By Rupert Hargreaves. Originally published at ValueWalk.
The Small Cap Investing Handbook Part Nine: 5 Rules For Small Caps. This is part nine of a ten-part series on small-cap investing.
Throughout this series, I’m looking at both the benefits, and drawbacks of investing in small caps, considering all of the evidence available to us today for both sides of the debate.
When completed we are planning to turn the series into an e-book, which we hope will be a comprehensive guide to investing in small caps.
The series is a collaboration between ValueWalk and ValueWalk’s new small-cap investing magazine Hidden Value Stocks, a quarterly publication which profiles two top-notch small-cap focused hedge funds in each issue. small-cap ideas each. To find out more, head over to www.hiddenvaluestocks.com.
For the other parts of this series please follow the links below:
- Part One: Introduction
- Part Two: The Small-Cap Premium
- Part Three: Size Matters
- Part Four: Quality Over Quantity
- Part Five: Peter Lynch’s Rules
- Part Six: Peter’s Principles
So far in this series, I’ve looked at the academic research behind small cap stock return and advice from professional investors about how to achieve the best returns, and limit your downside, when investing in this section of the market.
In this part, I have pulled together five rules to a successful small cap strategy, compiled according to the information presented so far. These five rules may not be a comprehensive guide small cap investing by themselves, but when used with the rest of the information in this series, they will certainly help you refine your small cap investing process.
Small Cap Investing – Top five rules
The business should be simple and easy to understand
Warren Buffett often jokes that he has a ‘too hard pile’ where the investments he cannot understand end up. This is a principle that many investors overlook. To be able to invest in a company with any confidence, you really need to know and understand how the business makes its money. It’s simply not just enough to understand the valuation, if you don’t understand how and why the business generates profits, the valuation means nothing. Peter Lynch had a ‘two minute’ drill, a two-minute timeframe when he had to describe why he liked the company he was studying and this is a great hurdle to incorporating your own investing process. If you cannot describe why you like the company and what it does in two minutes, you might have to reconsider your investment decision. After all, if you don’t understand what the business does, how are you ever going to judge whether or not it is a good business?
The company must have room, and a plan for growth
Small cap investing is about looking for tomorrow’s winners today. These companies must have a large addressable market to grow into, in order for them to succeed over the long-term, if not they may become stuck in a holding pattern. Earlier in the series I highlighted the study which showed that the best returns, from high quality, high growth small caps. If there is no market for the company to grow into, or the market is already saturated, returns will most likely be subpar.
Management is key
being able to trust management is vital in any investment, but for small caps its even more important. These small businesses need a trustworthy, driven management team that you can rely on to make the best decisions. Unlike mega-cap blue chips, small cap managements tend to be more involved in the day-to-day running of the business, so making the right decision is vital as there are fewer layers of management to question whether or not this the right course of action. At such an early stage in a company’s development, you need to be sure that you can trust management to make the right decision, at the right time without compromising growth or financial stability.
Financially independent
unlike mega-caps, small caps will have to work hard for almost everything especially when it comes to financing. Financing a small business is notoriously challenging, and it’s no different for public companies. This means if a small business is dependent on creditors, its future hangs in the balance of its ability to sell itself and the mood of creditors.
To achieve the best results, it may be wise to stay away from such scenarios. Companies dependent on debt are at the mercy of wider market sentiment and may find themselves unable to raise cash when it’s most needed. Companies that are able to tout their story may find it easier to raise additional funds, but to make life easier, it might just be better to avoid leveraged businesses altogether and stick to those companies that have a record of strong cash generation and cash rich balance sheet.
The capital structure
something that most blue-chip investors will overlook is a small caps capital structure. There are two points to make on this topic. First of all, as the growth potential of the small cap is almost entirely dependent on management’s devotion to the business, management should have skin in the game to ensure that they make the right decisions. Second, many entrepreneurs go public by teaming up with a shell corporation that’s listed on an exchange, the shell then acquires the private operating company by issuing its owners shares in the shell and they then take over the listed company. There’s nothing wrong with this process but it does greatly improve the chances of capital structure abuse. There are lots of shops out there which sell shells to unwitting entrepreneurs for far more than they’re worth. The seller of the shell then pumps up the stock price to dump their interest in the business at a premium. Such actions will distract the entrepreneur from the running of the business and ruin the company’s public reputation, neither of which will lead to a desirable outcome for investors.
The post The Small-Cap Investing Handbook Part Nine: 5 Rules For Small Caps appeared first on ValueWalk.
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