Analyzing Small Caps

By Nancy Zambell, Contributing Editor, Financially Fit

In last week's issue of Financially Fit, I introduced the concept of small-cap investing, citing a couple of studies that illustrated the profit potential of investing in that sector. I also briefly talked about a few of the risks that are inherent in buying shares in small-cap companies, including their lower liquidity when compared to their larger-cap brethren, the occasional difficulty in finding accurate quotes, and the potential for fraud through the hype often associated with stocks whose prices are generally subject to greater volatility.

Today, I want to give you a few ideas that will not only help you analyze the small-cap stocks that you are interested in adding to your portfolio, but will also assist you in avoiding these problems.

Just to reiterate, when I refer to "small cap," I am talking about companies with market capitalizations of less than $1 billion, including micro-caps (less than $100 million) and nano-caps (less than $50 million). And very important, for our purposes today, I am not talking about penny stocks (those whose shares trade below $5/share). In my opinion, those types of stocks are just too speculative for the average investor.

Let's get started!

First of all, I will caution you that small-cap investing is not for the tame of heart. These shares tend to fluctuate more often and more steeply than the shares of most larger-cap companies. So, don't buy them unless you can sleep at night knowing you may awaken to a 20%-50% drop in their value. However, I do have a suggestion that will help you sleep a little better - setting stop-losses, which I will cover in a few paragraphs.

As regular readers of this column know, I am a bottoms-up investor. That means, instead of tearing my hair out over which industry will be the next "hot" one, I prefer to begin with the company, finding well-run, fundamentally-strong businesses whose shares appear to be undervalued. And fortunately, small-cap analysis blends in perfectly with that strategy. According to State Street Global Advisors, 80% of the performance of small-cap stocks is attributed to bottom-up stock selection.

Some Simple Ratios

In our very first issue of Financially Fit, we discussed our favorite ratios for analyzing stocks. Each of those likewise is crucial to analyzing small-cap companies. But let me elaborate on a few that you absolutely must review prior to purchasing shares in a small-cap business.

For ratio analysis I especially like using a particular feature on Reuters' website. Go to http://stocks.us.reuters.com/stocks/lookup.asp?symbol= and look for the "Ratios" table after entering a stock's symbol. I also like using www.finance.yahoo.com for additional information, as noted below. Be sure that you are comparing your company's ratios and financial situation to others in its industry, as well as to its own historical behavior.

The shares should be undervalued. A good ratio to use here is P/E, which is the ratio of a company's share price to its per-share earnings, as well as the PEG equation, which compares the price of the stock to the growth of the company. P/E's should normally be less than 45 for small caps, but could be extended to the 60's for fairly new, high growth companies. Beware of companies whose P/Es are accelerating with nothing to show for it - falling earnings and/or sales, lost business, financial statement restatements, major lawsuits, and the like.

The company should have above average earnings and revenue growth (Reuters). Note that a fairly new company will be growing its top line - revenue - much faster than the bottom line (net earnings). Nevertheless, you want to buy stock in a company that is making money now.

As well, the potential to increase its profit in the future is of paramount importance (Yahoo; Analyst Estimates).

A strong balance sheet is a necessity: Low debt, strong cash flow (Yahoo; Key Statistics, and Financial Statements, Cash Flow). You may also want to compare share price as a percentage of operating cash flow and as a percentage of free cash flow (Reuters; Ratios). You will also want to find out what the company is using its cash for.  Paying down debt, buying back shares and paying dividends are all good uses of cash.

New or increasing interest from institutions and company insiders may also be a good indicator of near-term appreciation in share price (Yahoo; Insider Transactions).

Additional Quantitative Factors

Look for companies with decent liquidity, preferably average dollar trading volume of $1 million -$25 million.

A series of positive earnings surprises may also indicate coming share appreciation. According to Zack's, companies who have reported one earnings surprise have a 41% chance of repeating and those with four quarters in a row of positive surprises have a 74% chance of repeating (Yahoo; Analyst Estimates).

Qualitative Factors

Now it's time to roll up your sleeves and do a little more work to determine if your company meets the following standards:

• Does it have innovative products and services?
• Is the management team experienced, with at least five years of track record behind it? Is the founder(s) still running the company? Last year, popular web site Motley Fool reported that 84% of the top 100 performing small caps of the last decade had either a founder or an experienced and devoted CEO leading them.
• How good are the industry prospects?
• Are the company's financial statements transparent - i.e., are they easy to read, make sense and consistent from year-to-year?
• Does the company have a good - and growing - market share in the segments in which it operates?
• How is the company's reputation among its customers and suppliers?
• Does the company publicly state its mission/goals? Do they make sense?

To answer these questions, you are going to have to go to the Internet and stock up on the pertinent news regarding the company and its industry. You will also benefit by reading and examining its financial statements, and by speaking with the company itself. Just go to the company's web site (accessible via either Reuters or Yahoo), and find the phone number for its Investor Relations Department. Believe me, most companies will jump through hoops to help a retail investor learn about itself.

Now, about those stop losses. I always encourage investors to limit their losses, typically to 20-30% below your entry price. Granted, you will be stopped out of some very volatile stocks, but it will help you sleep at night.

One warning:  I caution you to diversify your portfolio. That means, do not put all of your investment in one company, or all in small caps, or all in one industry. Sure, you can make a killing if you hit just right, but you can also lose your shirt pretty rapidly if the tide turns.

Years ago, I loved to help my father in his workshop. And his motto - measure twice, cut once - can also be used in small cap analysis. Research, analyze then research and analyze some more before you invest.

Tune in next week for some mutual fund and ETF ideas that may help you get started in your small-cap investing mission…

This concludes this week's issue of Financially Fit.  We encourage you to visit our website to review past issues of Financially Fit:

http://www.brokeradviser.com/newsletter.cfm


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