Diamonds In The Rough

Often small capitalization stocks are overlooked by the market. This means there are significant opportunities for investors and traders, but also significant risks. Here I'll run through some tips for investing in small cap stocks.

Finding diamonds
So, you want to find the next Microsoft or the next Cochlear. Sounds great, but it's not as easy as it seems. There are over 1,000 small cap companies listed on the ASX.

How do you find the potential diamonds in the dirt when there is not always a lot of information around these companies and certainly not a lot of research available?

Research
Brokerage houses and analysts tend to report on the top 200 stocks on the Australian market. Beyond that, it's a case of finding a research group that specialises in small caps or to do it yourself.

ASX Small Cap Index
If you want to invest in a basket of small caps, there is the ASX small cap index. This invests in the top 300 companies which are not also in the top 100 index.

What is a small cap?
Small cap companies are those with a market capitalisation of less than $300 million on the Australian sharemarket.

Companies tend to have their own life cycle. With small caps you are usually looking at businesses which are focused on growth. That focus on growth obviously brings extra risk but also the potential for a greater return.
Growth tends to be popular when the market is rising but highly unpopular when the market is falling.

Bear markets
If there is a bear market (falling), chances are any small cap stocks you have will be hammered.

That's because risk is the first thing that tends to be eliminated from portfolios when the market is falling.

Investors and traders have a tendency to rush back to safe havens like cash or relative safe havens such as the defensive blue chip companies.

Bull markets
On the flipside, in a bull (rising) market, small caps will usually tend to perform relatively well as investors add risk back into their portfolios.

Earnings
The problem with small caps is that many of them are not yet turning over a profit so it's quite difficult to evaluate them from an earnings prospective. The traditional ratios such as P/E and return on equity (ROE) aren't relevant when there aren't any historical earnings.

If the company has sales, you can look at sales growth and the price to sales ratio. At some point the sales will have to translate into profit for the business model to be viable.

Finding stocks
Here are a few tips to help you find these diamonds in the rough yourself:

Have a look at the shareholders of the company. Does the company have the backing of a large organisation? Or perhaps even a venture capital firm that has taken a majority stake? Although this is not foolproof, it can be a sign that these shareholders have done the hard yards and looked deep down for the business potential of the underlying business.

How many years until commercialisation and what's the probability of commercialisation? Have a read through the annual report to work out a timeline and the business plan for the organisation. What's the potential market once commercialisation has been achieved? What P/E ratios are potential competitors or similar companies trading at? What type of return can you hope for based on those valuations?

Who is in management? Do they have expertise in doing the same type of thing before? Is there visibility on what is happening within the business or as a shareholder? Will it be a guessing game?

It takes faith
Investing in small caps usually takes time. And it usually takes a lot of faith to determine whether the ups and downs of a smaller growing company are worth your investment.

It is highly risky. But on the flipside there are potentially many companies out there that will become the next Cochlear, Resmed or Fortescue.

Why not dig in and get your hands dirty? You may just find that diamond in the rough.