Small cap value stocks can be highly profitable investments. I have been investing in small cap value stocks for over 25 years and have guided 100s of other investors through my newsletters. Most financial writers call investing in small cap value stocks risky. It is not. The risk-reward equation in this asset class actually favors small retail investors significantly, but you need to understand a few things before you can start profiting from all the potential that exists here.
For our purposes, I define small cap as companies with market capitalization between $30 million and $2 Billion. This may include many stocks others would consider micro-cap.
Below is a list of 10 things you need to know before you invest in small cap value stocks, in no particular order.
Small cap stocks are not liquid
Trading volumes can be low, making it harder to enter or exit positions without impacting the price. Many times if you are transacting a large amount of stock, you will need to set up a long-term Good till Cancelled order (GTC) and let it fill over time. Alternatively, you may want to break up a large order in smaller chunks and execute them in tranches. Taking a full position may be drawn out over a period of days, weeks or even months.
Use limit orders exclusively
Avoid market orders to protect against wide bid-ask spreads and unexpected price fluctuations. There are two very good reasons to do this.
1) you want to make sure you do not overpay or undersell as the bid-ask spreads can be large and the prices are volatile, and,
2) If you set up a limit GTC order, you give the market makers a chance to work their order book to meet your limit price.
High volatility, but high rewards
Small-cap stocks can experience extreme price swings, both up and down. This is mainly because of limited supply of the shares in the market. One large order in either direction can temporarily disrupt the demand-supply equilibrium and cause price swings. The reward for taking this volatility risk is the potential for higher returns.
Market inefficiency
These stocks are less analyzed by Wall Street, offering opportunities for informed investors. But because there are less eyes and computing power trained on these stocks, more undervalued opportunities exist in small caps compared to other larger stocks. Not only that, a greater proportion of these undervalued stocks may be significantly undervalued.
Time-intensive but often simpler research
Due diligence is critical as reliable information may be harder to find compared to large caps. There may not be any analyst reports to look up. You are your own analyst. On the other hand, most of the small cap companies have much simpler business models compared to the larger companies, and therefore they are easier to understand and analyze.
Another bonus: I have had a great degree of success reaching out to the management of the small cap companies if I have a question that requires clarification.
Less access to capital markets
Many small caps have limited financial resources and higher debt levels. Additionally, their access to the debt markets is limited. They cannot issue new bonds to fund projects just as a matter of course, and even if they are able to, their bonds would typically be rated less than investment grade, and therefore will require them to pay higher interest.
Management quality matters
Leadership is often a key factor; many small-cap companies have relatively inexperienced management teams. Many small companies are also run by the founder as their own private ATM – they are not run for the benefit of the external shareholders. This can be viewed in 2 different ways:
1) As long as the founder is still around, the stock price will probably stay as a value trap, so you should avoid this stock, or,
2) If you or someone else can find a way to dislodge the founder and install professional management, significant shareholder value can be unleashed. The question then becomes, can you be the activist or do you have a reason to believe some other activist is taking interest?
Small Cap Value Stocks are Often Catalyst-driven
Price movements in small caps often depend on company-specific catalysts like new contracts, product launches, or regulatory approvals. The product portfolio for a small cap company may be small with limited number of revenue streams, so a catalyst can move the stock price significantly. Larger companies have a wide product portfolio and multiple revenue streams, so such events cause relatively smaller ripples.
Growth vs. value traps
Ensure the company is truly undervalued and not a “value trap” with no growth potential. An undervalued small cap stock can remain undervalued for a long time if there is no catalyst to unlock the value. The catalyst can be business growth, activist investors, mergers, going private actions, etc. Since all other catalysts is not under our control, the only thing we can insist on is to ensure that there is a clear pathway to growth and that the company is on that pathway.
Scalability of operations
Check if the company’s business model can scale effectively as it grows. Can it expand into new geographical areas? Can it add new product lines? Can it gain market share and is the total addressable market big enough that a meaningful market share will move it to mid or large-cap level? And of course, is the management looking to scale? – some management teams are content with where they are as it satisfies their lifestyle needs.
Over time as you get used to investing in small cap value stocks, you will find other things to add to this list. Until then, please understand that while small cap value stocks are highly profitable investments, you need the patience and due diligence to benefit from them. For me personally, I like to invest where odds are stacked in my favor, which is why I choose small cap value stocks. Every other asset class is continuously analyzed by the wall street and there is not much opportunity there.
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