Active Investing in Small Cap Stocks

by JT McGee

I wanted to put together a FAQ for people who are interested in active investing in small cap stocks. I’ve tried to cover as much as I could think up, but if you have any other questions, leave them in the comments so I can add to this over time.

This is to continue the discussion from a guest post on passive vs. active investing at Boomer and Echo.

The Theoretical

1. Aren’t smaller companies riskier?

Not necessarily. For instance, it would be dangerous to be a $100 million company going up against Apple in the cell phone industry. But a lot of companies are smaller just because the industry is smaller.

Case in point: Have you seen one of these before?

WD-40 is in 80 percent of American homes. That’s almost as good as air conditioning (86% of homes have some form of air conditioning) and better than washing machines (two-thirds of homes).

Yet, WD-40 is a tiny company. The market values it at less than $800 million even after a gain of 17% so far this year. Is WD-40 a poor investment just because the market for waster-displacing spray is relatively small? That’s a silly way to find good investments, don’t you think?

Sure, WD-40 is a small company. But think like a competitor: how hard would it be to beat WD-40 in the water dispersing spray business? I’m thinking it’d be nearly impossible – no one will wake up tomorrow wanting to challenge it.

2. If anyone can do this, why doesn’t everyone do it?

Anyone can get rich slowly with index funds, too. Yet most people do not save enough, or at all, for a future well-funded retirement. Why doesn’t everyone save for retirement? Beats me.

3. Why don’t professionals analyze smaller stocks if these opportunities exist?

Analysts make money for their employers in three ways: finding good investments for a fund, creating trading activity by encouraging clients to buy and sell stocks, and selling their research to investors.

Analysts working for fund companies would be wasting their employer’s time looking for stocks too small for their portfolio. They might as well play Minesweeper non-stop from 9-5 instead. If the goal is to increase transactions for commission revenues, it makes a lot more sense to dedicate time to a company like…say, Apple, which is so large that the firm’s clients could never overwhelm the market with activity. Finally, analysts want to sell research to the biggest market possible – writing up a paper on a microcap is a waste of time.

4. What about corporate governance? If no one is watching the company, insiders can do whatever they want.

This is a common myth in smaller securities. If anything, you have far more power with smaller companies than larger companies. Case in point: one of the companies I identified in the post at Boomer and Echo was sold because of a complaint from an average shareholder. One shareholder wrote to another major shareholder, and before you knew it, a challenger to the board of directors appeared. The company was sold before a board election could take place – a resolution I’m pretty happy about.

The Practical

5. I have zero interest in business or finance. Is this something I could learn to enjoy?

No. Unless you love it; you’ll be bored. Frankly, the best part of it, for me, is that I get to learn something new every day. If you’re the kind of person who likes to learn, you’ll never grow old of it.

You have to enjoy reading, learning, and the pursuit of finding needles in haystacks. I should mention, though, that many of the best value investors of all time had very little academic training in finance. So if your concern is purely about your knowledge of business or finance, I wouldn’t sweat it.

6. What if I have a question about a company?

Every public company has an investors relations person or department. Give them a call – the number is listed in filings and/or the company website. If its a small cap, the person on the other end of the line will probably be happy to know that someone actually read the latest filing.

7. How much time does it take to find an investment?

A few hours at first. I like to go to Google’s stock screener to sort by industry and then market cap. From there, I start reading through every company’s annual and quarterly reports. I throw out 99% of the companies after about 3 minutes of poking around. The bad companies can be spotted from a mile away. It’s the few that make it through the first sorting that get preferential treatment, and an additional look-around.

By the way, start a spreadsheet. Often I’ll find an interesting company that just doesn’t cut it for one reason or another. Every few months I’ll go back through to see if anything has changed materially. That way I don’t have to start the hunt all over again.

8. How much capital do I need to get started?

I wouldn’t start with less than $5,000. Trading costs can get expensive, and anything less should be seen as fun money, not investment capital. Remember, it does require time to find each pick…and time is money, too. Pick a broker that charges commissions as a fee per share. There are countless brokers with a per-share commission schedule where you pay a flat minimum ($1 or $2) plus .5 to 1 cent per share, per trade.

Do not, I repeat, do not start investing until you have practiced interpreting information and valuing companies. “Paper trading” with a practice account is a good way to test your abilities before you start. Find 5 companies you like, put 20% of a practice account in each, and see how it pans out. There will always be more opportunities elsewhere – you lose nothing by practicing.

9. What’s the best way to start?

Find a small cap company in a business that you have some knowledge of. (How about WD-40, for starters? Consumer products are relatively simple.) Grab the annual report and start reading page by page. When you run into a vocabulary word you don’t understand, stop and Google it.

This really is the way I learned 99% of what I know about investing and business. The thing is, there is so much more public information than people recognize. And all you have to do to find it is look through the annual report.

10. Are there any books on valuing a company?

Yep! One of the best books is also the most dry: Security Analysis. It was written by an investing legend who crushed the market by searching for very undervalued companies in tiny corners of the stock market. You might have heard of Ben Graham before – he’s the guy Buffett learned from.

A better starting place might be Peter Lynch’s book, One Up on Wall Street. It’s less technical, and a good warm-up to the kinds of things you’ll want to look for in a company. My favorite advice from Lynch: buy growing companies in mature industries. When a whole industry is growing, it attracts competition and investor interest. A single growing company in a slow-growth industry makes for a hidden gem for investors.

Lynch’s book is spectacular on understanding businesses. Graham’s is better for finance.

11. What’s your best tip?

Stay away from any company with headquarters in China. Accounting fraud is business as usual.

12. How about a second tip?

Look at the company as if you were a customer. What makes this brand better than another? Is there any reason why I would want to pay a premium price for this brand? I haven’t analyzed WD-40 in quite some time, but if I were in the market for its spray, I’d undoubtedly buy WD-40 over any other competing product. I know it works, I know it’s quality – and I don’t care if it costs $.50 more.

That’s the kind of stuff that’s important.

13. Third?

Management is everything. Look into their background to get an idea of what the future holds. One company I bought into was managed by someone who had built a multi-million dollar education business before selling out for big money. His new project was a health care company. Education and health care have a lot in common: navigating legal red tape.

He actually brought the same people from the education company to the health care company, and they sold that company for big bucks, too. I’m keeping an eye on him to see if he picks up another project.

Should he start a new project, what do you think he’ll do? My guess is he’ll do what he’s good at: building a company in a competitive space, and selling out for hundreds of millions of dollars. His companies might be “too small” to attract fund attention, but he is, without question, one of the best small cap CEOs. I’ll follow him into anything he wants to start – the track record is great.

14. Emotions can make humans do stupid things. How do you control how you feel about an investment?

Stick with businesses that you know. I haven’t invested in pharmaceutical companies, and I won’t. That stuff’s way over my head, so I avoid it. For a medical student or current doctor, pharmaceuticals might be the most logical place to start.

15. Why should I manage my own money?

It’s not for everyone, but it can be for many people. I would venture to guess that more people than you think control their own retirement destiny by actively managing their investments. And I’m not just talking about stocks – real estate, small businesses, and other “alternative investments” are full of people who manage their own investment capital.

{ 4 comments… read them below or add one }

Robert @ The College Investor June 26, 2012 at 23:50

Don’t small cap stocks have a higher PE right now than average? Is not a good time to be getting into that sector?

Reply

JT McGee July 2, 2012 at 12:18

Well, the important thing here is that we’re looking for single stocks, not the whole small cap space. Looking at it as a matter of the whole market – or the whole small cap market – is a concerning way to go about it if you’re interested in individual companies. I know a firm that has a PE of 11.4. Not high, not low. But it has cash on hand worth roughly 60% of the market cap. When you net out that cash, the PE is really something more like 5, which is an insane value.

I’ve also run into companies that trade with a PE of 20, but have more current assets than total liabilities. In effect, the PE is irrelevant, since the company is essentially free.

Reply

Financial Samurai July 1, 2012 at 10:56

What about microcap? Always see so many pump and dumb stories.

Reply

JT McGee July 2, 2012 at 12:14

Well, that’s the rub: a lot more companies fall into microcap territory than fall into it. This could be a post of its own, but in general, never believe anyone else’s research about a microcap stock. I get mail all the time with pitches about the “next great company” only to see that the financials are in horrendous condition. A quick look at the financials can save you from 99.999% of these traps.

Reply

Leave a Comment

*

Previous post:

Next post: