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 can’t avoid what you don’t 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 stock’s 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 sales.

By 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.

See: Top Ideas

Read Disclaimer:

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.