When it comes to small-cap stocks, there definitely is a right way to do so. The key to analyzing small-cap stocks and whether they are a good fit for your portfolio lies in thorough research. Essentially, no stone should be left unturned when considering investing in small-cap—you must know how to research small-cap stocks. The main components of analyzing small-cap stocks the right way are the following: knowing the risks of investing in small-caps, searching for market shifts, looking at past indicators, recognizing the market cycle, and following the experts.
Know the Risks of Small-Cap Investing
All investments come with their risks, but small-caps may just be the riskiest of them all. Because they do not have as much financial cushioning and resources as large-cap companies, small-caps are more susceptible to failure during harsh economic conditions. Along with vulnerability to economic downturns, small-cap companies are typically in their expansion phase, which means that there will be volatile price swings in their stocks. Investing in a small-cap comes with risks of significant losses; they are by no means something that investors would call a “safe” investment. However, these risks can be managed and losses can be offset.
Being cognizant of the risks that small-caps carry with them is an important factor in determining whether you choose to proceed with investing in them or not. These risks can be managed and lowered when you do the proper research. For example, investing in a small-cap with past indicators of solid growth carries less risk than investing in one with little to no growth.
Portfolio diversification is also helpful when investing in small-caps; having a diverse portfolio can help offset any losses from other investments. For instance, you might lose some money on a small-cap that you thought would pan out but never did. But with portfolio diversification, chances are that you will have made enough returns to cover the loss of said stocks while still making some money.
Keep Your Eyes Open for Market Shifts
Once you are knowledgeable about the risks of small-cap investing, it is time to analyze the various markets and search for shifts. Market shifts happen when there is a sudden need for a solution to an unforeseen problem. For example, a couple of decades back, there was a shift from CD to DVD format. Because this shit was not largely foreseen or considered, there were not a lot of companies to provide the solution to this shift. Specific conversion software was needed, but few companies had it. Those companies that did have it were small-cap companies—and because they had a service that was in high demand, their stock value increased, helping them grow into large-cap companies.
Market shifts are a significant contributor to the rising price of some small-cap companies. Analyze different industries and read about them. Staying up-to-date with the latest developments may just give you some insight into a new and upcoming trend. Different industries to keep an eye on are the medical industry, the cannabis industry, and the technology industry. Spotting trends early will help you invest in little-known companies that could do well in upcoming market shifts, which can help you maximize your return.
Look at Past Indicators of Performance and Growth
Once you have analyzed potential market shifts and different industry trends, it is time to choose a potential contender to invest in. You can use online screening tools that are free of charge and have a lot of data readily available. For instance, you can search up “market cap under $500” or “covered by two or fewer analysts.” These will help you narrow down the search for a small-cap.
Once you have a small-cap company in mind, the next thing to do is to delve into the numbers and read up about the company. Because small-caps garner less attention than large-caps, finding data can be tricky. However, small-cap companies tend to publish their earnings, reports, press releases, and growth projections on different platforms. Once you find these resources, look through them, and consider these important factors:
- Past price appreciation
- Price-to-earnings ratio
- Price-to-sale ratio
- Total addressable market
- Optionality
Always keep an eye out for growth potential over 20%, as this is usually a good indicator of good performance. Typically, if a small-cap has been outperforming in the past, it will continue to do so in the future. Small profit margins are expected with small-caps since they are in their expansion phase, so do not be alarmed if a promising small-cap happens to have small profits. It could still be a good investment to consider.
Determine The Type of Market You Are In
One of the final steps to complete before finally investing in the small-cap of your choice is to analyze the type of market you are in. Just like other companies, small-cap companies are also impacted by the economy and different types of market cycles. The best time to invest in small-cap stocks is when the U.S. economy is strengthening or growing. Investing in small-caps during a young bull market can help minimize loss because small-caps are more likely to outperform in bull markets. It is also important to know that small-cap companies are more affected by local economies and markets than large-cap companies, which are affected by global economic conditions.
See What the Experts Are Doing
An easy launch point for small-cap investing is looking at what small-caps other large organizations and prominent investors are adding to their portfolio. It could be a good idea to follow suit and invest in the same ones that successful investors are interested in. However, take this with a grain of salt. While successful investors usually know what they are doing, a risk is still a risk. It could be that their investment does not pan out either, and if you follow their lead, you might lose as well. The best experts to follow are those who are transparent with their gains and losses and share their reasoning behind certain investment decisions.
You’re Ready to Start
Analyzing and researching small-cap stocks the right way will increase your chances of investing in a successful small-cap. Always consider market shifts, market cycles, past performance, and risks. Take the time to thoroughly review investment opportunities until you are comfortable with your investment pick—after all, you might just end up investing in the next big company. Check out Dear Retail Investors for more details!
