An asset class often overlooked by investors is micro-cap stocks; also known as the lottery stocks. I refer to them as lottery stocks because when an investor buys a micro-cap stock, it can be considered similar to buying a lottery ticket.
The definition of a micro-cap stock varies depending on where you look, but on average any stock with a market capitalization below $300 million will fall into the category. This makes investing in micro-cap stocks more risky than their peers, because micro caps are typically in their infancy stage or on their way down from being a larger company at one point.

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I feel there is room for micro-cap stocks in your portfolio, and this can be accomplished in one of two ways. The first option is to buy an ETF composed of a large basket of micro-cap stocks and track the entire asset class. The second, and more risky of the two, is to buy an individual micro-cap stock that has the fundamentals and technicals behind it.

Microcap ETFs
Currently three ETFs invest in the micro-cap sector: iShares Russell Micro-cap Index ETF (NYSE: IWC), PowerShares Zacks Mico-cap ETF (NYSE: PZI) and the First Trust Dow Jones Micro-cap ETF (NYSE: FDM). Of the three micro-cap ETFs, IWC is the most popular with the majority of assets in the sector. IWC is composed of over 1,300 micro-cap stocks, and the largest holding, Dana Holdings (NYSE: DAN), only makes up 0.7 percent of the entire portfolio. The diversification removes any company-specific risk that may be associated with a typical micro-cap stock.

To give you an idea of how IWC has performed versus the other asset classes, we can look at the last few years. Year-to-date in 2010, IWC is up 5 percent as the SPDR S&P 500 ETF (NYSE: SPY) fell 2 percent. In 2009, the SPY gained 23 percent and IWC gained 22 percent. During the rough year of 2008, the SPY fell 38 percent and IWC tumbled 40 percent. The numbers show the micro-cap stocks following the overall market recently, but that will not always be the case.

Stock-Picking Micros
After analyzing a large number of the stocks in the micro-cap sector, it was clear that an overwhelming number of them are junior biotech and medical equipment companies. This type of investing can be very risky as well as lucrative. The four stocks I chose are all included in IWC's allocation, and keep in mind they may have a market cap above $300 million at this time as they have grown over the last year.

Penwest Pharmaceutical (Nasdaq: PPCO) is a true micro cap with a market cap of only $110 million that focuses on drug development. Its proprietary drug delivery system could be the product that helps launch the company, but along with the reliance on one product comes big risk. The stock fell as low as 37 cents in 2008 and has since been in an uptrend to the $3.50 area.

DexCom (Nasdaq: DXCM) is also in the healthcare sector, a maker of medical devices that offer continuous monitoring of glucose for people with or without diabetes. The device is used by patients at home or by medical professionals. The stock hit a multi-year high recently and technically is very strong.

Terremark Worldwide (Nasdaq: TMRK) provides IT infrastructure services around the globe and is often considered a cloud computing stock. The company has recently inked deals in Europe and Latin America as it continues to expand, and the stock price has not disappointed.

Support.Com (Nasdaq: SPRT) helps businesses with technology issues via the internet and telephone. Sounds like a great business plan considering the issues my company runs into on a consistent basis. The volume has also picked up for the stock as it recently hit a new two-year high. (For related reading, check out How To Evaluate A Micro-Cap Company.)

Keep in mind the high risk with the four individual stocks, and if you are not the type of investor that can stomach a large loss, I suggest you go with IWC for your exposure to lottery-ticket stocks. (For more, see Finding Undiscovered Stocks.)

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

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