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Investing in Small-Cap Stocks
Over my many years of stock picking, I have developed these rules for investing in small-cap stocks that have helped me amass extraordinary returns for my clients. I apply these rules, each requiring tremendous research, to every stock I recommend in Cabot Small-Cap Confidential. I urge you to use them to become a smarter, savvier, and wealthier investor.
1. Search for paradigm shifts that are opening up new opportunities
I search for paradigm shifts in any field of business that requires a unique, new solution that will be provided by a stand-alone company. I then seek a niche supplier that will become an equal benefactor to that pioneering company.
A good example of such a paradigm shift was the move from the mainframe computer environment to the personal computer environment in the 1990s. All the new personal computers needed to be connected! And Cisco filled the void, supplying the industry with networking tools and its stock increased 70-fold. Another example was the move from CD to DVD format. Sonic Solutions provided the software for conversion to the new DVD format and its stock took off. In the consumer market, energy drinks burst on the scene in the late 1990s, giving the industry its first truly new product in decades. Hansen Natural stepped in to become the leader and its stock has been one of the best performers of the post-2002 bull market.
For Cabot Small-Cap Confidential, I dig deep to uncover the small company suppliers to the transition leaders—just as the top suppliers to Cisco, Sonic Solutions and Hansen became equal beneficiaries of the paradigm shifts, yet remained largely unnoticed by institutional investors until well into their industry transitions.
2. Invest only when the market opportunity is huge—and quantifiable
This is my Law of Large Numbers: Only invest in small companies that serve large, burgeoning markets because you can realize tremendous growth with even small shares of the market. The sheer size of these markets creates the potential for huge gains while helping to reduce your risk profile.
Large medical patient populations and new technology users are examples of vast markets to target. Here’s an example: By the age of 60, half of all men will have an enlarged prostate, a condition known as Benign Prostatic Hyperplasia (BPH). Research tells us that treatment for this condition will cost upward of $10 billion per year. The opportunity for a small company that captures even a fraction of this market would be enormous.
3. Invest in companies before the institutions notice them
I call this small cap strategy robbing the train before it arrives at the station. By applying my research advantage, I invest in companies before most big investors get on board—including mutual funds, hedge funds, and pensions.
I want to find stocks that institutions are attracted to, but in which they have yet to accumulate their stakes. So I seek small companies with less than 40% institutional ownership, and build my position before the majority of institutions recognize the opportunity. Subsequent investments by the institutions will drive up the value of the stock.
4. Measure the company, not the stock price
While some investors perceive low stock prices as bargains, I place stock price low on the hierarchy of importance. To put this in perspective, if my goal is to be rewarded for stock-investing prowess, why start with a handicap? A company with no earnings only contributes to risk and potential loss of capital.
However, one important clarification needs to be made. Many stocks that increase 5, 10, and 20 times their original value don’t show earnings right away. It’s part of the cycle of growth inherent to small emerging companies. For this reason, selecting a company with the right product and valid market opportunity is often far more important than positive earnings. Such a company may incur losses until the market accepts the product. At that point, the losses will turn into rapidly growing earnings.
5. Invest in small cap stocks that offer both growth and value
I seek big, growth-oriented ideas but I also apply value measurements to my candidates. A good candidate is a young company that has demonstrated significant growth in sales, yet is undervalued based on the company’s market potential versus its total market capitalization.
I also want to see a balance sheet with cash and little, if any, debt. Cash is important because it can carry a company through unexpected events. For example, should the much-anticipated launch of a product be delayed, I want the company to have enough cash available to see the product to market.
6. Validate market acceptance of the product
Market acceptance of a company’s product must be validated, never judged solely from my own viewpoint. The best way to do that is by looking at customer relationships, specifically OEM (Original Equipment Manufacture) deals.
OEM firms integrate a component product into a larger final product (think of semiconductors into personal computers). If an established OEM has a supply deal with our company, it provides tremendous recognition and product endorsement, as well as an inside view of the customer’s product plans. Like annuities, these supply deals provide predictable, stable flows of revenue over time. An OEM contract also offers the ability to raise prices to meet demand and can therefore contribute to even higher revenue rates.
7. Research what the institutions are holding
Mutual funds spend significant amounts of money researching companies and industries for stocks to include in their portfolios. By studying the individual stocks in the 13-F HR reports that mutual funds must file with the SEC, I can gain a sense of what industries and products they’re following—and what could become interesting to additional institutions in the future.
8. Invest in small cap stocks at the right time in the product cycle
The point at which you invest in a small cap stock is critical to your success. There is a direct correlation between the time of investment and the degree of risk and rate of return you can expect.
Generally, I consider the time period after venture capital investors come aboard to be the most promising point of investment. The most likely point to sell is after institutions have begun to invest en masse and driven up the price of the stock.
Here’s an ideal scenario: An industry has hit a roadblock and needs new technologies or products to keep growing. My targeted company offers a new and fresh solution that will be adopted, in time, by the industry leaders.
9. Concentrate on the very best ideas
When I take positions in stocks, I buy large amounts because I’ve found that few stocks meet my high standards for quality as investment candidates.
I’m not alone in my investment perspective; Warren Buffet buys approximately 12 stocks a year and only acquires large stakes, often controlling positions in his companies. Taking size in any stock is predicated on research. The more I know about the company, the markets served, and the competitive landscape, the more shares I can add to my holdings.
10. Keep our research current
All the preparatory research work I’ve elaborated is dynamic leading up to the stock purchase. As my companies do not operate in a vacuum, my research efforts must continue to confirm our company’s superiority.
And here are three ways I stay ahead of my investments:
I keep an open dialog with the officers of the company on a quarterly basis and look for clues indicating the pulse of the company. I pay close attention to tone of voice and level of enthusiasm as the officers respond to my questions. If their answers are upbeat instead of reserved, it’s a good indication business is picking up. If, on the other hand, they’re very zealous in their forecasts and spend enormous amounts of time on the phone, then perhaps there isn’t enough business to keep them busy.
I assess ongoing business conditions by viewing the company’s operating statements. Sales are the first indication of the wellness of the company. I compare the company’s revenues over the past quarter to the prior quarter to determine if they are growing sequentially. I make sure there’s parity between the growth rate of sales and receivables, as the two benchmarks should track each other in terms of percentage growth. If the sales are genuine, I move on to margins to ensure current gross margins are stable to rising versus the immediate past quarter.
My final health check is for any emerging technology coming that could leapfrog the company’s proprietary position in the marketplace. I gain a sense of what technologies are present or in the works by reading trade journals that are specific to my sector and going to the websites of venture capital firms to see what new technologies they’re investing in.
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Thomas Garrity
Small Cap Investment Specialist, Analyst and
Editor of Cabot Small-Cap Confidential
Tom Garrity is analyst and editor of the limited-subscription newsletter, Cabot Small-Cap Confidential. A lifelong investor, Tom has been a stockbroker, stock analyst, venture capitalist, and portfolio manager. His long career and varied experiences taught Tom to make investments only when the odds of winning significantly outweigh the risks. He applies this philosophy to every stock he recommends in Cabot Small-Cap Confidential.
Editors Note: According to the Associated Press, "Small-cap value funds have a return of 20.4% and small-cap growth funds are showing a return of 15.2%. Small-cap stocks often lead the stock market out of slumps as investors look to capitalize on companies that could see quick strengthening of their business."
Did you know that the Dow is up 33% in the past six months, while the S&P 500 is up 38%?
Even better, do you realize the undiscovered stocks in Cabot Small-Cap Confidential are up 93%?
Laszlo Birinyi of Forbes magazine says, "This recovery has been the strongest of the last 45 years, gaining 44% in 100 trading days (March 9
to July 29). Even the rally that kicked off the 1982--2000 bull market had gained only 38% at its 100-day mark."
If you're still sitting on the sideline, waiting for the news to get better, stop waiting. It's time to put your money to work.
The best place to put it, if you really want it to grow, is in undiscovered small-cap stocks. Over the past 79 years, small-cap stocks
have outperformed large-cap stocks by 165%.
And the best time to start is now.
So today I've got a Special Offer designed to help you get back in the market, and back to investing in stocks that can help you recover what the bear market took away.
But first let me tell you why small-cap stocks are such powerful moneymaking instruments.
They outperform the broad market--all those familiar, fully valued names--because they start out unknown and undervalued. It's the buying of
eagle-eyed prospectors that first gets them moving. And it's the buying of institutions--like pension plans and mutual funds--that finally
catapults them into the big-time.
If you wait until stocks are well known, it will be too late; you'll never achieve these kinds of gains.
But if you've got the courage to buy high-potential small-cap stocks--and the patience to hold them--then I can promise you great success.
For example, back in October, when our financial world was crumbling and stocks were under heavy selling pressure, Cabot Small-Cap Confidential editor Tom Garrity recommended Orthovita (VITA), a little company in the bone healing business, writing this:
"Orthovita not only makes some of the most advanced synthetic bone graft materials on the market, it also makes a better load-bearing bone cement for use in spine repairs. And almost as a bonus, Orthovita has a thriving topical hemostat business. Hemostats are used to stop bleeding during surgery. It may not sound glamorous or revolutionary, but if you've ever watched a hospital drama, you can understand why it's a $589 million market.
"And finally there's Orthovita's possibly even-less-glamorous bone marrow harvesting needle-which is just what it sounds like. The needle is
evidence of the intelligence present at the top levels of the company. Why? Well, surgeons need to extract bone marrow to use some of Orthovita's other products, so why not sell them the tool they're going to use?
"It's part of Orthovita's strategy for becoming a premier technology supplier to the lucrative and growing orthopedic and spine surgery
markets, and we like the way they think! Of course it doesn't hurt that the company's flagship bone substitute can also be used in the legs, arms
and pelvis and that its hemostats are approved for most open surgeries. That's just making its large numbers larger."
Back then, the stock was trading at 2.33, an overlooked bargain. It traded in the same region until April ... but then it started moving,
picking up speed day after day and week after week. Insiders knew something was happening. By the start of June, it had hit 4.00. And on
June 8, when the FDA announced that Orthovita's bone augmentation material had received clearance to be used in vertical compression fractures, the stock hit 5.45.
That's a profit of 134%.
So if you've got the courage to buy high-potential small stocks, and if you've got the patience to hold on until payday arrives (for example, wise investors are now taking some profits in the stock mentioned above), then Cabot Small-Cap Confidential might be the perfect investment guide for you.
To get started with a no-risk trial subscription, simply click below.
Cabot Small-Cap Confidential's circulation is limited to just 500 subscribers. That’s a small number for us. I could sell thousands of subscriptions to this service. But if I set hordes of investors pushing around the stocks Tom has so diligently uncovered, their buy orders would just push the stock prices up … temporarily. And I want you to buy these stocks when they’re cheap! So I limit the publication’s circulation.
Get started today!