Seven Critical Factors to Evaluating Small Cap Stocks

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I wanted to present you with one more gem from my friend Nancy Zambell. This is probably one of the best articles written on the key metrics necessary to evaluate small cap stocks. Follow the advice below and you will be well on your way to finding a few hidden gems in the small cap market.

You only need to turn on the TV to see gurus and best-selling authors who can't wait to sell you their latest stock market gimmicks that promise you "instant millions." Their 'guaranteed' technical trading systems, proprietary methodologies, complex economic models, and even some that chart astrological systems, are generally not worth the paper they are written on.

In my years of investing, I have yet to see any of these "systems" consistently beat a good old-fashioned look at a company, its industry and how it relates to the current and projected economic realities.

If a business is fundamentally strong (i.e. it actually makes money), has a diversified product line, and is in a solid position in its market, you are 90% of the way to finding a good investment. The remaining 10% is just a matter of looking at a few parameters - no matter what the company does - to determine if it's the best stock for your investment dollars.

In this column, we'll review seven key metrics that should be reviewed before buying any stock. These indicators should help you get most of the way in understanding a company, its operations, and its underlying business.

1. Institutional activity . Pension funds, mutual funds, hedge funds, insurance companies and corporations that buy and sell huge blocks of shares can create tremendous volatility in prices. To lessen this risk in your investments, try to buy shares in companies where institutions own less than 40% of their shares. You can find this information at Reuters , in the Institutional Holders section.

2. Analyst coverage . Another indication of future share volatility is the number of Wall Street analysts covering a stock. Analysts - like the big institutions - have a herd mentality. When one sells, so do the rest, resulting in great numbers of shares changing hands, and usually leading to price declines. It's best to avoid companies with more than 10, or fewer than 2 analysts following them. (You need some analyst interest or you may be waiting a long time for price appreciation, even in the strongest and most undervalued company) . You can locate the number of analysts - and which firms they work for - at Yahoo! Finance ; then select Analyst Opinion.

3. Price-earnings ratio (P/E) . The price of one share of a company's stock divided by four quarters of its earnings per share, the P/E ratio is of utmost importance in determining if a company's shares are over- or under-valued. For the best perspective, go to Reuters , then select Ratios and compare the current P/E of the company to its average P/E for the last 3-5 years, to its estimated future P/E and to the average P/E of its industry or sector. One note: If a company's P/E is more than 35, it might be too pricy. You may want to stick with companies that are trading at lower P/Es, particularly if you are fairly new to investing.

4. Cash flow. One of the most important parts of a financial report is its Statement of Cash Flows, which is a summary of how the company made and spent its money. Go to Yahoo! Finance , Financials, then to Cash Flow and select Annual or Quarterly, depending on which period you want to review. Then find Total Cash Flow From Operating Activities, which represents the cash the company took in from its primary business operations. If it sells clothes, it's the cash collected from selling clothes.

It's important that this number be positive, or at least trending positive over the course of a year. After all, if the business isn't making money from its primary product - not from investing in real estate or the stock market - then you probably want to pass it by.

5. Debt/equity. This ratio is how much debt per dollar of ownership the business has incurred. Compare the firm's historic debt/equity ratios, so you can find out if its debt level over the past few years has been rising too rapidly. Debt isn't bad, as long as it is used as a springboard to grow sales and earnings. Next, contrast the company's ratio with its competitors and its industry so you can further determine if your company's debt position is reasonable. These ratios can also be found at Reuters , under the Ratios tab.

6. Growing sales and income. A rule of thumb that has always served me well: Buy shares in companies whose sales and net income are growing at double-digit rates. I cannot emphasize this enough, as, appreciation in stock prices is generally precipitated by growth in earnings (which usually follows expansion of sales) . It's certainly possible to buy stock in a company that has no earnings growth (a new business, or a tech company in the late 90's, for example) and still make money on the shares - short-term - but it's not a formula for serious, successful long-term investing. This ratio can also be found on Reuters , on the Ratios page.

7. Insider activity. Investors will also want to review the buying and selling activities of a company's insiders - its top officers and directors. A sudden rush to sell large quantities of the firm's shares may be a good indicator that the business is falling on rough times. Likewise, a large increase in purchases may mean good news is on the way. The website, Yahoo! Finance , under the Insider Transactions tab, lists all the recent insider activity at the company, as well as the number of shares remaining after the sale - an extremely important figure.

I would like to leave you with one last thought on using these indicators: Remember that no one ratio will determine the validity or potential of your investment. It is of utmost importance that you take a complete look at a company's financial strength and its future prospects, by conducting a thorough analysis - over time - usually a 3-5 year track-record.

With these 7 critical factors in hand, it won't be long before you feel very comfortable in analyzing stocks in almost any industry.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

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