10 Rules For Investing in Small-Cap Stocks
By Thomas E. Garrity ,
Chief Analyst of Cabot Small-Cap Confidential
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 readers.
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. That will be a good small-cap stock to buy.
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.
What are Small-Cap Stocks?
Small-Cap stocks are stocks with low market values, generally less than $1 billion, and often far below that.
These stocks offer the potential for rapid price appreciation, as a business grows and the stock becomes discovered by institutional investors. But they also offer greater risk, because smaller businesses fail more easily than large ones, and the lack of support from institutional investors means these stocks can collapse quickly.
In any event, deep fundamental research is required for successful investing in small-cap stocks, in part because their charts provide less information than the charts of heavily traded larger stocks.
A subsector of small-cap stocks is penny stocks, which trade, as the name says, for pennies—less than dollar a share.
Cabot Small-Cap Confidential prefers stocks trading between one dollar and ten dollars per share, though there are exceptions. We’ve found the best profits—and fewest losses—by investing in stocks in this region, and we’d love to share our ideas with you.
3. Invest in small-caps 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.
Click on these links for more information about small-cap stocks:
Guide to Small-Cap Investing
An introductory guide to small-cap investing—ten rules for investing early in tomorrow’s top stocks.
How to Manage your Small-Cap Stock Portfolio
Here are some tips for getting the most from your small-cap investments.
Small-Cap Stock FAQs
A collection of selected questions from Cabot Small-Cap Confidential Report subscribers and responses from Editor Thomas Garrity.
Stop-Losses for Small-Caps
Stop losses aren't of great value with small-cap stocks since they are so thinly traded and volatile.
Small Cap Buy and Sell Philosophy
The size of any given holding may be determined based on the risk profile of the company.