active market, as they are not necessarily looking to buy or sell in a moment's notice to the first willing investor.

Furthermore, it's comforting to know that these stocks are typically shielded from the dramatic impact often caused by large institutional traders. Multi-billion dollar portfolios, for example, would see a virtually negligible impact from the inclusion of such tiny holdings. As such, those who oversee them are usually forced to chase bigger game. Warren Buffett, for example, would love to have the luxury of exploiting the advantages inherent to this sector. In fact, Buffett has even claimed that he could earn +50% a year if he were able to manage a relatively modest portfolio of small companies.

Investing in overlooked and unloved micro-cap stocks can be rewarding over the long run, but can also present challenges at times. This year has been a particularly challenging one. However, that shouldn't come as a huge surprise, as the micro-cap sector has enjoyed a tremendous run-up over the last three years. As such, we were bound to see a short-term pullback.

Not only are micro-cap stocks attracting closer scrutiny from investors seeking to profit from their inefficient pricing, but many investors are also taking the opportunity to lock in profits. In fact, micro-cap value has been the market's worst performing sector lately, posting a -5% loss in the year-to-date period.

Nevertheless, attractive opportunities abound in this often undervalued area. In the end, investing is a competition, so why not compete in the overlooked micro-cap sector? After all, this is often a turf filled with weaker players who lack the time, expertise, or resources to conduct thorough, quality research. As a result, savvy investors are often able to earn outsized gains by investing in small, overlooked securities. I sincerely hope that I've been able to help you spot at least a few of these "undiscovered gems."

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Important Note: The above article was merely a small excerpt from a recent issue we sent to subscribers of our premium value investing service -- Margin-of-Safety Investing. In each issue of that newsletter, editors Nathan Slaughter and Paul Tracy deliver an in-depth look at a variety of other deeply discounted stocks that should provide investors with a solid margin of safety at current prices. To receive your copy of our most recent issue of Margin-of-Safety Investing, as well as other guidance similar to this twice per month, you'll need to subscribe to this publication. To learn more, please visit:
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Thanks for reading!

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