Ten Rules for Investing in Small-Cap Stocks

As chief analyst of the limited-subscription newsletter, Cabot Small-Cap Confidential, I’m delighted to present this guide as an introduction to my small-cap investing methodology.

The investment methodology I’ve developed requires a series of qualitative and quantitative evaluations for each company I’m considering. The company’s products must target large markets, the science or technology must be proven, the balance sheet must be strong enough to support research or investment activity, and the idea must be strong enough to attract future institutional investment.

My analysis results in a portfolio of stocks of companies that are pioneers in their areas of business. In most cases, these companies are creating whole new micro-industries, providing essential tools for an entire industry’s growth. Because these stocks have little or no institutional or research coverage, Small-Cap Confidential subscribers can acquire significant positions in these companies more cheaply than if their stocks were widely followed.

Over my many years of stock picking, I have developed my own rules for small-cap investing that have helped me amass extraordinary returns for my clients. I apply these rules, each requiring tremendous research, to every stock I recommend in Cabot Small-Cap Confidential.

These are the rigorous metrics that I apply to each stock that I recommend in Small-Cap Confidential. I urge you to use them to become a smarter, savvier, and wealthier investor.

1. Search for paradigm shifts that are opening up new opportunities

I search for paradigm shifts in any field of business that requires a unique, new solution that will be provided by a stand-alone company. I then seek a niche supplier that will become an equal benefactor to that pioneering company.

A good example of such a paradigm shift was the move from the mainframe computer environment to the personal computer environment in the 1990s. All the new personal computers needed to be connected! And Cisco filled the void, supplying the industry with networking tools and its stock increased 70-fold. Another example was the move from CD to DVD format. Sonic Solutions provided the software for conversion to the new DVD format and its stock took off. In the consumer market, energy drinks burst on the scene in the late 1990s, giving the industry its first truly new product in decades. Hansen Natural stepped in to become the leader and its stock has been one of the best performers of the post-2002 bull market.

For Cabot Small-Cap Confidential, I dig deep to uncover the small company suppliers to the transition leaders—just as the top suppliers to Cisco, Sonic Solutions and Hansen became equal beneficiaries of the paradigm shifts, yet remained largely unnoticed by institutional investors until well into their industry transitions.

2. Invest only when the market opportunity is huge—and quantifiable

This is my Law of Large Numbers: Only invest in small companies that serve large, burgeoning markets because you can realize tremendous growth with even small shares of the market. The sheer size of these markets creates the potential for huge gains while helping to reduce your risk profile.

Large medical patient populations and new technology users are examples of vast markets to target. Here’s an example: By the age of 60, half of all men will have an enlarged prostate, a condition known as Benign Prostatic Hyperplasia (BPH). Research tells us that treatment for this condition will cost upward of $10 billion per year. The opportunity for a small company that captures even a fraction of this market would be enormous.

3. Invest in companies before the institutions notice them

I call this strategy robbing the train before it arrives at the station. By applying my research advantage, I invest in companies before most big investors get on board—including mutual funds, hedge funds and pensions.

I want to find stocks that institutions are attracted to, but in which they have yet to accumulate their stakes. So I seek small companies with less than 40% institutional ownership, and build my position before the majority of institutions recognize the opportunity. Subsequent investments by the institutions will drive up the value of the stock.

4. Measure the company, not the stock price

While some investors perceive low stock prices as bargains, I place stock price low on the hierarchy of importance. To put this in perspective, if my goal is to be rewarded for stock-investing prowess, why start with a handicap? A company with no earnings only contributes to risk and potential loss of capital.

However, one important clarification needs to be made. Many stocks that increase 5, 10 and 20 times their original value don’t show earnings right away. It’s part of the cycle of growth inherent to small emerging companies. For this reason, selecting a company with the right product and valid market opportunity is often far more important than positive earnings. Such a company may incur losses until the market accepts the product. At that point, the losses will turn into rapidly growing earnings.

5. Invest in stocks that offer both growth and value

I seek big, growth-oriented ideas but I also apply value measurements to my candidates. A good candidate is a young company that has demonstrated significant growth in sales, yet is undervalued based on the company’s market potential versus its total market capitalization.

I also want to see a balance sheet with cash and little, if any, debt. Cash is important because it can carry a company through unexpected events. For example, should the much-anticipated launch of a product be delayed, I want the company to have enough cash available to see the product to market.

6. Validate market acceptance of the product

Market acceptance of a company’s product must be validated, never judged solely from my own viewpoint. The best way to do that is by looking at customer relationships, specifically OEM (Original Equipment Manufacture) deals.

OEM firms integrate a component product into a larger final product (think of semiconductors into personal computers). If an established OEM has a supply deal with our company, it provides tremendous recognition and product endorsement, as well as an inside view of the customer’s product plans. Like annuities, these supply deals provide predictable, stable flows of revenue over time. An OEM contract also offers the ability to raise prices to meet demand and can therefore contribute to even higher revenue rates.

7. Research what the institutions are holding

Mutual funds spend significant amounts of money researching companies and industries for stocks to include in their portfolios. By studying the individual stocks in the 13-F HR reports that mutual funds must file with the SEC, I can gain a sense of what industries and products they’re following—and what could become interesting to additional institutions in the future.

8. Invest at the right time in the product cycle

The point at which you invest in a stock is critical to your success. There is a direct correlation between the time of investment and the degree of risk and rate of return you can expect.

Generally, I consider the time period after venture capital investors come aboard to be the most promising point of investment. The most likely point to sell is after institutions have begun to invest en masse and driven up the price of the stock.

Here’s an ideal scenario: An industry has hit a roadblock and needs new technologies or products to keep growing. My targeted company offers a new and fresh solution that will be adopted, in time, by the industry leaders.

9. Concentrate on the very best ideas

When I take positions in stocks, I buy large amounts because I’ve found that few stocks meet my high standards for quality as investment candidates.

I’m not alone in my investment perspective; Warren Buffet buys approximately 12 stocks a year and only acquires large stakes, often controlling positions in his companies. Taking size in any stock is predicated on research. The more I know about the company, the markets served and the competitive landscape, the more shares I can add to my holdings.

10. Keep research current

All the preparatory research work I’ve elaborated is dynamic leading up to the stock purchase. As my companies do not operate in a vacuum, my research efforts must continue to confirm our company’s superiority.

And here are three ways I stay ahead of my investments:

•    I pay close attention to tone of voice and level of enthusiasm as the officers respond to question on conference calls. If their answers are upbeat instead of reserved, it’s a good indication business is picking up. If, on the other hand, they’re very zealous in their forecasts and spend enormous amounts of time on the phone, then perhaps there isn’t enough business to keep them busy.

•    I assess ongoing business conditions by viewing the company’s operating statements. Sales are the first indication of the wellness of the company. I compare the company’s revenues over the past quarter to the prior quarter to determine if they are growing sequentially. I make sure there’s parity between the growth rate of sales and receivables, as the two benchmarks should track each other in terms of percentage growth. If the sales are genuine, I move on to margins to ensure current gross margins are stable to rising versus the immediate past quarter.

•    My final health check is for any emerging technology coming that could leapfrog the company’s proprietary position in the marketplace. I gain a sense of what technologies are present or in the works by reading trade journals that are specific to my sector and going to the websites of venture capital firms to see what new technologies they’re investing in.

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