It’s no surprise that investors on the hunt for differentiated returns often end up considering small-cap stocks; the asset class’s long-term, index-besting returns speak for themselves.
This article is a journalistic opinion piece which has been written based on independent research. It is intended to inform investors and should not be taken as a recommendation or financial advice.
However, there are potentially dire consequences awaiting investors who jump the gun and put money to work without getting a proper handle on expectations.
With numerous well-respected institutions, such as Royce, Barron’s and Franklin Templeton, building a case for small-cap stocks’ near-term resurgence, it’s the perfect time to set a firm foundation for new investors in the space.
The 10 commandments of investing in small-cap stocks
- Thou shalt perform thy own research.
- Thou shalt not underestimate volatility.
- Thou shalt beware of the lack of liquidity.
- Thou shalt seek value.
- Thou shalt seek explosive growth.
- Thou shalt invest in what you understand.
- Thou shalt understand the debt burden.
- Thou shalt be patient and long-term focused.
- Thou shalt not be fooled by speculation.
- Thou shalt remember thy purpose.
1. Thou shalt perform thy own research
Because small-cap stocks are too small to receive much coverage from financial analysts, if any, and stock tips are good dinner conversation but never financial advice, it’s up to investors to examine companies for themselves, analyzing financial reports, investor decks, official websites and news releases to build a picture of business fundamentals and reasonable future expectations.
2. Thou shalt not underestimate volatility
Given their typical lack of coverage, minimal investor interest, often limited resources and dependence on capital markets, small-cap stocks are prone to wider price swings than the broader stock market.
This volatility, potentially caused by geopolitical uncertainty, economic downturns, or some other black swan event, may lead your investment to lose 50 per cent of its value or more, sometimes over multi-year periods, vastly undervaluing what assets and operations are really worth.
3. Thou shalt beware of the lack of liquidity
An important quality stemming from small-cap stocks’ generally small number of investors is lack of liquidity, meaning that there’s likely to be a limited number of shares available to trade each day, making it difficult to build or sell your position over short timeframes and at a consistent price. This is why it pays to do your own research and differentiate between companies destined to waver in obscurity and those whose investment prospects are worth the wait.
4. Thou shalt seek value
Thanks to small-cap stocks’ lack of broader market awareness, share prices may not accurately reflect the value a company is creating. This could take the form of a brand or technological advantage that separates a company from competitors, a high-conviction path to profitability, or a macroeconomic tide depressing all boats regardless of fundamentals, among many other iterations.
Identifying price-value dislocations is then one of the individual investor’s most powerful tools to substantiate theses for share price re-ratings, contribute to overall portfolio returns and expedite the funding of their long-term goals.
5. Thou shalt seek explosive growth
Going hand in hand with small-caps’ propensity for undervaluation is their ability to deliver growth in market capitalization. After all, unless a mid-cap or large-cap company went public at those sizes, it will have had to post strong financial results while fulfilling an unmet need in its target market to grow out of its small-cap origins.
The key question for investors to ask here is, are the companies on my watchlist solving problems in their industries capable of profitable, long-term demand? Sustained increases in revenue and net income, or adjusted EBITDA if the company is reinvesting heavily in operations, will form the first half of your answer. Evidence of a value-added product will form the second half, the determination of which may or may not be within your reach.
6. Thou shalt invest in what you understand
All investing in individual stocks should be limited by your particular research interests and skills, ensuring that you’re able to adequately de-risk the money your put to work. Warren Buffett famously refers to this view as staying within your circle of competence, outside of which lie all the stocks tied to companies too complex for you to understand.
There’s no shame in recognizing the specific limits of our expertise and admitting that we shouldn’t invest in opto-electronic data communications technology, for example, or real estate, or junior mineral exploration companies, whatever may not be our cup of tea, and sticking to industries where we’re more confident about identifying value drivers.
7. Thou shalt understand the debt burden
True to their name, small-cap companies tend to be in the earlier stages of their lives, often requiring debt to fund growth plans. This makes them more sensitive to changes in interest rates, which determine borrowing costs, as well as default risk, contingent on the company’s ability to cover loan payments.
A good rule of thumb is to make sure companies on your watchlist own enough short-term assets to cover both short-term and long-term debt payments, with bonus points for debt reduction over at least a three-year period demonstrating management’s commitment to shareholder value.
8. Thou shalt be patient and long-term focused
All your carefully curated research will be for naught unless you’re prepared to hunker down and give your small-cap stocks time to develop. Certain businesses with steeply rising demand, such as artificial intelligence technology, may need 3-5 years to make a comprehensive push into their target market, while others such as mine development might ask you to wait for 10 years or more before you see a return on your investment. Whatever the timeframe, the stock market has long established that it can deliver value over time, regardless of the wars, recessions and varied unknown unknowns thrown in its way.
This is why it’s important to pick stocks in industries backed by widely studied long-term tailwinds – ideally supported by technical trends – expected to deliver growth over the coming decades.
9. Thou shalt not be fooled by speculation
The low profile of most small-cap stocks, as per human nature, lends itself to management’s temptation to make blue-sky promises, painting rosy pictures of near-term, exponential growth, at the risk of underdelivering and suffering a hit to shareholder value.
Do not be swayed by stories that are too good to be true, just because they sound good, without putting companies’ feet to the fire by comparing their assets, management and chosen market with the potential purportedly on the table. You can click through the links included in this article for supplementary material to get your research process started.
10. Thou shalt remember thy purpose
Finally, an investment has no point without a goal, which is by definition delineated by the experiences you consider meaningful, your current financial means and your psychological ability to tolerate risk.
It’s funding a trip around the world, buying that new house or retiring a decade early that should be your guiding lights, not outperforming the S&P 500, meaning that increasing your exposure to small-cap stocks and earning potentially higher returns is an unavoidably personal decision.
Tying it all together
There is no such thing as an investment without risks, and small-cap stocks come with their fair share, which can be mitigated by following our 10 commandments but never fully neutralized.
Keeping tabs on your portfolio is then an essential component of sound investment management, rebalancing positions as necessary to reflect changes in business quality or in your beliefs about what’s worth saving for.
Whether your due diligence calls for letting a winner run or cutting your losses before further depths are reached, maintain a data-driven approach to keep probability on your side and make your time in the market as fruitful as possible.
Join the discussion: Find out what investors are saying about small-cap stocks on Stockhouse’s stock forums and message boards.
Stockhouse does not provide investment advice or recommendations. All investment decisions should be made based on your own research and consultation with a registered investment professional. The issuer is solely responsible for the accuracy of the information contained herein.
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