Buying a stock that is priced for perfection is a common mistake by small cap
Yes, it is true that the vast majority of small/microcap stocks' share prices
have retreated from their year-to-date highs as much as 50% to 60%, and many
growth investors are feeling the financial pain.
the market sentiment has a higher aversion to risk than it had just six months
ago. The result: Small cap stock prices have been trending lower with trading
volumes that are on the decline. Why the high risk aversion? Is it the threat
of North Korea, US debt ceiling
concerns, the unpredictability of the Trump Government? Who knows what the
reasons are and it is anybody’s guess if the recent retreat will turn around
any time soon.
most difficult decision for most small cap investors is not when to buy but,
rather, is there a need to sell? The decision to sell becomes even more
emotional when your small cap investment has declined in value much below your
can be many unexpected reasons (both market and company-specific) that can have
a dramatic impact on small cap stocks' valuation. To this point, small cap
stocks can be very volatile and rarely behave like perfect investments while you
why would investors buy small cap stocks that are already priced for
common mistake for many novice investors is that they often purchase that small
cap/microcap stock based on its sexy industry, share price momentum or they
heard about the stock recommended on a business television show by a so-called
small cap guru. Such investment decisions ignore stock valuation metrics.
cap stocks that are priced for perfection trade at market valuation that
assumes the underlying Company’s longer-term business plan has already been
executed. As such, the stock trades today at excessive future sales and
earnings valuation multiplies or does not take into account the possibility of
dilution from future financings. That said, too often we see high-flying small cap
companies which may have grown their sales to $10 million but which trade at a
market valuation five to ten times that amount.
often than not, investors who buy small cap stocks that are already priced for
perfection will be faced with the decision as to whether they should sell
because the stock has significantly declined in price and they are now losing
money. The decision is complicated by the fact that the stock may takes years
to recoup the valuation that the investor initially paid, if all things go
the Investorfile blog preaches that if small cap investors buy wisely on a
valuation basis, they may not be faced with the decision to sell due to a small
cap stock’s unexpected price decline.
Buying wisely is buying a small cap stock with a good balance sheet; preferably
a company that has cash and little or no debt. Should its stock price decline
from poor market conditions, you have peace of mind knowing that the company is
in no immediate need of financing which could be highly dilutive, to its
shareholders. A small cap company with a strong balance sheet can better
withstand changes in the marketplace.
Due to the fact that small cap companies have very few meaningful comparables
for valuation purposes, when buying small cap shares do not pay excessive
multiples. We suggest no more than 15 times earnings per share or less than six
times Enterprise Value (market capitalization plus debt, less cash) to annual
EBITDA (earnings before interest, taxes, depreciation, and amortization.) Sales
multiples to market valuation should be under 2.5 times.
need to be aware as the market moves, multiples expand, but as markets decline,
multiples contract. If you buy wisely, rarely will a share price decline from
poor market conditions result in investors losing on their original investments
and feeling the pressure to sell at the wrong time.
Today many of the small cap stocks that were priced for perfection just six
months ago have seen their share value decline significantly. On a valuation
basis now may be the perfect time to buy them!
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.