A good small cap company does not always translate into a good small cap investment when its valuation needs a reality check.

How many times as investors have we bought shares of small cap growth stocks priced off hype by investment bankers, analyst calls and portfolio managers’ picks in the media? If you purchased shares in Patient Home Monitoring Corp. or a slew of other small cap healthcare stocks earlier this year you will know what I mean, unfortunately.

Good information and analysis is critical for small cap investments. But acting on the information from a consensus view from others can be precarious for investing in small cap stocks.

Informational herding arises in situations where investors observe the actions of others, derive information from them and then, seemingly, disregard their own information to follow the majority action. Applying this idea to small cap stocks, one could argue that recommendations by a visible group of small cap fund managers and newsletter writers which induce others to follow will cause such stocks to jump in one direction. This is when a share price will deviate far from the small cap stock’s true fundamental value.

This herding effect was in full force earlier this year. Fund managers and investment gurus alike kept recommending to investors to buy the same group of small cap health care stocks, already trading at a lofty valuation levels.

Were these stock prices sustainable? No. Today a majority of these stocks are 60-80% down in value from their trading highs this year.

When stock valuations are too high, so are expectations. Too high expectations will always lead to disappointment, under performance and, often, share price collapse. This was the case for small cap health care stocks, as any negative triggers, operational or not, dramatically discounted these stocks' valuations and the selling herd trampled over retail investors.

Why pay for this hype? Buy small cap growth stock when its valuation is still reasonable, which allows the Company to generate positive surprises and exceed on lower expectations to outperform. Avoid making buying decisions solely based on a recommendation from fund managers in the media.

More importantly, one must realize what makes a good company does not always translate to what makes good investment if the valuations levels become distorted.

That said, Patient Home Monitoring Corp. may well be a good small cap company, but it was bad investment for those small cap investors who followed the herd.

Read Disclaimer:

This article is for informational purposes only. This article is based on the author's independent analysis and judgment 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.