Very few large caps are going to post sharp gains in a short period of time, but isn't that the best feeling when you are looking at your portfolio for the day? However, with the lure of excess gains, comes additional risk. After all, there is no such thing as a free lunch.
So, what sets good stocks apart from the bad in the small cap arena? How can you mitigate the risk, but still collect the returns? And what are some of the differences in researching these companies compared to larger caps? Here are the answers to these questions:
A Needle in a Haystack
There are literally thousands of small cap stocks out there. Sifting through all the bad tickers to find a gem can be like finding a needle in a haystack. The first thing you need to do when trying to find the next winner is get yourself a smaller haystack. By using a few guidelines you can whittle the endless list of companies down to a manageable few. For me that process always starts with earnings.
First things first. If the earnings picture is not good, then why look any further? The Zacks Rank provides the best way to evaluate the quality of the earnings outlook for a company. This is important for reviewing all stocks, but especially small caps.
Investors also want to find stocks with explosive growth potential. Too often they disregard stocks which don't have year-over-year earnings growth. Yes, that is great to have under normal conditions. However, after a deep recession like now, year over year growth is hard to find and simply unnecessary.
So, do not skip over the shares with little or no year-over-year growth, they may have incredible EPS momentum going forward. The Zacks Rank is great at picking up these trends as well.
Be a Penny Pincher
Valuations seem to be a concept lost on many small cap investors. Not everyone ignores the P/E for these stocks, but you have to look a lot further than that.
Imagine a 50% decrease in earnings. Sounds horrible right? But with a small cap company that might only mean that EPS dropped from 2 cents to 1. However, that same company's sales may be unchanged, or even improving.
Price-to-sales is one of the best valuation metrics for smaller companies, especially in cyclical industries. Earnings can be extremely volatile and unreliable, given the liberty in some accounting practices. So, look beyond your father's P/E ratio and dig deeper to find value.
Who? What? Where? When?
Given the attributes above, which can easily be handled in seconds by a stock screener, you should now be looking at a much smaller list of stocks. Now it's time to roll up your sleeves and dig in.
Finding out what is behind that ticker is one of the most interesting parts of investing. Who are they? What do they do? Where do they do it? Making sure a company can justify those growth projections is of the utmost importance. Just ask anyone who thought Crocs was going to continue to grow exponentially once the fad was over.
Finding out where a company operates is another big factor. The BRIC countries (Brazil, Russia, India, China) are very hot, and for good reason. If you can find a stock in an economy that is taking off, you have just significantly increased you chances of success.
A Contingency Plan
Even the best laid plans have a chance of ending in disaster. Small cap stocks climb fast and fall even faster, so make sure you put a stop-loss in.
Some will choose an arbitrary percentage based on their threshold for pain. Others look at charts to find failed support levels or other indicators. Which ever you chose, put them in and follow them.
We tend to fall in love with stocks and allow emotion to get in the way of our trading profits. Avoid this common pitfall by setting and following stops.
An Easy Path to the Best Small Cap Stocks
You will find most of the resources needed to analyze small cap stocks on Zacks.com and other investment websites. However, it will still require many hours of work each month to help pick the best stocks. So let me offer you an easier way.
Until Monday night, investors are invited to join the restricted group that receives Zacks' best-performing small cap stocks. By screening Zacks #1 Rank companies with certain growth and valuation metrics, we end up with a list of potent small cap stocks. How potent? From 2000 to 2009 they have produced an average annual return of +32.7%.
This has caused a stir in the Zacks community and the service already had to close to new investors because it became too popular. Now a few openings are available, but the opportunity will close again at 11:59 pm Monday, February 7 at the latest. So if you are interested, please click here to learn more.
About Bill Wilton and Zacks Investment Research
Bill is an expert on the Zacks Rank stock picking system, and has authored many aggressive growth stock articles on Zacks.com. He is also the editor of the highly successful Zacks Small Cap Trader.
Zacks.com is a property of Zacks Investment Research, Inc., which was formed in 1978 by Len Zacks. The company continually processes stock reports issued by 3,000 analysts from 150 brokerage firms. It monitors more than 200,000 earnings estimates, looking for changes.
Then, when changes are discovered, they're applied to help assign more than 4,400 stocks into five Zacks Rank categories: #1 Strong Buy, #2 Buy, #3 Hold, #4 Sell, and #5 Strong Sell. This proprietary stock-picking system continues to outperform the market by a nearly 3-to-1 margin.
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Disclaimer: Past performance does not guarantee future results. Investors should always research companies and securities before making any investments. Nothing herein should be construed as an offer or solicitation to buy or sell any security.