Small-Cap Investing, 10 Rules for Success

Small-cap investing can be highly profitable if you know where to look. Here are 10 rules to find the next small-cap leaders.

business investment:plant growing on green background

Most investors are familiar with blue-chip, large-cap companies with heavy trading volume and lots of media coverage. Small-cap investing, which typically involves companies with much less notoriety, can be highly profitable if you’re able to identify and invest in those companies before larger investment firms begin accumulating shares.

The following 10 rules can help you narrow your focus and identify specific targets that are poised for success. Small-cap investing, when done right, can allow you to identify the next industry leaders years before the average investor.

Rule 1: Search for paradigm shifts that are opening up new opportunities

I search for paradigm shifts in any field of business that requires a unique, new solution that will be provided by a stand-alone company. I then seek a niche supplier that will become an equal benefactor to that pioneering company.

Rule 2:  Invest only when the market opportunity is huge—and quantifiable

This is my Law of Large Numbers: Only invest in small companies that serve large, burgeoning markets because you can realize tremendous growth with even small shares of the market. The sheer size of these markets creates the potential for huge gains while helping to reduce your risk profile.

Rule 3: Invest in companies before the institutions notice them

I call this strategy robbing the train before it arrives at the station. By applying my research advantage, I invest in companies before most big investors get on board—including mutual funds, hedge funds and pensions. I want to find stocks that institutions are attracted to, but have not yet accumulated stakes in. So I seek small companies with less than 40% institutional ownership.

Rule 4: Measure the company, not the stock price

While some investors perceive low stock prices as bargains, I place stock price low on the hierarchy of importance. To put this in perspective, if my goal is to be rewarded for stock investing prowess, why start with a handicap? A company with no earnings only contributes to risk and potential loss of capital. However, one important clarification needs to be made. Many stocks that increase 5, 10, and 20 times their original value don’t show earnings right away.

Rule 5: Invest in stocks that offer both growth and value

I seek big, growth-oriented ideas but I also apply value measurements to my candidates. A good candidate is a young company that has demonstrated significant growth in sales, yet is undervalued based on the company’s market potential versus its total market capitalization.

Rule 6: Validate market acceptance of the product

Market acceptance of a company’s product must be validated, never judged solely from my own viewpoint. The best way to do that is by looking at customer relationships, specifically OEM (Original Equipment Manufacture) deals. OEM firms integrate a component product into a larger final product (think of semiconductors into personal computers). If an established OEM has a supply deal with our company, it provides tremendous recognition and product endorsement, as well as an inside view of the customer’s product plans.

Rule 7: Research what the top institutions are holding

Mutual funds spend significant amounts of money researching companies and industries for stocks to include in their portfolios. By studying the individual stocks in the 13-F HR reports that mutual funds must file with the SEC, I can gain a sense of what industries and products they’re following—and what could become interesting to additional institutions in the future.

Rule 8: Invest at the right time in the product cycle

The point at which you invest in a stock is critical to your success. There is a direct correlation between the time of investment and the degree of risk and rate of return you can expect. Generally, I consider the time period after venture capital investors come aboard to be the most promising point of investment. The most likely point to sell is after institutions have begun to invest en masse and driven up the price of the stock.

Rule 9: Concentrate on the very best ideas

Here’s an ideal scenario: An industry has hit a roadblock and needs new technologies or products to keep growing. My targeted company offers a new and fresh solution that will be adopted, in time, by the industry leaders. When I take positions in stocks, I buy large amounts because I’ve found that few stocks meet my high standards for quality as investment candidates.

Rule 10: Keep research current

All the preparatory research work I’ve elaborated is dynamic leading up to the stock purchase. As my companies do not operate in a vacuum, my research efforts must continue to confirm our company’s superiority.

You can find more information about small-cap investing in Tyler’s advisories Cabot Small-Cap Confidential and Cabot Early Opportunities.

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