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Small Cap Stock Investing
by Carmelo J. Montalbano
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Overview
Small Cap Stock Investing
There are three basic responsibilities necessary for successful small cap stock investing that must be met. The first is the ability to patiently invest for an intermediate and long-term basis because the small cap market is illiquid. The second requirement is the ability of the investor to research and study companies with little outside, independent research. The third factor necessary for success is to develop a methodical structure for limiting risk through protective stops and money management.
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Identification
It is important to understand that nearly half of all stocks traded on the major American exchanges are either small cap or micro cap stocks. Capitalization is the number of shares times the current share price. Small cap stocks have capitalizations between $250 million and $1 billion. Micro cap stocks are under $250 million in capitalization. Because of the regulatory limits as to how many shares an institution can buy most institutions skip small cap stocks because they cannot buy enough shares to affect performance. As a result, these stocks are under invested creating opportunity for the individual investor.
Small Cap Stock Investing
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Small Cap Stocks Are Illiquid
It is not unusual for small cap stocks to have the bid and offered quotes for a stock more than 5 percent apart. This large amount does not invite day trading or short-term holdings of these stocks. The best way to buy small cap stocks is to place an order slightly above the bid side of the market and wait for the order to be executed. Small cap stocks should be sold by offering stock just below the offered price. Patience is always required when buying small cap stocks. Look at the average daily trading volume. Do not try to buy more than 20 percent of the daily volume in any one day or you will probably cause the price to jump noticeably.
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How to Find Small Cap Stocks
There is one outstanding source for small cap stock information. It is the Value Line Investment Survey for Small Cap stocks. It is a subscription service that lists more than 5000 stocks, both small and micro cap stocks. Investors should also peruse other websites or investigate small cap companies. Additionally, investors should decide whether the company has developed a new or improved technology that reduces costs or whether the company has stopped growing and is using its cash flow to pay down debt and grow cash reserves. In the former, case growth will drive the stock price. In the case of mature stocks, the value of the company's assets and value as a cash rich going concern will attract attention to the stock price.
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Analyzing a Company's Balance Sheet
It is recommended to use formal financial analysis, such as the price earnings ratio, the price to book value, the debt to equity ratio and the cash to current assets ratio, to compare the company to those of its competitors. An an investor should also consider cash flow per share and sales per share. An investor should look at the growth rate of sales for estimating future growth. It is important to understand that companies that grow quickly will have higher debt levels forcing them to issue more stock to finance further growth. New technology companies are often bought by larger rivals who do not wish their current products to be made obsolete.
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Protective Stop Loss
Because of the liquidity risk, investors should consider small positions in many stocks. For example, a $100,000 portfolio might only invest 20 percent of its portfolio in small cap stocks. The $20,000 might be divided among 10 stocks. Investors should always use protective stops. Protective stops represent how much of a loss investors are willing to incur per investment. Thus, a protective stop on a $2000 investment might be 10 percent of the purchase price. Protective stops are absolutely necessary to prevent small losses from becoming large losses.
