Small-cap stocks are those with market capitalizations that fall between $300 million and $2 billion (number of shares outstanding x price per share). There are over 1,000 publicly traded small-cap stocks in the market, and they comprise roughly half of the Russell 2000 index.
Unlike large-cap stocks, which are usually large, well-known companies. Small-cap stocks are largely unknown to most investors, although some companies with which you’re familiar may be small caps.
Daily Journal (DJCO), the company previously helmed by well-known value investor Charlie Munger is a small-cap stock. As is Hovnanian Enterprises (HOV), the homebuilder otherwise known as K. Hovnanian. You’ll also find well-known brands like Winnebago (WGO) and Cracker Barrel (CBRL) among the ranks of small-cap stocks.
Investing in small-cap stocks is a popular strategy for investors looking for outsized returns. The smaller companies often have the most potential for growth. They also carry plenty of risk for small-cap investors.
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Small caps are also less likely to have reached maturity in their growth cycles. Some small-cap stocks are clinical-stage biotechs whose drugs have yet to be approved for commercial use. Others are chipmakers or cloud-computing companies that have plenty of promise but have not yet been embraced by the market.
It’s impossible to take the risk completely out of small-cap stock investing. But there are ways to minimize those risks without sacrificing potential profits.
For starters, set up a clearly established set of rules ahead of time, and stick to them.
6 Things to Look for with Small-Cap Stocks
Our small-cap expert, Tyler Laundon, has a very specific set of rules for finding small-cap stocks. Those are:
- Search for paradigm shifts in any field of business that requires a unique, new solution that will be provided by a stand-alone company. Then seek a niche supplier that will become an equal benefactor to that pioneering company.
- Invest only when the market opportunity is huge—and quantifiable. Only invest in small companies that serve large, burgeoning markets because you can realize tremendous growth with even small shares of the market.
- Get into a small-cap stock before institutional investors become aware of it. Sometimes it takes a while for the big hedge funds or mutual funds to discover small yet promising companies. Once they do, it quickly drives up the price.
- Invest in stocks that offer both growth and value. Look for relatively young companies with growing sales, that are undervalued based on the company’s market potential versus its total market capitalization. A balance sheet with little to no debt is also a big plus.
- Invest at the right time in the product cycle. There is a direct correlation between the time of investment and the degree of risk and rate of return you can expect. The time period after venture capital investors come aboard is generally the most promising.
- Lastly, concentrate on the very best ideas. Look for industries that have hit a roadblock and need new technologies to keep growing. The small companies that provide those breakthrough technologies make for the best small-cap stocks.
One other practical rule for handling small-cap stocks is to use position sizing to manage your risk.
For most investors, it’s not appropriate to commit your full portfolio to even a basket of small caps. Consider allocating a fixed percentage of your portfolio (depending on your risk tolerance) to the asset class as a whole.
You could use a fixed percentage, such as 10% or 20% of your portfolio, for your small-cap investing.
By keeping your overall exposure limited, you’re reducing portfolio volatility as small caps tend to be more volatile than large-cap or mid-cap stocks.
These rules won’t help you pick all winners, but they should give you a leg up in selecting the right stocks.
If you’re interested in receiving top-tier recommendations on the best small-cap stocks, subscribe to Tyler Laundon’s Cabot Small-Cap Confidential.
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