Small-cap stocks’ higher expected returns versus the market are inextricably tied to identifying companies delivering profitable growth with minimal or negative share-price recognition.
In this article, we’ll explain how to go about sourcing these companies and evaluating them before a potential investment. First, let’s get a little terminology housekeeping out of the way.
What are small-cap stocks?
As they pertain to the Canadian market, small-cap stocks are anywhere from a few hundred million to about C$2 billion in market capitalization, depending on your source, and are commonly characterized by heightened volatility because of unprofitability, lack of liquidity and/or lack of market awareness. These factors make dislocations between stock price and business potential a common occurrence, offering investors ample opportunities to pick up attractive assets at a discount. Here’s a working model to suss out names to put this thesis in play:
4 steps to unlocking the potential of investing in small-cap stocks
- Start with the income statement.
- Identify market misperceptions.
- Risk-adjust your investment.
- Set a sell strategy.
1. Start with the income statement
As you probably already know, the stock market rewards companies that make money over the long term. Seeing as smaller companies are, all in all, less established than their large-cap counterparts, unprofitability and lack of revenue are more common occurrences, making them reg flags to be avoided at the outset of searching for your next small-cap investment.
Instead, spend your time on companies sending value-accretive signals to the market through rising net income or adjusted EBITDA, ideally paired with revenue growth, proving demand for their products and services and management’s ability to meet it in line with shareholder value.
Money-making names among the top Bullboards that look attractive at first glance include Gatekeeper Systems (TSXV:GSI), Thermal Energy International (TSXV:TMG), ADF Group (TSX:DRX) and WELL Health Technologies (TSX:WELL).
While it is possible to build a high-conviction case for investing in a company that doesn’t make money, the exacerbated risk of total loss, in the absence of traditional valuation metrics, makes this scenario more akin to speculation, which may or may not align with your financial plan.
2. Identify market misperceptions
While the stock market differentiates companies by the dollars they generate over the long-term, short-term volatility because of macroeconomic or geopolitical turmoil can push quality stocks below what they should arguably be worth. These stocks may present themselves in two ways, soaring and going higher or tanking and primed for a re-rating:
Soaring and going higher
In this case, a small-cap stock has been on a steady uptrend driven by profitable growth, suggesting the business has what it takes to continue on this path over the long-term, all things being equal.
Take Wajax (TSX:WJX), for example, a diversified industrial products and services provider that grew revenue and net income every year from 2020 to 2023, but experienced a drop in these figures in 2024 because of weakening Canadian business and consumer sentiment. The drop caused the stock to shed over 40 per cent of its value year-over-year, while remaining up by 100 per cent since 2020.
Should management succeed at deriving further value from ongoing cost-cutting initiatives, Wajax will likely be able to determine its own future through strategic acquisitions. Operating cash flow reached C$75.9 million in Q4 2024.
Tanking and primed for a re-rating
In this case, a small-cap stock is sitting at a loss, despite its underlying business showing improvement in terms of profitability. Saturn Oil & Gas (TSX:SOIL), for example, is down by almost 50 per cent since 2022, even though it has produced exponential revenue growth and almost C$450 million in net income over the period.
3. Risk-adjust your investment
Now that you’ve performed due diligence on a small-cap stock and determined it worthy of your portfolio, take care to size the investment according to standard financial planning best practices. From a high level, we can simplify this process into two broad steps:
- Staying true to your financial goals: Considering that a diversified portfolio of index funds is likely to average mid-single-digit returns over an investment lifetime, and that, unlike index funds, investing in single stocks opens you up to the possibility of a total loss, the question to ask here is, How much money can you lose from investing in small-cap stocks without endangering your financial goals? Whether that’s C$100, C$100 or C$1,000, keep your future self front-and-centre when putting money to work in the stock market.
- Respecting your risk tolerance: The truth about losing money in the stock market is that, while it’s easy to discuss in theory, experiencing it in practice can prove overwhelming, leading to hasty decisions like buying high and selling low. If you’re unsure about the bounds of your tolerance when it comes to carrying on with daily life while your portfolio is deep in the red, it is essential that you delineate this boundary before investing. Simply pair your stocks with an appropriate percentage of bonds and cash, such that the resulting volatility allows you to sleep at night and reach your financial goals. According to Vanguard ETF model portfolios from Canadian Portfolio Manager, an all-stock allocation experienced a maximum drawdown of 42.06 per cent looking back 20 years. Compare this to a portfolio of 20 per cent stocks and 80 per cent bonds, which fell by a maximum of only 3.11 per cent over the same period.
If you err on the side of caution when it comes to these financial planning fundamentals, you will go a long way towards enhancing outcomes and minimizing active investing’s inevitable (and hopefully occasional) losses by aligning your portfolio with the life you want to live.
4. Set a sell strategy
To close the loop in our survey of small-cap stocks and how to invest in them, we must address the question of selling your shares, delineating some rule-of-thumb scenarios that might merit the liquidity. Here are three:
- Selling to fund a goal: Regardless of your view on a stock’s valuation, you should feel free to sell shares once they’ll pay for an experience or product central to your version of a happy life. There are infinite iterations here, but some common ones are a car, a house or a wedding.
- Selling because your thesis is proven wrong: As it pertains to this article, this scenario refers to companies that fall short on expectations in terms of growth and profitability, overstaying their welcome in your portfolio. There is no sure-fire timeframe here, because if there was, everybody would be following it. That said, it will often take years for a small-cap stock to find favour in the market given the business’ limited resources and unproven track record.
- Selling because the company changes for the worse: Given the idiosyncratic nature of single stocks, investors will be regularly faced with internal operational changes that may challenge their view of a company. Maybe the CEO retires and is replaced by someone less than stellar, or a series of acquisitions exposes the company to sectors it has limited experience in. Whatever the shift, if it infringes on your high conviction, your money is best served in a more prospective company.
Now that you have all the tools you need to responsibly search for small-cap stocks positioned for long-term success, all that’s left is to start building your watchlist, filling out your portfolio and funding your wildest dreams. Happy investing!
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(Top image, generated by AI: Adobe Stock)