Small caps have the ability to produce huge returns for investors. These young companies with innovative ideas and personnel pose a huge threat to industry leaders with the ability to adjust quickly to dynamic markets.
Amazon (AMZN) is a great example.
Back in the late 1990s, the company blazed a trail in e-commerce by creating a platform for consumers to buy goods online. Traditional brick-and-mortar retailers like Wal-Mart (WMT) and Sears Holdings (SHLD) were slow to respond to the new online paradigm, enabling Amazon to capture the market and catapult to a $120 billion valuation.
These are the kind of innovative companies Andy Obermueller profiles in his Game-Changing Stocks newsletter. Take a look at the big gain below.
Of course, small caps don't always grow into global mega-caps. Many small caps fall victim to overly ambitious growth projections or a severe lack of demand. And that can lead to huge losses for investors.
A123 Systems (AONEQ) is a great example of small-cap business risk. This company specializes in lithium-ion batteries and was hot after its April 2011 IPO. But with demand coming in much weaker than expected, the company quickly took a nosedive, with shares falling into the pennies and creating a 100% loss for investors.
Small caps can deliver big gains, but they can also create big-time losses. That's why I like to look at what I consider to be one of the most important indicators when evaluating small-cap opportunities.
Small caps with heavy insider ownership send a big message to the market and investors.
The first is that management is putting its money where its mouth is. Part of management's job description is to be bullish on sales. It doesn't do management any good to present a bearish disposition to the Street. But actual inside ownership enables investors to evaluate how insiders really feel about company prospects.
High inside ownership is a clear indication that management is bullish on growth -- and has actual skin in the game. This creates a clear financial incentive that directly ties compensation to company success. That aligns the interests of the board, management and shareholders.
That's why I always check inside ownership when evaluating new small-cap opportunities. Below is a list of seven small caps from the Small Cap 600 Index with high inside ownership.
From the list, I'm highlighting Boston Beer Co. (SAM) because of its strong upward momentum and Hi-Tech Pharmacal (HITK) for its compelling valuation.
Boston Beer Co.
Boston Beer Co. has seen big gains in the past year, with shares up a market-beating 42%.
That upward momentum has been driven by steady growth in the both sales and earnings, with the brewer of the popular Samuel Adams beer successfully navigating a tepid consumer environment and higher commodity costs.
[See also: "Profit From Customer Loyalty With These 7 'Sin Stocks']
Analysts are projecting full-year earnings of $4.98 a share in 2013, up 10% from last year, and earnings growth of 13% in 2014. Shares currently trade with a forward price-to-earnings (P/E) ratio of 30, just below the 10-year high of 33.
But what Boston Beer Co. lacks in value, it makes up for in momentum, with shares looking strong on the chart despite the higher valuation. Inside ownership of 36% shows that management is invested in the success of the company.
Hi-Tech Pharmacal is a specialty pharmaceutical company that develops, makes and sells generic and branded drugs in the United States.
Although shares are down 5% on the year, Hi-Tech Pharmacal is up 270% in the past five years. Those are the kind of outsize gains that small caps can produce as they grow into mid- and large caps.
Hi-Tech Pharmacal's gains have been driven by earnings growth, pushing the company's share price into value territory despite its gains. With a forward P/E of 11, the stock trades at a discount to its 10-year average of 13 and its peer average of 25. The inside ownership percentage stands at 18%.
Risks to Consider: Small caps are more volatile than mid- and large caps. In a highly competitive environment, some small caps will go out of business.
Action to Take --> Small caps are companies in the early stages of growth and have the ability to produce big gains. But small caps are also known for volatility. That's why I like small caps with big inside ownership. These seven small caps have the highest inside ownership in the Small Cap 600 Index, meaning the interests of management and investors are aligned.
- 7 Small-Cap Stocks With Heavy Insider Ownership
- No Drama, Just Consistent Gains
- Insiders Are Snapping Up These Stocks -- Should You?