By Bill Wilton of Zacks Investment Research
Investors are drawn to companies with small capitalizations, and I am no exception. While there are numerous reasons I enjoy researching these lesser-known stocks, the biggest is the potential to outperform the market.
Very few large caps are going to post sharp gains in a short period of time, but isn't that the best feeling when you are looking at your portfolio for the day? However, with the lure of excess gains comes additional risk. After all, there is no such thing as a free lunch.
So, what sets good stocks apart from the bad in the small cap arena? How can you mitigate the risk, but still collect the returns? And what are some of the differences in researching these companies compared to larger caps? I'll share the answers with you below.
A Needle in a Haystack
There are literally thousands of small cap stocks out there. Sifting through all the bad tickers to find a gem can be like finding a needle in a haystack. The first thing you need to do when trying to find the next winner is get yourself a smaller haystack. By using a few guidelines you can whittle the endless list of companies down to a manageable few. For me that process always starts with earnings.
First things first. If the earnings picture is not good, then why look any further? The Zacks Rank provides the best way to evaluate the quality of the earnings outlook for a company. This is important for reviewing all stocks, but especially small caps.
Investors also want to find stocks with explosive growth potential. Too often they disregard stocks that don't have year-over-year earnings growth. Earnings momentum, or a rising consensus estimate, is much more important that the nominal growth rate.
So, do not skip over the shares with little or no year-over-year growth, they may have incredible EPS momentum going forward. The Zacks Rank is great at picking up these trends as well.
Be a Penny Pincher
Valuations seem to be a concept lost on many small cap investors. I am not saying that everyone ignores the P/E for these stocks, but you have to look a lot further than that.
Imagine a 50% decrease in earnings. Sounds horrible right? But with a small cap company that might only mean that EPS dropped from 2 cents to 1 cent. However, that same company's sales may be unchanged, or even improving.
Price-to-sales is one of the best valuation metrics for smaller companies, especially in cyclical industries. Earnings can be extremely volatile and unreliable, given the liberty in some accounting practices. So look beyond your father's P/E ratio and dig deeper to find value.
Who? What? Where? When?
Given the attributes above, which can easily be handled in seconds by a stock screener, you should now be looking at a much smaller list of stocks. Now it's time to roll up our sleeves and dig in.
Finding out what is behind that ticker is one of the most interesting parts of investing. Who are they? What do they do? Where do they do it? Making sure a company can justify those growth projections is of the utmost importance. Just ask anyone who thought Crocs was going to continue to grow exponentially once the fad was over.
Finding out where a company operates is another big factor. The BRIC countries (Brazil, Russia, India, China) are very hot, and for good reason. If you can find a stock in an economy that is taking off, you have just significantly increased your chances of success.
A Contingency Plan
Even the best laid plans have a chance of ending in disaster. Small cap stocks climb fast and fall even faster, so make sure you put in a stop-loss.
Some will choose an arbitrary percentage based on their threshold for pain. Others look at charts to find failed support levels or other indicators. Whichever you choose, put them in and follow them.
We tend to fall in love with stocks and allow emotion to get in the way of our trading profits. Avoid this common pitfall by setting and following stops.
An Easy Path to the Best Small Cap Stocks
You will find most of the resources needed to analyze small cap stocks on Zacks.com and other investment websites. However, it will still require many hours of work each month to help pick the best stocks. So let me suggest an easier way.
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