How to Handle Small-Cap Stocks
Small Caps Combine Value and Growth
Frequently Asked Questions
Over time, small-caps have been the best place to invest your money as an investor in individual stocks. They are exceptional builders of wealth. As more investors become aware of this high-potential asset class, there's a good chance they will invest in small-cap stocks, further enhancing their returns.
Valuation is just one reason why small cap stocks are so attractive-as institutions largely ignore small-cap stocks, smaller investors can often buy them for reasonable prices. The other major reason is growth potential.
Small companies breed innovation, which is at the heart of product differentiation. As companies decide how best to maximize what little capital resources they have, their products represent their potential for rapid payback, increasing market share and entry into fresh markets.
Companies that want to gain a competitive lead are likely to make investments in cutting edge technologies. It goes without saying that spending by companies to get ahead is important, and that shifts the balance of power in the direction of smaller, more nimble organizations. Products with mass appeal are the trademarks of successful small-cap companies.
Here are some selected questions from Cabot Small-Cap Confidential subscribers; I think they will give you a good sense of how I uncover high-potential small companies and capture big profits in their stocks.
Would you shed some light on how I might systematically use Cabot Small-Cap Confidential to invest, i.e., do I invest a little in every recommended issue, etc.?
Thomas Garrity: To start, I recommend investing in stocks that coincide with your risk profile. Not every stock in Cabot Small-Cap Confidential will match your investment objectives nor will every one become a homerun. Read each new stock profile carefully and evaluate its investment in relation to your other stocks.
Here are some tips for getting the most from your small-cap investments:
1. Take Partial Profits
I've found that a key to better performance is to take partial profits on some winners. In the past, some of my stocks have gone around the world: a 100% gain turned into a 25% gain-which is something we want to avoid, so I advocate paying yourself periodically.
2. Follow Advice in the Weekly Updates
I also advise taking advantage of my timely trade advice in the weekly updates. Pay attention to phrases like "This is a Strong Buy," which generally means the stock is potentially set up to make some easy gains. In the event of a price decline, "Accumulate more stock here" may be an attempt to reduce the cost basis (perhaps because the market has overreacted to news or corrected as a result of profit taking or general market action).
3. Allocate More Funds to Your Strongest Stocks
In cases when you're comfortable with a company and knowledgeable about its business, build large positions in the stock. Generally, I recommend allocating more funds to stocks that are showing strength (consistency in their price movement).
4. Selling Some of Your Top Stocks and Laggards
When a stock goes up say 50% or more, take some profits and redistribute them in your other strong stocks. As for underperforming stocks, there too you should make partial sells and re-allocate your funds to stronger candidates.
Lastly, write options against your positions when available to generate income and improve overall yield.
As expected with some of the small caps that I have seen you recommend, the volume is quite light and the bid/ask spread is substantial-especially if the stock is low-priced. If I want to buy $15,000 worth of a 1.50 stock, how do I buy 10,000 shares without dramatically affecting its price?
Thomas Garrity: First, a habit you should get into is buying stocks off the bid versus the ask side of the spread. Second, consider building your position in a stock on days when the share price is under pressure. Third, use multiple buy orders rather than a lump sum. Finally, enter your stock orders with bid limits. Run your trading like your business-on your terms-and be diligent.
What characteristics are you looking for in the individual stocks you recommend?
Thomas Garrity: One of my investment hallmarks has always been to give Wall Street's unknown stocks a chance, and I will continue to do that, relying on the metrics that have served me well for decades. I'm partial to companies that have dominant positions in thriving industries or what I like to call pure plays (a company with a product that has created its own category in a large addressable market). Second, I seek companies with dedicated research teams to develop the products, and sales staffs that will bring the products to market.
What advice would you give someone who is ready to start investing in small companies?
Thomas Garrity: Set up some clearly defined investment rules for stock investing. Here are some of mine:
- Make certain the company you're considering has enough capital to run its operations for many years and its balance sheet is (for the most part) debt free.
-Time your investment with a company-specific event.
-Get into a stock before institutional investors become aware of it.
- To the best of your ability, ensure that your investment has the highest probability for success. The proof will come from doing research and assessing data. Any company can fail, big or small, you just want to try to avoid being a shareholder when that happens.
- Only put capital to work in a stock that correlates with your investment risk tolerance and timeline.
- Be committed to your investment, which entails being comfortable with market volatility and having the patience to let it succeed.
What is Cabot Small-Cap Confidential's sell strategy?
Thomas Garrity: I stick with a position in a stock until A) profit objectives are met or B) the market deteriorates or C) the management of a company gets stupid or greedy.
Here's how I deal with a stock that has appreciated more than historical market returns: If the stock is up 50%, I sell one-third to one-half of my original core position to bank profits and hold the rest until A, B or C above.
If a stock exhibits a loss beyond a normal threshold, I'll tolerate the loss (on paper) if nothing has changed fundamentally with the company or the markets they address. If the company's balance sheet is strong, and it has key products and good management, the stock will eventually come back into favor. And I always remain aware that every stock eventually disappoints.
Do you use stop-losses?
Thomas Garrity: In certain instances, I recommend stop losses-usually to protect a large profit-but it's important to remember that stop-losses can work both ways. For example, we were stopped out of MAKO and EZCH, only to have share prices go higher. Conversely, stop-losses performed well with other holdings. I expect our stocks to routinely encounter very strong price fluctuations. We are longer-term investors, so we maintain a position until we're convinced the company or the market it serves will not support our growth expectations. We expect to own a number of stocks that will go up significantly in price and we expect there will be stocks in the portfolio that will show losses (although we also expect our gains to more than cover our losses).
To increase our chance of overall success, we take small profits on leading stocks and re-allocate those dollars in stocks just beginning to show price strength and stocks which have fallen deeper into undervalued situations.
How does the economic climate factor into your stock picks and outlook on the market?
Thomas Garrity: I'm a research junkie, so the company and its industry are foremost in my mind when I'm selecting stocks. I have an affinity for stocks that are not bound to economic cycles, so the economy isn't a huge factor. Being invested in small-cap stocks doesn't fully protect me from economic swings, but if I've invested in a young company with the right fundamentals, I stand a good chance of avoiding most of the market-based volatility.
One thing I pay close attention to is the IPO market, which gives me an indication of how much money is flowing into stocks with new ideas. What is key with small-cap stocks is that the product and message line up with market perceptions, despite economic events. Otherwise, the maturation of such investments will be prolonged and investors will be taking a bigger risk. At the end of the day, I do consider the economy as I pick stocks, but I don't let it affect my decisions too much.
What did you learn from the Great Recession?
Thomas Garrity: The bear market reminded me that when financial markets are deteriorating, investors could ignore even companies with strong balance sheets and healthy growth prospects. When the market is challenging, it's tough to get investors interested in even the best stocks, which is what's needed to push them higher. Therefore, I recommend raising cash when the market is weak and investing again once the market is healthy.
The recovery has also been instructive. Financial stocks have been a favorite investor holding during the recovery, primarily due to the government aid that banks received. This has resulted in massive price swings in these stocks, especially as big investors seek to unwind their positions and look for more stable investments.
These relatively short-term swings demonstrate that many investors are holding stocks for shorter periods of time right now. As I've often said, "You don't have a profit until you sell." In light of this, I often advise taking profits sooner rather than later.
What sectors are you interested in right now? Why?
Thomas Garrity: I've always been interested in technology and medical stocks and more recently, I've been increasingly drawn to alternative energy stocks. Technology stocks have historically had little trouble drawing investors to them, probably because they have a high potential for appreciation. It can be tedious to wait for investors to recognize the value of a technology stock, but once they do, these investments can be very profitable.
If you look at great companies, like Apple and Cisco, you'll see that each started out very small. What enabled them to grow by great leaps and bounds was their inventiveness and vision. In some cases, they designed their products ahead of actual customer demand, defining an industry niche by the time people caught on.
That's the beauty of a small-cap investment; there's a great deal of patience involved waiting for the stocks to appreciate, but when they do, the rewards can be enormous. Putting aside economic woes, technology companies and their products will almost always be in demand, since change is what brings about growth in the overall economy.
Like technology stocks, medical stocks offer the unusually large upside potential. The same opportunistic characteristics apply; the only difference is that the medical sector is subject to regulation.
But the sector I'm most excited about right now is alternative energy. This sector can include such diverse areas as electric vehicles, efficient building materials and lighting and bio-fuels derived from waste. The bottom line here is that these industries are tapping into areas that we as a society need to engage in. They are creating jobs, lowering energy costs and lessening pollution. As an example, building an electric vehicle plant creates jobs, reduces dependence on oil and improves air quality.
What is your current emphasis in Cabot Small-Cap Confidential?
Thomas Garrity: We hit some home runs last year and we still have many stocks in the Cabot Small-Cap Confidential portfolio with compelling stories that will eventually be discovered by large institutional investors. As always, my efforts this year will be research driven as I look for stocks that can become market leaders with large addressable markets.
I've been advising investors to lock in profits by taking small portions of positions off the table as stocks climb higher. However, I still advise keeping a core holding if the stock looks like it has farther to run. In addition, booking some gains frees up cash to open other positions in new stocks.
Editor of Cabot Small-Cap Confidential
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.