7 Steps To Successful Small-Cap Investing

 

By Nancy Zambell, 

Editor of Investment Digest and Dividend Digest

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Why Invest in Small-Cap Stocks?

Risk, Loss and Excitement

7 Steps to Successful Small-Cap Investing

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Spreading your assets among different classes and sectors of investments, as well as in investments with various market capitalizations, can help minimize your portfolio risk. And while most investors realize that proper diversification will definitely reduce the volatility (and risk) of your portfolio, many don’t understand that it can also substantially boost your returns.

How? By adding one class of investments that scares the pants off many investors—small-cap stocks. One reason for the fear is that the media generally shies away from small-caps to focus on the larger-cap companies that generate the most news and interest from investors. And they love to exaggerate the risks in small-cap investing, ignoring the obvious benefits.

Currently, Wall Street generally defines the various categories of market capitalization as:

• Large-caps: greater than $10 billion
• Mid-caps: $2-$10 billion
• Small-caps: less than $2 billion, which also includes the following categories:
  1. Micro-caps: $50-$250 million
  2. Nano-caps: less than $50 million

When investors hear small-cap, it immediately conjures up three words: risk, loss and excitement.

Risk and loss: Certainly, small-cap investing can be risky. Many small-cap companies are the new kids on the block, with unproven products and/or little in the way of earnings and revenue track records. And they come with additional concerns:

Generally, small-caps trade at low volumes compared with higher-capitalization companies. That means that there may come a time when you will not easily be able to find a buyer for the shares you are selling.

Finding accurate quotes may be difficult, at times. For the majority of the small-caps you should be buying (those that are fundamentally strong with solid sales and earnings), this won’t be a problem. But if you are buying and selling micro- or nano-caps, you may encounter this challenge.

Potential for fraud. Again, this most likely won’t be a problem unless you are buying very small-cap stocks. However, you should be aware that this potential exists and exercise due caution. It is very easy in today’s world of constant communication from thousands of sources to be misled by so-called “experts” who exist only to “pump and dump” small-cap companies onto unwitting investors.

Excitement:

Yes, there’s the potential to make a killing! But a killing is rare, and the potential to lose your hide is much greater—especially in the wee, speculative issues. However, if you exercise the same caution and good investment practices—including a thorough analysis of the company—that you do when you buy any other stock, small-cap stocks do hold the potential to significantly add to your portfolio returns.

Last year, the Russell 2000 stock index, the standard gauge of small-company stock performance, overshot the performance of the Standard & Poor’s 500 Index, gaining 37.0% vs. the 29.6% for the large-cap S&P 500 index.

And according to Morningstar, from 1926 through 2012, small-cap stocks have outperformed large-cap stocks by 238 basis points (2.38%) annually.

Furthermore, in an April, 2014 study by Deutsche Bank, the evidence continues: Over a 15-year period, small-caps outperformed large-caps, 8.42% vs. 5.08%.

Certainly, there are cycles of good and bad years. What may surprise you is that, historically, small-caps have substantially outperformed their larger peers during the weakest of economic periods. Russell Research studied the 35-year period between 1979 and 2013 and found that GDP growth was less than 3% about half of that time. Furthermore, small-caps outperformed the large-cap companies in 12 of the 18 years of slower growth—by about 8% per year.

I hope that leaves you with one conclusion: Small-cap stocks should be a part of every investor’s portfolio.

Consequently, I want to give you a few ideas that will not only help you analyze the small-cap stocks that you are interested in adding to your portfolio, but will also assist you in avoiding the problems that can arise with small-cap investing.

A Few Caveats

First, I will caution you that small-cap investing is not for the weak of heart. These shares tend to fluctuate more than shares of most larger-cap companies. So, don’t buy them unless you can sleep at night knowing you may awaken to a 20%-50% drop in their value. However, I do have a suggestion that will help you sleep a little better—setting stop-losses, which I will cover in a few paragraphs.

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7 Simple Ratios to Maximize your Gains

I’m primarily a fundamental analyst, which means that I love to pore through a company’s financial statement in order to determine if it is a good candidate for my investing dollars. Part of that analysis is determining which data are important and which ratios will tell me what I need to know about the company.

I use a lot of the same ratios for investing in almost any company, but there are seven that you absolutely must review prior to purchasing shares in a small-cap business.

1. For ratio analysis, I especially like the Financials section on Reuters’ website. Go to http://www.reuters.com/finance/stocks and enter your stock symbol. Then, click on the Financials tab, and you’ll see a host of ratios that compare your company to its industry, sector and the S&P 500.

2. I also like using http://www.finance.yahoo.com for additional information, as noted below. Be sure that you are comparing your company’s ratios and financial situation to others in its industry, as well as to its own historical behavior.

3. The shares should be undervalued. A good ratio to use here is P/E, which is the ratio of a company’s share price to its per-share earnings, as well as the PEG equation, which compares the price of the stock to the growth of the company. P/Es should normally be less than 45 for small-caps, but could be extended to the 60s for fairly new, high-growth companies. Beware of companies whose P/Es are accelerating with nothing to show for it—falling earnings and/or sales, lost business, financial statement restatements, major lawsuits, and the like.

4. The company should have above-average earnings and revenue growth (Reuters). Note that a fairly new company will be growing its top line—revenue—much faster than the bottom line (net earnings). Nevertheless, you want to buy stock in a company that is making money now.

5. As well, the potential to increase its profit in the future is of paramount importance (Yahoo/Analyst Estimates).

6. A strong balance sheet is a necessity: Low debt, strong cash flow (Yahoo/Key Statistics, and Financial Statements, Cash Flow). You may also want to compare share price as a percentage of operating cash flow and as a percentage of free cash flow (Reuters/Ratios). You will also want to find out what the company is using its cash for. Paying down debt, buying back shares and paying dividends are all good uses of cash.

7. New or increasing interest from institutions and company insiders may also be a good indicator of near-term appreciation in share price (Yahoo/Insider Transactions).

One More Step: Look Beyond the Numbers

Look for companies with decent liquidity, preferably with trading volume averaging at least half a million dollars daily.

A series of positive earnings surprises may also indicate coming share appreciation. A few years ago, Zacks conducted a review of positive earnings surprises and found that companies who have reported one earnings surprise have a 41% chance of repeating, and those with four quarters in a row of positive surprises have a 74% chance of repeating (Yahoo/Analyst Estimates).

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7 Qualitative Factors to Evaluate

Now it’s time to roll up your sleeves and do a little more work to determine if your company meets the following standards:

• Does it have innovative products and services?
• Is the management team experienced, with at least five years of track record? Is the founder(s) still running the company? A study from the Wharton School of Business found that founder CEOs, driven by their higher equity stakes, outperform professional CEOs.
• How good are the industry prospects?
• Are the company’s financial statements transparent—i.e., are they easy to read and consistent from year-to-year?
• Does the company have a good—and growing—market share in the segments in which it operates?
• How is the company’s reputation among its customers and suppliers?
• Does the company publicly state its mission and goals? Do they make sense?

To answer these questions, you are going to have to go to the Internet and study the pertinent news regarding the company and its industry. You will also benefit by reading and examining its financial statements, and by speaking with the company itself. Just go to the company’s website (accessible via either Reuters or Yahoo), and find the phone number for its Investor Relations Department. Believe me, most companies will jump through hoops to help a retail investor learn about the business.

Now, about those stop losses. I always encourage investors to limit their losses, typically to 20%-30% below your entry price. Granted, you will be stopped out of some very volatile stocks, but it will help you sleep at night.

One warning: I caution you to diversify your portfolio. That means, do not put all of your investment in one company, or all in small-caps or all in one industry. Sure, you can make a killing if you hit just right, but you can also lose your shirt pretty rapidly if the tide turns.

For guidance on the best stocks to buy, consider a risk-free trial subscription to Investment Digest. I’ll do all the research for you and email you the best recommendation to your inbox each day. Investment Digest features a variety of investment opportunities including low-priced stocks, technology and biotech stocks, mutual funds and ETFs. Click here for more details.

Sincerely,

Nancy Zambell
Editor of Investment Digest and Dividend Digest


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