Secrets of Small-Cap Investing

For the majority of individuals in the stock market, a patient, long-term-oriented approach to investing offers rewards far beyond those of any other investment strategy. Investing regularly in a portfolio of quality companies and holding them for periods of years or decades can deliver returns that outpace those offered by equity mutual funds.

The potentially higher returns offered up by small-cap stocks means that investors who seek the highest returns from their portfolios must not exclude smaller companies from their portfolios. A healthy mix of companies of all sizes helps to reduce overall risk levels and boost returns for stock investors over the long term. In the 32 years ended in 2010, the small-cap Russell 2000 Index has posted an annualized return of 12.83%, higher than the S&P 500’s annualized return of 11.94%.

The stock analysis tools that work well for large blue-chip stocks, however, need some adjustment when focusing on smaller companies. This is where the SmallCap Informer comes in — helping subscribers to identify and find success with smaller companies.

Here, then, are our five key areas of con-sideration when seeking out and analyzing small-cap stocks for presentation in the Informer.
 

1. Demand Proof of Managerial Excellence

Great businesses are made, not born. And the secret to making a great business is having solid leadership in place — a management team that can drive a company on the route to sustainable excellence. As with any stock investment, it’s imperative to establish that a small company’s leaders are more than competent — they have the skill and expertise to deliver profits to shareholders.

Although there are many ways to determine whether a company’s management team is up to the task, a few factors rise to the top.

First, a company should have an operating history of at least three years. For companies that have recently gone public, this period could include years before its initial offering. There should have been no jarring changes of management during the company’s recent past as well. A company’s management can’t be evaluated without evidence, so the team responsible for the success of the venture to date must still be in place in order to make judgments.

Second, a company must be profitable to be considered for investment. The promise of future profits is not sufficient. Nor is it enough for a company to have recently turned the corner and posted positive earnings for the first time in its history. If a company has been able to deliver several recent years of profitability, management has passed the most important test of its skills.

But it’s not enough that a business’s management is merely competent. Our third suggestion is that stock investors strive for excellence — seek companies that meet or surpass the performance measures of their peers and competitors.

Fourth, the strength and consistency of historical growth is certainly area where investors can discern the hand of management in building a business poised for long-term future success.

Fifth, the trend and level of a company‘s pre-tax profit margins is perhaps the single most important comparative factor. Successful, quality companies can be identified by the margins they eke out on each dollar of revenue. Higher margins than competitors are almost always a sign of management expertise. Relatively stable annual margins are demanded of all companies. Growing margins are a positive.

To be sure, smaller companies may be in the phase of building their business, investing now to support greater success in the future, so the analysis of margins when compared with more established competitors should keep this possibility in mind.

A company’s return on equity should be reviewed carefully, but this measure not be less useful as a quality consideration for newer-stage businesses. Smaller companies can earn higher returns on initial equity, but these levels are not sustainable. Caution must again be exercised when comparing small businesses with established enterprises.

Finally, any company included in a growth stock portfolio must have identifiable drivers of future growth. Tailwinds should be stronger than headwinds. No business can coast to success on the coattails of its past success, so management must be able to present a viable vision for how it intends to grow the business in the years ahead.
 

2. Invest for the Long Term (but Monitor in the Short Term)

Successful stock investors know that a long-term approach often pays off by allowing individuals to ride out a company’s temporary setbacks and realize gains over a period of five years or a decade or even longer. In addition, minimizing transaction costs and short-term capital gains taxes can add to the overall rates of return.

With small-cap stocks, however, some tweaking to the buy-and-hold strategy used in a large-cap stock portfolio may be necessary. Because smaller companies are less established, there is often a higher degree of risk and volatility involved in holding these kinds of stocks.  That’s not to say that a buy-and-hold approach can’t work, though, but just a reminder that “buy and hold” does not mean “buy and forget.” With small-cap stocks it can be prudent to maintain a somewhat higher level of vigilance on their activities, watching for signs of trouble and selling promptly when real problems affect a company.

When problems do arise, the market is often less forgiving of small companies when they hit roadblocks. Even when management eventually steers these companies back in the right direction, investors may stay away until they are receive excessive degrees of reassurance, keeping stock prices depressed all the while.

It’s never good to be swayed into action by irrational market moves, however, and patience is frequently required to become a successful stock investor. Smaller companies often don’t have the broad institutional interest required to support share price growth. As a result, stock prices may only grow moderately until a tipping point is reached, at which the market seems to wakes up to the potential of a company. Investors who have already discovered the stock will then be nicely rewarded.
 

3. Pay Particular Attention to Valuation

Small companies are often attractive to growth stock investors because of their rapid growth rates. But these high growth rates often command a premium in the stock market, so these companies are assigned very high P/E ratios.

That’s fine, as long as the company can continue to churn out above-average growth. Eventually, however, the company’s growth will slow — it must slow — and then the stock’s P/E ratio will come back down to earth.

The math isn’t complicated — a small business can double or triple its sales and earnings in its first few years of operations. But it must see the percentage of annual growth decline as the company grows.

The relationship of a company’s growth to its share price and P/E ratio makes it particularly important to pay attention to the valuation of small-cap stocks in a portfolio. Reviewing past annual high and low P/E ratios may not reveal much about the likely P/E ratios a company’s shares will sell for in the future.

As a result, investors must take special care to make sure that estimated future P/E ratios are in line with expected future growth, which can be quite a bit lower than historical growth rates.
 

4. Invest Less in More Stocks

Stock investors should always aim to hold a diversified portfolio of stocks, spread out among companies of all sizes and in many different industry groups and sectors. At the same time, it’s important to concentrate a stock portfolio into a small number of holdings. Research shows that a portfolio of more than 20 stocks adds little diversification benefit and actually reduces the chance that the portfolio will outperform the broad market averages. Most investors can see the maximum levels of risk and return with a portfolio of between 12 and 20 individual stocks.

Since small-cap stocks have a higher risk profile than larger stocks, though, some modification to this portfolio strategy may be in order. Risk can be diluted in a portfolio by spreading small stock exposure among a greater number of individual companies.

For example, an individual investor who seeks to own 12-15 stocks in a portfolio, with 25% of the overall value of the portfolio directed to small-company opportunities, would aim for four to seven small companies instead of three to five companies. By adding more small companies, the risk of a single company underperforming is thus somewhat mitigated.
 

5. Replenish Small-Cap Exposure Regularly

Successful small companies become large companies. It’s an unavoidable part of investing in small-cap stocks, only amplified by increased success in picking winning stocks.

It is also prudent to expect that more small-company stocks will stumble than the larger companies selected for a portfolio. These stocks will be sold to make way for other opportunities.

Both of these certainties require investors to be on the constant lookout for small-company prospects. On an ongoing basis, investors must refill their portfolios from the bottom up.