The numbers don’t lie: small-cap stocks are, historically, better performers than large-cap stocks. The average annual return in the S&P 600 Small-Cap Index over the past 20 years is 10.5%, compared to a 7.9% annual return in the S&P 500 during that time.
Whether you were aware of that statistic or not, you’ve probably been tempted to invest in small caps at some point. But one thing has prevented you from doing so: you don’t know how to find small-cap stocks—or at least the right small-cap stocks.
I’m here to steer you in the right direction. Fortunately, small-cap investing happens to be my specialty, and as chief analyst of our Cabot Small-Cap Confidential investment advisory, I have dedicated my career to helping investors like you learn not only how to find small-cap stocks, but where to find them.
Each time the market has made this shift we racked up gains of 396%, 500% and 876% as unwitting investors lost their shirts.
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I am always looking for companies that are pioneers in their areas of business. In many cases, these companies are creating whole new micro-industries, providing essential tools for an entire industry’s growth, or doing something better or faster than in the past.
But I don’t like to discount traditional businesses. A lot of very successful small-cap investments come from very basic business models. The corner convenience store, the healthy food manufacturer, the high-volume concrete company … a lot of money can be made by keeping things simple.
The common thread will always be that I see 100% or greater upside with each stock within a two-year time frame.
Because it’s institutional investors who drive up stock prices, I look for the same thing they look for, but because I’m seeking far greater returns, my approach must be different. My forensic research digs significantly deeper into the industry and company to uncover information that gives me a unique advantage over the big boys.
Getting more specific, there are a few steps that I follow to insure that every small-company stock I recommend has the potential to bring strong profits. Here are the five most important steps.
How to Find Small-Cap Stocks in Five Steps
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. I call these companies “pure plays.”
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 (CSCO) 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 (SNIC) 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 (HANS) stepped in to become the leader and its stock, now renamed Monster Beverage (MNST), has been one of the best performers of the post-2002 bull market.
I try to 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 the Law of Large Numbers: Only invest in small companies that serve large, burgeoning markets because the companies can realize tremendous growth with even small market share. The sheer size of the 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
This strategy is called robbing the train before it arrives at the station. By gaining a research advantage, we can invest in companies before most big investors get on board—including mutual funds, hedge funds and pensions.
In many cases, I’ll invest in companies that have less than 50% institutional ownership. The idea here is that subsequent investments by institutions will drive up the value of the stock.
4. Invest in stocks that offer both growth and value
Big, growth-oriented ideas are awesome, but it’s also important to consider valuation and buying when valuation as compared to peers is reasonable. A good candidate may be 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.
5. Avoid big losses
It’s last on my list, but certainly far from my least important rule for how to find small-cap stocks.
Since 1925, small-cap stocks have posted greater gains than any other asset class—2% to 5% a year more than mid-caps and large caps. And between September 2011 and September 2015, small caps rallied by 20% more than large caps, posting a total return of 97%.
That long-term outperformance helps to make a strong case for owning small-cap stocks. But investors do need to understand that the larger moves to the upside are typically mirrored on the downside during bear markets and market corrections.
As a general rule, small caps are more volatile than large caps, but less volatile than emerging markets stocks. This isn’t reason to steer clear, it just means that you should expect larger swings in their prices, and you should use stop losses to avoid really big losses.
Many advisors advocate a 10% to 15% stop loss for large caps. For small caps, I like to widen this to 25% to 30%. The reason is that we often see quality small caps drop 20% or so during market corrections. And often, these are the times to buy, not to sell. We don’t want to get chased out of a quality stock because of market volatility.
If a small-cap stock falls by 25% from my entry point, I start to watch very, very closely. The critical thing to do at this point is determine if the decline is due to some fundamentally negative event, or trend, that undermines the company’s longer-term potential, or if it is simply the result of market turbulence.
If it is the prior, then the stock is more than likely a candidate to sell. While turnaround stories do happen, the bottom line is that investors need to cut losses short on bad stocks that continue to fall.
If it is the latter, it may make sense to give the stock a little more wiggle room, and see if it hits that 30% stop-loss level. If it does, then at that point it really is a matter of watching extremely closely for a good exit point.
The idea here is to avoid catastrophic losses. A couple of 30% or so losses a year is not a big deal. But allowing those losses to get bigger really does curb the overall profit potential of your portfolio.
Ultimately, you’ll need to decide what stop loss level works for you, and what will make sure you sleep well at night.
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Tyler Laundon is chief analyst of Cabot Small-Cap Confidential. The circulation of Small-Cap Confidential is strictly limited because the undiscovered stocks with sky-high-potential that Tyler recommends are often low-priced and thinly traded. Don’t share these recommendations!Learn More
*The original version of this article was written on December 14, 2016.