The world of investing is a volatile one at the best of times – not least when it involves pinning your hopes on the successful scaling of a small company that’s yet to fully establish itself.
The movie Wolf of Wall Street went some way in projecting a frightening image of sleazy penny stock brokers trying to sell worthless shares in startups that have their head offices located in a garden shed.
Funny it might be, but it’s not an accurate portrayal of small company investment – well, most of the time.
Today, the most effective way of investing in a promising small company is through the use of small-cap stocks. These refer to the stocks of a publicly-traded company that has a market capitalization that ranges from $300m to $2 billion – hence the use of the word ‘cap.’
This means that the definition of a ‘small’ company is subjective but loosely conforms to this capitalization band. Because they have significantly more room to grow compared to companies that have already established themselves, investing in small-cap stocks can be highly lucrative. However, there’s plenty more danger of said businesses folding at the same time.
(Small-cap indexes of S&P 600 and Russell 2000 Index show significantly higher growth potential compared to the larger cap index of S&P 500. Image: CFI)
In the chart above, we can see a clear correlation between the returns of the small-cap markets (S&P 600 and Russell 2000 Index), as opposed to the larger cap market of S&P 500.
This makes the act of investing in smaller companies significantly more lucrative for investors who choose their businesses wisely. But how easy is it to find the right small company to invest in? And is it possible to maximise your chances of making a profit? Here’s a deeper look at how to invest appropriately into the dynamic world of the smaller scale public companies:
Small-cap markets vs penny stocks
It’s worth taking a deeper look at the differences between small-cap stocks and the aforementioned penny stocks. While most small-cap stocks actually operate as penny stocks, their share value can easily rise beyond the $5 cut-off price for penny stocks. As well as this, small-cap stocks enjoy a greater level of liquidity as opposed to their market counterparts.
Look out for volatility
Market volatility can be a great ally for small-cap investors. If we take the time to learn our lessons from previous periods of high-volatility, the unpredictable nature of the market today will likely lead to another ‘baby-out-with-the-bathwater’ effect where low trading volumes punish price disproportionately for smaller companies.
Although it sounds like an incredible risky melting pot of market uncertainty, there can be some great value opportunities for investors who have bided their time in waiting for the right small-cap dips.
Use the right tools
There are plenty of places where you can find scores of data on the share information of smaller companies. Most online tools come free of charge when it comes to monitoring small-cap stocks, and companies like CNBC.com possess an accessible free stock screener that can easily be customised.
Because of the massive array of metrics that come with stock monitoring tools, there’s plenty of advice out there for users who would like to know exactly where to find their best bets for increased revenue.
According to CNBC, some of the most effective ways of identifying the best small companies to invest in can be found by using tools to search for stocks with a market cap of less than $500, or a year-over-year revenue growth of over 10%, or one-year EPS growth of more than 15%.
It’s also worth searching the small-cap markets for companies with a P/E ratio of 15 or less, and stocks with coverage of significantly fewer analysts – hidden gems are the best way of leveraging a big payout.
Utilising these criteria, there’s a relatively good chance of identifying a few strong candidates for deeper analysis. Although it’s important that these investments conform to your personal goals and asset allocation approaches.
There are also numerous tools out there that can be bought for a competitive subscription rate that could greatly benefit users who may want to sit on a diverse portfolio of small businesses. Some of the better stock comparison tools are capable of providing aggregated performance scores that reflect various multiples.
It’s important to critically analyse why a specific small company may be attracting interest. Try running a few searches of the company name and gauging why so many investors are sitting up and taking note.
If the company’s web profile appears to be low compared to that of ofter similarly positioned small companies then there’s a chance that few investors will be in a position to learn of its ongoing scaling until at least the next release of a quarterly earnings report, of the Securities and Exchange Commission’s Form 8-K – with the letter being filled out only in the instance of a sizeable change that will considerably enhance the company’s profit margins.
Speculation can ultimately be a great way of drawing in investors, but it’s important to know if further interest is likely after you take the plunge and invest. Companies that are better at generating buzz tend to perform well in converting interest into shares.
Look closer to home
There can be great value found in looking into stocks that come from local businesses as opposed to companies that operate over one thousand miles away. Through local news outlets, it’s possible to keep abreast of big developments within local businesses ahead of the stories reaching the rest of the country. Your local business could be about to unveil a new development, partnership or product before an 8-K is released or other investors have a chance to join the bandwagon.
This isn’t necessarily a flawless approach of course, and there’s plenty of danger surrounding confirmation bias in this area. Local businesses – especially those based in labor-intensive industries – are typically front-and-centre in the minds of local residents, and can perpetuate familiarity bias – leaving more locals with too many shares and a significant lack of portfolio diversification.
However, if you heed these warnings, and dedicate enough attention to pursuing the promise of new local businesses, it’s possible that you could effectively tap into an exciting new investment that the rest of the market is yet to know about.