Most of us have a small portion of our portfolio that we are aggressive with. Small cap companies can be a good component of an aggressive portfolio, especially when mid and large cap companies seem overvalued. The stock prices of these companies are generally more volatile and can offer the investor higher returns. Unfortunately, this potential for higher returns is coupled with greater risk. Taking the time to evaluate a company's business plan, financial statements, and management team can help you maximize your risk/reward ratio when investing in smaller companies.
Most investors assume that any publicly traded company is going to have a viable business plan. Making this "assumption" has led to the total loss of many investors' principal in small cap companies. In order to be successful, most small cap companies have to supply a product which fills a need in a niche market that they can thrive in. Trying to directly take on the established industry leader who has brand awareness, a large marketing budget, and a huge distribution network for its products is a recipe for disaster. Make sure that any small company you invest in has identified its potential customer, and can provide a cost-effective product which that customer either wants or needs at a price that will enable the company to profit.
Before buying any stock, it is imperative to review that company's financial statements. It is impossible to evaluate a company and determine a target price per share of its stock without examining a company's income statement, balance sheet, and statement of cash flows. When available, the most recent quarterly and annual conference call should also be listened to. Most companies will provide a link to these conference calls on the investor relations parts of their website. When dealing with small cap companies, one should pay close attention to the cash on hand that the company has. When dealing with companies that are not yet profitable, the amount of cash on the balance sheet becomes even more important. As a rule of thumb (with medical or mining companies being possible exceptions), you should never buy shares of an unprofitable company that has little or no cash, or a high amount of debt. These companies will be forced to raise money in the future, usually in the form of an equity private placement, and at a discount to the current market price. If you are still insistent on purchasing some shares, it may be a good idea to call the company and see if you can participate in any potential private placement where you can acquire stock at a discounted price to the market.
The most important component of any small cap company is their management team. The greatest of products can easily fail with a poor management team, while I have seen companies with mediocre products thrive with strong management. Spend some time and research the background and history of the CEO and CFO. You will find that their track record of success or failure is very likely to repeat itself. Any companies with management teams that have a history of litigation should be avoided, since legal proceedings can be death blows to small cap companies.
Most seasoned investors in small cap companies will have a track record of some extraordinary gains and losses. Those who have trouble stomaching the downside volatility should avoid them altogether. Investing in small caps requires good judgement and experience. Unfortunately, many investors gain the most experience from their bad judgements of the past. Spending time to evaluate companies before you invest in them is critical, especially when dealing with small caps.
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