Analyzing The Potential Of Small Companies

Small companies do better than mid- or large- cap companies in the long run. They can run up ten times in value in three to five years. All this is possible because the companies are usually more nimble due to their smaller size and limited bureaucracy. They have management teams who frequently own large stakes and are entrepreneurial in the way they think. Many companies are too small to even get onto the radar screen of larger institutional investors, so these companies tend to stay hidden longer.

What about risk? Generally, you expect to be rewarded more for taking greater risks. However, to jump into a stock on a hot tip is not taking a calculated risk — that's gambling. You minimize your risks by looking for companies that are fundamentally sound. You maximize your chances of finding a solid outperformer by analyzing the management team and the company's intrinsic value. Let's look at some techniques that you can follow to be successful in small-cap investing.

USE INDEPENDENT JUDGEMENT

First, be independent and seek out opportunities where others aren't. Don't mistake a bad company for a bad investment. In other words, just because a stock is out of favor does not mean it can't make you a lot of money. Furthermore, don't mistake a good company for a good investment. If you have just seen a tremendous run up in a solid stock that you've watched for years, it may have gotten ahead of itself, and an investment in the stock could turn out to be a bad one. Evaluate each investment on its own merits relative to its price today.

ALWAYS DIVERSIFY

You've heard the adage, "Don't put all your eggs in one basket". Nothing can be more poignant. If you make one investment and have one failure, you've lost all of your principal. However, if you invest in ten companies and five out of ten do well, four become complete duds, and one knocks the ball out of the park, you've created a winning portfolio. Good diversification lets you sleep at night by reducing volatility that you might otherwise expect from a single investment.

WATCH & LEARN FROM MANAGEMENT

An unskilled manager at the helm can sink a company faster than the Titanic. Analyze the strengths and weaknesses of the management team. Find out all you can. The SEC can provide information on public figures who run public companies. Most solid leaders will have plenty of information available about them. If you don't like what you see, don't invest. If management has a lot of stock, this is a good thing. Why? At least you know management is very well motivated to ensure that the stock price does well. In a sense, they're in the same boat as you. They stand to gain quite a bit if the stock price does well, but so do you.

FIND NICHE COMPANIES

Look for companies that are focusing on a niche market rather than those who are trying to do everything and be everything. Focusing on a single objective is easier for management to do and most often, more profitable. It is easier to become a leader in a space when you are doing one thing really well because customers and investors will recognize the company for that.

LOOK AT THE FUNDAMENTALS

Make sure that the company you invest in is commited to strengthening the balance sheet and paying down debt. Look to see that sales, margins, return on equity and cash flows are rising steadily - assuming that the company has already posted sales in its life cycle. Many small companies have not yet entered their production phases, but have market tested their product and are gearing up for their first product introduction. There is nothing wrong with these companies as long as the company's projections seem reasonable to you.

KEEP YOUR WINNERS, SELL YOUR LOSERS

Human psychology is interesting. When a stock is going down, many people, in order to avoid realizing the pain of regret from making a bad investment decision, hold onto their losers in the hope that the stock will eventually recover and they will break-even. On the other hand, when stocks have had a good run, many people sell these winners in order to realize the feeling of pride from making a good investment decision. This emotionally driven strategy will often lead to portfolio losses. You should sell a stock when you believe that something fundamental has changed that provides a less attractive future outlook for the stock. On the other hand, if nothing has changed fundamentally with a winning stock, there's no real reason to sell it. Sell a winner if its future prospects have changed for the worse.

So, get out there and find some winners. Will you be able to find one that performs like Microsoft, Dell or Starbucks? Who knows? You're best bet is to follow the advice here and maximize your chances of success. Remember:

USE INDEPENDENT JUDGEMENT

ALWAYS DIVERSIFY

WATCH & LEARN FROM MANAGEMENT

FIND NICHE COMPANIES

LOOK AT THE FUNDAMENTALS

KEEP YOUR WINNERS, SELL YOUR LOSERS

Good investing!