Despite their recent underperformance, historically, investing in small-cap stocks has been more profitable than investing in large-cap stocks.
In fact, on average, small caps outperform large caps in three out of every five years.
Although that hasn’t been the case for the last five years, as large-cap stocks (as measured by the S&P 500, up 83.3%) have outperformed small-cap stocks (as measured by the Russell 2000, up 34.7%) by more than 2-to-1.
But the reasons for their historical outperformance are as true today as they’ve ever been.
Small-cap stocks typically draw less analyst coverage and are harder to uncover.
There are structural issues (like lower liquidity and minimum share price guidelines) that prevent large institutions from taking outsized positions in smaller companies.
But, for individual investors, the structural issues that hamstring institutional buyers can become an advantage.
Identifying a promising small-cap company before big buyers can start to accumulate positions can lead to significant outperformance for early investors.
But, once you’ve found the small caps to invest in, how do you handle them?
Below is a five-step plan for successfully managing your small-cap stocks. These are the same five steps I use in my Cabot Small-Cap Confidential advisory.
5 Steps for Handling Small-Cap Gems
Historically, small-cap stocks outperform the market. But small-cap stocks can be more volatile on the way up so it’s good to have a plan to help you focus on the end goal. Research and a disciplined investment strategy are key.
1) Have a Plan:
a. You’ll be more comfortable—and more successful—investing in small caps if you follow a plan that covers:
i. What percentage of your portfolio will you invest in small caps?
ii. What is your time horizon?
iii. What are your profit goals?iv. How much are you willing to be down on a position and for how long?
2) Buy with Discipline:
a. In general, buy when:
i. A stock’s price is reasonably steady, not surging or crashing
ii. Fundamentals suggest the stock is reasonably valued
iii. There is no known catalyst that’s driven excessive price appreciation
iv. You’ve done your research and understand the potential, and the risks.
3) Sell Losers with Discipline:
a. Generally, sell when …
i. Anticipated growth catalysts are unlikely to materialize
ii. Unanticipated negative events have changed the growth outlook
iii. Fundamentals suggest value traps
iv. Industry growth trends break down
v. A stock is down 25% to 30% from your entry point.
4) Sell Winners with Discipline:
a. Generally, sell when one or more of the following happens or is likely…
i. Anticipated growth catalysts have run their course
ii. Slowing growth appears unlikely to sustain investor interest
iii. A buyout offer has come from a company you don’t care to own
iv. The stock is up 50% to 100% (or more) and partial profits are warranted
v. The stock begins to break down and/or underperform its benchmark index.
5) Do Your Research:
It’s a simple fact: most small-cap stocks are so small that the big Wall Street firms don’t have analysts covering them. You’re on your own. And because a lot of small-cap trading happens based on rumors, personal hunches or insider information, there is often a big information gap. We can fill that knowledge gap, to help you base your small-cap investing on solid research, and fundamental and technical analysis. That’s how you make money in small caps!
