Why some small cap stocks become our Top Ideas.
1. Aim to buy wisely.
Buying a stock wisely is buying a stock cheaply. Small cap stocks have very few
meaningful comparables for valuation purposes. Therefore, when buying small
caps, look to pay low multiples; less than 10 times earnings per share or under
six times Enterprise Value (market capitalization plus debt, less cash) to
annual EBITDA (earnings before interest, taxes, depreciation, and amortization)
on current or near-term expected results. As the small cap stock garners
attention and the market moves, multiples will expand, but as markets and
trading volumes decline, multiples can contract. If you buy wisely, rarely a
share price decline from unexpected market conditions will result in paper
losses on your original investments, which can pressure you to sell a good
small cap stock at the wrong time.
2. Avoid debt to avoid losses. By
their very nature, small cap stocks are risky investments. But to better avoid
a big loss, expect the unexpected when owning a small cap stock. Small
companies are very vulnerable to unforeseeable events. A major customer loss,
product delays or economic downturn can have a material impact on a small
company. Such events can lead to debt covenant breach (from companies with
debt) that can spiral into insolvency and big losses for small cap
shareholders. But survival from the unexpected is a better bet by investing in
small cap companies that remain debt-free and have plenty of cash on hand to
weather the storm. You canít avoid what you donít expect, but you can dodge big
losses from the unexpected by investing in debt-free small cap companies.
3. Look at the ignored. No
analyst coverage, illiquid stock and few institutional investors are not
negatives; they are positives for buying a small cap stock. The majority of
small caps which are undervalued are less well-known because they are currently
misunderstood, require no capital raises, operate in a temporarily
out-of-favour industry or are in a turnaround mode. But that does not mean all
these stocks are not fundamentally strong with growth potential. Purchasing
small cap stocks should be based on a sound financial analysis of the balance
sheet and cash flow. Study a stockís current business model for determining
good investment opportunities, not what others say or do. In other words, seek
the undervalued small cap company before it gets recognized by other investors
who will drive up the stock's price to fair value and beyond.
4. Fewer shares outstanding the better.
The biggest upside potential is from small cap stocks that have the fewest
shares issued. The early years for small cap stocks are generally the most
dilutive from financings. The sooner a small company can fund its growth from
internal cash generated, the less stock needs to be issued to raise equity.
Also small cap companies that require no money force larger investors to
acquire its stock on the open market and at market prices, which is good for
existing shareholders. Ultimately (for a takeover bid) the small cap stock is
valued by its market capitalization (share price times shares outstanding).
Therefore, with a smaller amount of shares outstanding, each share will command
a higher price. Small cap stocks with fewer shares issued are more attractive
in the long run.
5. Simplicity is best. A
small cap company with a simple business model is easier to understand for
investors. Straightforward business models are also less problematic to
implement for management. A complicated sales cycle adds a level of uncertainly
to a small cap stock. A small company that markets its
products or services to customers in Western Economies is less
risky. Better still is a small cap stock with a high percentage of recurring
no means are all five principles the only factors Investorfile will consider
for its Top Ideas. But if they pass this checklist, the small cap stock is
almost a shoe-in.
This article is for informational purposes only. This article is based on the
author's independent analysis and judgement and does not guarantee the
information's accuracy or completeness. The information contained in this
article is subject to change without notice, and the author assumes no
responsibility to update the information contained in this article. The
information contained within this article should not be construed as offering
of investment advice. Those seeking direct investment advice, should consult a
qualified, registered, investment professional. This is not a direct or implied
solicitation to buy or sell securities. Readers are advised to conduct their
own due diligence prior to considering buying or selling any stock.