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17
Accept that small cap stocks are not perfect investments
Posted by: Gerry Wimmer
9/17/2017
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Buying a stock that is priced for perfection is a common mistake by small cap investors.

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.

Today 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.

The 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 cost base.

There 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 hold them.

Therefore, why would investors buy small cap stocks that are already priced for perfection?

A 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.

Small 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.

More 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 well.

Therefore, 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.

Investors 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!


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.

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Gerry: Thanks for small cap stock suggestions over the past 5-years. Your record is very impressive and your analysis has been excellent over the years. I think small investors (and fund managers) should pay much more attention to your work. I look forward reading your blog over the next 5-years!