How to Find Small-Cap Stocks

Plus, 3 Early-Stage Cloud Software Stocks to Buy Now

The numbers don’t lie: small-cap stocks are, historically, better performers than large-cap stocks. Entering 2020, the average annual return in the S&P 600 Small-Cap Index over the past 20 years was 10.5%, compared to a 7.9% annual return in the S&P 500 during that time. Whether you were aware of that statistic or not, you’ve probably been tempted to invest in small caps at some point. But one thing has prevented you from doing so: you don’t know how to find small-cap stocks – or at least the right small-cap stocks.

I’m here to steer you in the right direction. Fortunately, small-cap investing happens to be my specialty, and as a chief analyst of my own small-cap investment advisory, I have dedicated my career to helping investors like you learn not only how to find small-cap stocks, but where to find them.

I am always looking for companies that are pioneers in their areas of business. In many cases, these companies are creating whole new micro-industries, providing essential tools for an entire industry’s growth, or doing something better or faster than in the past.

But I don’t like to discount traditional businesses. A lot of very successful small-cap investments come from very basic business models. The corner convenience store, the healthy food manufacturer, the high-volume concrete company … a lot of money can be made by keeping things simple.

The common thread will always be that I see 100% or greater upside with each stock within a two-year time frame.

Because it’s institutional investors who drive up stock prices, I look for the same thing they look for, but because I’m seeking far greater returns, my approach must be different. My forensic research digs significantly deeper into the industry and company to uncover information that gives me a unique advantage over the big boys.

Getting more specific, there are a few steps that I follow to insure that every small-company stock I recommend has the potential to bring strong profits. Here are the five most important steps.

How to Find Small-Cap Stocks in Five Steps

  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. I call these companies “pure plays.”

A good example of such a paradigm shift was the move from the mainframe computer environment to the personal computer environment in the 1990s. All the new personal computers needed to be connected! And Cisco (CSCO) filled the void, supplying the industry with networking tools and its stock increased 70-fold.

Another example was the move from CD to DVD format. Sonic Solutions (SNIC) provided the software for conversion to the new DVD format and its stock took off. In the consumer market, energy drinks burst on the scene in the late 1990s, giving the industry its first truly new product in decades. Hansen Natural (HANS) stepped in to become the leader and its stock, now renamed Monster Beverage (MNST), has been one of the best performers of the post-2002 bull market.

I try to dig deep to uncover the small company suppliers to the transition leaders—just as the top suppliers to Cisco, Sonic Solutions and Hansen became equal beneficiaries of the paradigm shifts, yet remained largely unnoticed by institutional investors until well into their industry transitions.

  1. Invest only when the market opportunity is huge—and quantifiable

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

Large medical patient populations and new technology users are examples of vast markets to target. Here’s an example: By the age of 60, half of all men will have an enlarged prostate, a condition known as Benign Prostatic Hyperplasia (BPH).

Research tells us that treatment for this condition will cost upward of $10 billion per year. The opportunity for a small company that captures even a fraction of this market would be enormous.

  1. Invest in companies before the institutions notice them

This strategy is called robbing the train before it arrives at the station. By gaining a research advantage, we can invest in companies before most big investors get on board—including mutual funds, hedge funds and pensions.

In many cases, I’ll invest in companies that have less than 50% institutional ownership. The idea here is that subsequent investments by institutions will drive up the value of the stock.

  1. Invest in stocks that offer both growth and value

Big, growth-oriented ideas are awesome, but it’s also important to consider valuation and buying when valuation as compared to peers is reasonable. A good candidate may be 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.

I also want to see a balance sheet with cash and little, if any, debt. Cash is important because it can carry a company through unexpected events. For example, should the much-anticipated launch of a product be delayed, I want the company to have enough cash available to see the product to market.

  1. Avoid big losses

It’s last on my list, but certainly far from my least important rule for how to find small-cap stocks.

Since 1925, small-cap stocks have posted greater gains than any other asset class—2% to 5% a year more than mid caps and large caps. And between September 2011 and September 2015, small caps rallied by 20% more than large caps, posting a total return of 97%.

That long-term outperformance helps to make a strong case for owning small-cap stocks. But investors do need to understand that the larger moves to the upside are typically mirrored on the downside during bear markets and market corrections like we saw in the February and March of this year.

As a general rule, small caps are more volatile than large caps, but less volatile than emerging markets stocks. This isn’t reason to steer clear, it just means that you should expect larger swings in their prices, and you should use stop losses to avoid really big losses.

Many advisors advocate a 10% to 15% stop loss for large caps. For small caps, I like to widen this to 25% to 30%. The reason is that we often see quality small caps drop 20% or so during market corrections. And often, these are the times to buy, not to sell. We don’t want to get chased out of a quality stock because of market volatility.

If a small-cap stock falls 25% from my entry point, I start to watch very, very closely. The critical thing to do at this point is determine if the decline is due to some fundamentally negative event, or trend, that undermines the company’s longer-term potential, or if it is simply the result of market turbulence.

If it is the prior, then the stock is more than likely a candidate to sell. While turnaround stories do happen, the bottom line is that investors need to cut losses short on bad stocks that continue to fall.

If it is the latter, it may make sense to give the stock a little more wiggle room, and see if it hits that 30% stop-loss level. If it does, then at that point it really is a matter of watching extremely closely for a good exit point.

The idea here is to avoid catastrophic losses. A couple of 30% or so losses a year is not a big deal. But allowing those losses to get bigger really does curb the overall profit potential of your portfolio.

Ultimately, you’ll need to decide what stop loss level works for you, and what will make sure you sleep well at night.

Now, let give you a little taste of the types of stocks I look for, in one of my favorite small-cap sectors.

3 Early-Stage Cloud Software Stocks to Buy Now

I cover many cloud software stocks in my advisory.

The reason is simple: cloud software is one of the biggest technology trends since the dawn of the internet. It is reshaping commerce, communications, supply chains, corporate strategies and even corporate and national security interests around the world.

Just about every company out there, regardless of industry, age and growth profile, has embraced a cloud strategy and/or a subscription-based business model of some sort, whether it be for services they provide or those they consumer.

Those that haven’t gotten on board have dubious futures indeed, especially in the new world where COVID-19 is driving digital adoption at a furious pace.

You can play the trend with the big boys, which help to provide the infrastructure that allows cloud software to be delivered around the globe. This includes Microsoft (MSFT), Amazon (AMZN) and Alphabet (GOOG).

But those are established players. Our focus is on the huge wave of young companies that were founded on cloud strategies and software-as-a-service (SaaS) business models—and which have their best days ahead of them.

These are the up and comers, the companies that represent the best investment opportunities over the next decade. You’ve probably never heard of them.

Here are three ideas that I like right now. Note: not all of them remain small-cap stocks (market caps of $3 billion or less); two outgrew that designation only recently. However, all three remain small, and relatively undiscovered.

Coupa Software (COUP)

If you’re an executive that needs help managing the millions of dollars your company spends on procurement, sourcing, expense management, inventory and other areas, you’ve probably heard of Coupa Software. The $12 billion market cap company is to business spend management (BSM) what Salesforce.com is to sales. And it’s expanding its solutions to address the roughly $56 billion addressable market right in front of it.

Coupa’s software is becoming a strategic extension to enterprise ERP platforms since it consolidates many back-office activities into one, unified solution. Innovative and simple-to-use applications have won Coupa the admiration of industry analysts; it is a “Leader” in its industry according to Forrester, Gartner and IDC.

The company benefits from powerful network effects resulting from its growing base of customers, suppliers and partners, all of which are funneled into its best-of-breed Coupa Unified Spend Platform. At the end of 2020 this platform is estimated to have over $1 trillion in cumulative spend under management.

The virtuous cycle powering Coupa’s growth is best illustrated by a typical upsell example, which expands the amount of money a customer spends each year. Let’s say a customer initially purchases the company’s core spend management and procurement software. After seeing the value, it commits to the full suite of applications. In this scenario, the customer’s total annual spend increases by a factor of three.

Coupa won’t report next quarterly results until early June. Revenue in fiscal year 2020 (ended January 31) was up 50% to $390 million, and analysts estimate revenues will grow 26% this fiscal year. Coupa also delivered adjusted EPS of $0.52 last year, but that figure is expected to dip to $0.33 in 2021.

This is a good company in a great market; however, demand for spend management may dip as enterprises reduce costs in their systems. Plus, shares are trading near all-time highs. Prior to the next quarterly earnings report I advise that investors only add a small starter position then evaluate based on the next report in June.

BlackLine (BL) 

BlackLine (BL) is a Software-as-a-Service (SaaS) company with products for finance and accounting departments. Companies use the software to perform a variety of processes, including account reconciliation, intercompany accounting and the financial close, a recurring process that takes raw financial data and turns it into the audited financials that senior management reviews, that gets submitted to the SEC, and that becomes available for investors like us to view.

Prior to BlackLine much of this work was still done manually, using spreadsheets. That is a cumbersome, inefficient and error-prone way to do it.

BlackLine has come up with a better way. The company’s cloud platform helps automate the process, pulling in data from banks, ERPs (SAP, Oracle, NetSuite, etc.), transactional systems and more, then running it through the appropriate BlackLine products, which can be set up with internal controls.

The idea is to transform a quarterly, recurring process into a continuous one so that accountants, controllers, managers and auditors can have real-time visibility into the state of a company’s books.

BlackLine was founded by Theresa Tucker, who previously worked as Chief Technology Officer for SunGuard Treasury Systems (acquired by FIS in 2015). In the early days the company sold on-premise software, then made the leap to cloud-based software in 2007. That was the year the first iPhone came out and it was good timing; companies wanted to move away from expensive desktop software toward software subscriptions, especially when the recession struck.

Private equity firms took note of BlackLine’s success, jumped in, and the rest is history. Today, BlackLine is going after a big opportunity with over 165,000 global companies that could use its software. It has been working on expanding internationally, where there are many untapped markets, growing a partner network, including with SAP, and developing new products, including an Intercompany Hub Product that helps streamline inter-company accounting.

In Q1 2020, reported on April 30, management reported that global demand remained reasonably strong in the face of COVID-19 and that it added 32 net new customers, bringing total customer count up to 3,056. That translated to 271,975 users and net revenue retention stayed steady at 110%, meaning that current customers continued to increase their spending with Blackline in Q4.

Blackline grew revenue by 29% to $82.6 million and adjusted EPS came in at $0.10. Both results beat expectations. However, management did pull prior full-year guidance, which had been for revenue in a range of $347 million to $352 million, implying just over 20% growth, and adjusted EPS of $0.45 to $0.48, implying growth of around 27%.

As with all stocks right now investors should start slow and look to average in on weakness.

Smartsheet (SMAR)

Smartsheet (SMAR) is a $6.5 billion market cap software company that was founded in 2005, went public in 2018 and is growing at rapid clip today. What’s the scoop behind the success? The company has developed a flexible, cloud-based, low-code collaboration platform that helps teams organize, capture, manage, automate and report on their work at a huge scale. The result is the holy grail of corporate leader aspirations; more efficient processes and better business outcomes.

The market for Smartsheet’s products is mostly business users that just want to get more done, more quickly and with less hassle. This often means a better solution than what was previously handled through email, spreadsheets and whiteboards. That, combined with a user interface that’s familiar (similar to MS Excel and Google Sheets), is why the company’s products have been spreading virally, reaching almost 100,000 customers of all sizes, including over 75% of the Fortune 500.

Smartsheet’s solutions are more than just glorified Microsoft Excel spreadsheets that require another subscription. The platform integrates with a huge variety of other enterprise tools, including those from Microsoft, Slack, Google, Tableau, Facebook, Okta and more. There are over 2,000 use cases covering all the unstructured projects that business users need help streamlining.

The company achieved FedRAMP authorization back in August, which drove federal agencies like the National Oceanic and Atmospheric Administration (NOAA) to become the first customer on shartsheet.gov. All in, analysts see the company targeting a $21 billion market. And Smartsheet has only grabbed about 1% of it.

To keep growth alive and well Smartsheet is expanding overseas, developing more Accelerators (automated smartsheets for specific projects) and building out more integrations, including one with Adobe Creative Cloud. These high value offerings are helping to drive 130% plus net revenue retention (showing existing customers spending more) and revenue growth north of 50%.

In the most recent quarter (Q4 Fiscal 2020) revenue jumped 51% to $78.5 million. Despite COVID-19 analysts see a 47% jump in Q4. While the company is not profitable (adjusted EPS in Q4 was -$0.13) due to investments (which will likely continue for years), investors will likely be fine with that (for now) given the rapid growth profile.

 

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