Buying wisely makes the decision to sell a lot easier.
Is it the European debt crisis, slowing emerging markets, sluggish North American economy or the beginning of the summer market doldrums? Who knows, but the majority of small cap stocks have retreated from their year-to-date highs. Small cap stock prices have headed lower with trading volumes on the decline from all of the current negative market sediment and aversion to risk.
Will this trend turn soon? Maybe, or maybe not!
The most difficult decision for most small cap investors is not when to buy but, rather, is there a need to sell? The decision to sell becomes even more emotional when your small cap stock share price is on the decline.
If you initially bought that small cap stock based on its sexy industry, share price momentum or you heard about the stock on a business TV show, your decision to sell as its stock price falls is not easy. Good luck!
But, if you bought wisely, you may not be faced with the decision: Do I need sell?
There are numerous factors an investor can consider when buying that small cap stock, including growth prospects, management strength, cash flow, etc. That aside, I start with the balance sheet.
Buying wisely is buying a small cap stock with a strong balance sheet; preferably a company that has lots of cash and little or no debt. Should its stock price decline from poor market conditions you have the peace of mind knowing that the company is in no immediate need of financing, which would be dilutive to its current shareholders. A small cap company with a strong balance sheet can better withstand changes in the marketplace.
Next, buying wisely is buying cheaply. Small cap companies have very few meaningful comparables for valuation purposes. Therefore, when buying small cap shares, pay low multiples; less than 10 times earnings per share or less than four times Enterprise Value (market capitalization plus debt, less cash) to annual EBITDA (earnings before interest, taxes, depreciation, amortization) on current results. As the market moves, multiples expand, but as markets decline, multiples contract. If you buy wisely, rarely a share price decline from poor market conditions will result in investors losing on their original investments and feeling the pressure to sell at the wrong time.
Therefore, next time you buy small cap shares, make your decision to sell simple; check the balance sheet and pay less. You will end up making more.