What should an investor look at while picking stocks in this collection of Small-cap stocks?

 

What should an investor look at while picking stocks in this collection of Small-cap stocks?

Financial Strength: 

This is one of the common criteria which Investors should look at before Investing in any company. Generally small-cap companies do not have as much sales as large-cap or mid-cap companies but if the company’s balance sheet is stable with decent cash flows and low debt, these companies can relatively survive and do better against their peers. So, No matter what the size of the business is, it is important to invest in financially stable companies combined with high potential to grow in the future.

Top-Line & Bottom-Line Growth:

It is also important to check the past performance of small cap companies. These companies should have a decent track record in atleast last 5 years. For instance check the company’s last 5 years Sales and Profit CAGR growth and compare the same with its peers. This will give you an idea as to how that particular company has performed compared to its peers. A company which grows its sales and profits consistently eventually provides better returns to investors. 

Market size & Positioning:

Generally, small cap companies are single product or single service line companies. It is important to know the overall market size of the business a company is operating in, and also the presence of that company in that particular market. This will give you a broad outlook on the positioning of the company in the market size of its business. A niche positioning in the market or some entry barriers created can make a significant difference to the company’s valuations.

Management Quality & Commentary:

In every company its Management plays a crucial role in deciding the company’s future. Before Investing in a small-cap company it is better to scrutinize its management history and any possible lapses done by them in the past. As we see, a lot of small companies and even some bigger companies fall prey to poor corporate governance and inflation of financial statements. Also avoid those companies which are facing legal/regulatory battles. Small cap companies tend to get overwhelmed by such regulatory challenges and it is best to avoid such cases.

Key risks associated with Small-cap companies:

Value Traps: Value trap is when a company is consistently operating in lower profits with very limited cash flows and cannot break through the phase while investors wait for them to turn profitable one day. Small-cap companies, especially the low ranking ones, are more prone to being value traps and might go defunct if the trend continues for a longer period.

Stay away from small caps facing Regulatory charges: Small-cap companies are more prone to going bankrupt especially when they are facing any legal or regulatory issues. So it is advisable to investors to stay away from those companies which are facing any legal issues.Also company’s debt is an important factor, you should stay away from high debt companies as they are more prone to bankruptcy than any other stocks. It is advisable to invest in very low or zero debt companies to avoid this risk.

Market cycle: A small-cap company’s exceptional performance can be a result of a high up-cycle. A small-cap company grows at an exponential phase in this up-cycle/financial bubble. Let’s understand this with an example. During the 90s almost all IT stock were booming and most of the returns were given by small IT companies because there was a consensus that IT sector will do well in coming decade so every IT stock was booming but the Dot-com bubble burst in the year 1999 and those small cap stocks were the first to get beaten down the most. So, It’s important to find the market cycle for a particular business before Investing in them.