Small-Cap Stocks: The Basics

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Small Caps Premium ChartInvesting in small-cap stocks can be a great way to find opportunities that deliver skyrocketing gains from a modest starting point. While small-caps are often regarded as risky and time consuming, a well-developed small-cap strategy can make the difference between taking shots in the dark and pin-pointing companies with the potential to double or even triple in size.

A "small-cap" stock is classified by its market capitalization (total shares outstanding multiplied by the price per share). They fall between a market cap of $250 million and $2 billion.

Small caps are not to be confused with micro-caps, which have a market cap below $250 million, or penny stocks, which trade at less than $1 per share. (While plenty of small caps are also penny stocks, many trade higher, have more liquidity and less inherent risk than a typical penny stock.)

Small caps appeal to individual investors who are looking for the chance to find that relatively small company that's poised to be the next household name. They want to find the next Apple Inc. (NASDAQ:AAPL), while it's still a small shop run out of a garage.

For example, if you had invested in Amazon (NASDAQ:AMZN) in mid-May, 1998, one year after its IPO when it was still a relatively unknown company and sold it exactly 10 years later, you would have seen gains of 1,040%. If you had held it, as of this writing, you would have seen gains of 5,214%....

That's the kind of performance that small-cap investors know they can't get with large caps. The law of diminishing returns dictates that small companies will double or triple in size much more frequently than large companies.

Of course there are times when the majority of small caps are overvalued due to broader trends in the economy -and you will typically hear analysis of these valuations discussed in terms of the Russell 2000 Index, which is to small caps what the S&P 500 is to large cap stocks.

But the key to small-cap investing is to find the catalysts, or "sparks" that very often signal an individual stock is well positioned to take off. These are the sparks that ignite the rocket investors can ride to incredible gains.

To gain a better knowledge of these "sparks", it's necessary to have a contextual understanding of the intrinsic, macro and regulatory forces that influence small cap valuations. Small-caps have a number of attributes that can either be benefits or drawbacks, depending on your approach. Here are a few....

Scarcity of Attention and the "Bestseller Effect"

Wall Street and analysts don't spend a lot of time considering small-caps. Large-caps, because they are considered representative of particular industries or bellwethers for their sectors, are more frequently reported on and much more information is published about them.

Similarly, many institutional investors, especially mutual funds, have limitations when it comes to investing in small-caps. Often they are limited by regulatory factors that restrict their ability to establish sizeable positions in one stock. In some cases fund managers simply cannot, by law, invest in smaller companies (no matter how much they want to do so) until the stock, or the company, achieves certain benchmarks.

One drawback for small-cap investors is that your due diligence takes a lot longer. You'll have to find and crunch the numbers on your own. That means doing the research and calculations to conduct ratio analysis, understand the company's debt situation and infer the hidden costs and inefficiencies in the financial statements.

In one sense, small-caps can be seen as victims of the "bestseller effect", which refers to the compounding advantages that accrue with increasing success. The term comes from book publishing, where bestsellers get listed, get more reviews, and get featured on websites and in-store display, thus perpetuating their bestseller status.

This effect can be observed in any competitive environment, and with stocks, it can result in smaller companies being extremely undervalued. This places a disproportionate burden on small-caps, but it can be a huge advantage for individual investors who have the ability to spot promising companies and get in early on companies that have potential exposure to a bestseller effect.

The limitations on institutional investors, for example, prevent them from placing single order of $100 million in a small-cap stock. But when institutions do want to get in, they do so in a big way, and they spread their purchases out over much longer time frames in order to keep their cards close to their vest and avoid pricing anomalies. It's not uncommon for an institutional buyer to take several weeks or even months to build a desired position.

For this reason, small-cap stocks provide opportunities, to ride waves of gains as the big institutions incrementally build their positions, both creating and propagating massive bestseller effects.

A Reputation of Risk

There are enormous growth opportunities that small-cap stocks can offer. But they tend to have the reputation of being risky relative to large-cap companies. In some ways, that reputation can be warranted. Small-caps can be extremely volatile, because it takes a much lower volume of trading to cause price fluctuations.

Small-caps also have the challenge of demonstrating that their business model is scalable. In other words, will they be able to consistently generate revenue and expand profits as the size of their market and operations becomes larger. That isn't easy to do, and it's the only way that the stock is going to truly take off.

Other lines of reasoning that contribute to small-cap skepticism are less sound. Many investors don't trust smaller companies because of what they view as a lack of accountability and increased potential of fraud. Since they are smaller and get less attention, they are regarded as less trustworthy.

The reality is that -as anyone who's paid attention over the last decade can tell you -there are plenty of large companies who are less than scrupulous or transparent in their reporting and accounting practices....

While small cap investing may require a bit more endurance and patience than other segments, the same risk management techniques apply. Always set a trailing stop to protect your gains, and limit losses, and never bet the farm on any single company - ever!

Keep in mind, though, if you have the ability to identify the features of a company that is primed to take off -and the "sparks" that indicate it will happen - investing in small-caps can be exceptionally profitable.

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