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Is Now a Good Time for Small-Cap Stocks?
By: Cabot Heritage Corporation
Interview with Thomas Garrity
Is Now the Time to Invest in Small-Caps?
Tom's Criteria for Selecting Small-Cap Stocks
Editor's note: This is the second in a series of interviews with Thomas Garrity, Analyst and Editor of the limited-subscription newsletter, Cabot Small-Cap Confidential. Read part one here.
A lifelong investor, Tom has been a stockbroker, stock analyst, venture capitalist and portfolio manager. His long career and varied experiences taught him to make investments only when the odds of winning significantly outweigh the risks. He applies this philosophy to every stock he recommends in Cabot Small-Cap Confidential. His disciplined investment methodology uses a series of qualitative and quantitative metrics that are evaluated for each company under his investment consideration. The company's products must target large markets, the science or technology must be proven, the balance sheet must be strong enough to support research or investment activity, and the idea must be strong enough to attract future institutional investment.
Tom's analysis results in a portfolio of stocks of companies that are pioneers in their areas of business. In most cases, these companies are creating whole new micro-industries, providing essential tools for an entire industry's growth. Because these stocks have little or no institutional or research coverage, Small-Cap Confidential subscribers can acquire significant positions in these companies more cheaply than if their stocks were widely followed.
Paul: Is now a good time to invest in Small-Cap stocks?
Tom Garrity: The economic recovery may stay muted due to a confidence crisis by both investors and businesses owners brought on by the uncertainties about the health of the global economy. The macroeconomic picture reveals weighty unanswered questions relating to investment and GDP growth such as the debt crisis in Europe, political instability, Fiscal Cliff aftermath, tax expirations, Obamacare and continual high unemployment.
Uncertainty surrounding the reconciliation of such important engines for capitalism will likely persist into 2013. Since the stock market gets its cues from the pace of production and consumption of goods and services, even a perception of a slowing in any of these underpinnings can pressure small-cap equity valuations.
However, the best opportunities for small-cap investors are often in just such times of risk-aversion! Fear can create mispricing of small-cap stocks, allowing us to pay less for stocks with great growth potential.
The most important factor powering the performance of small-cap stocks is economic growth. During times of improving supply/demand conditions and rising interest rates, small-cap stocks tend to outperform large-caps. Studies involving past rates of returns have shown that when an economy regains its footing, small-cap stocks are the first group to rise. In 2012, the small-cap index measured by the Russell 2000 was up 16.35%.
With the backdrop of a weak economy, I expect small-caps indexes to post impressive gains in 2013, and my stock selections to be considerably higher.
Paul: What qualities do you seek in a company/stock before you recommend it in Cabot Small-Cap Confidential?
Tom Garrity: The first thing that attracts me to any particular company is how excited I can get about their new products.
To start, here's what I avoid: Products tied to the economic cycle, products that can be mass produced, products that are subject to continual price competition, products that participate in a marketplace with many competitors, products that are more than a year away from getting to market (unless it's a biotechnology company), products that are capital-intensive and products with low profit margins (in the absence of scale volume).
The company that earns a spot on the Cabot Small-Cap Confidential focus list looks like this: A unique enterprise that's a pioneer in a start-up field, with products ready to launch or about to be commercialized very soon.
Since the company is producing a never-before-seen gadget that offers a fresh way of doing something, I can label the business as leading edge. Because the company's products/services address or solve a growing need, target a very large end-market and are in high demand, the potential for sales growth is exceptional.
The final ingredients needed to earn a spot in my small-cap stock focus list are that the company must have 1) quality management and 2) a clean balance sheet.
Regardless of how radical and compelling the company's offerings may be, unless the leader running the show is an evangelist, the fruit will die on the tree. However, when company leaders are adept at spreading the word about their innovations with the kind of conviction that converts prospects into customers, then I know I'm closer to being in the right stock.
Lastly, I look for a balance sheet that has little debt, a stock with few shares outstanding (too many shares spoils the EPS porridge) and cash on the books to fund operations for a couple of years before sales take off. This makes for a satisfactory investment choice.
All the best,
Editor of Cabot China & Emerging Markets Report
and Cabot Wealth Advisory