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Small Caps: How to Analyze Them and the Trends That May Move Them

- By Robert Abbott

The analysis of small caps is the focus of chapter three of Ian Wyatt's book, "The Small-Cap Investor: Secrets to Winning Big with Small-Cap Stocks."

His first step in analyzing small-cap companies is to get to know the company well, thinking of himself as the buyer of a business. To explain, he showed readers how he approached Graham Corp. (GHC) in February 2008. He listed these questions about the company:

  • What does it do? It is a design/build contractor for custom vacuum and heat transfer equipment; products include steam-jet ejector systems, surface condensers for steam turbines, compressors and heat exchangers.
  • Who are the customers? Graham's products are used in several industries, including oil refining, chemicals, pharmaceuticals, plastics, fertilizers, soap manufacturing and air conditioning systems manufacturing.
  • Is its industry growing? While the U.S. economy was sputtering in 2008, international markets such as Brazil, Russia, India and China were buying to expand petrochemical plants, oil refining and electric power generation. Middle Eastern markets were building new natural gas plants.
  • What is the company's latest news? It had recently announced a $1.8 million order for surface condensers that would be installed in a coal-to-liquid facility in China; coal-to-liquid was an emerging, and potentially big, technology.
  • What is in the future? Graham's CEO was focused on emerging technologies such as coal-to-liquid, gas-to-liquid and biodiesel.

Wyatt added that the knowledge gleaned with these questions would help put the essential metrics into a clearer context. He had recommended Graham's stock on Feb. 21, 2008 at a price of $17.30. Fortunately, the price of oil was about to surge; the stock price jumped 154% to $43.91 about five months later. Soon after, it plunged in the other direction as oil prices slumped.

This GuruFocus chart shows Graham's ups and downs, of which there have been many. Note that the period covered above is in the second (and highest) spike:

Graham Corp price chart

This was a company driven by oil prices and, as Wyatt pointed out, the big price jump (trend) of 2008 was the result of several factors: the Iraq war, Hurricane Katrina and the decline of domestic stockpiles. The price of oil passed through the $100 mark on its way to $147 per barrel in mid-2008. Then, the economy contracted during and after the 2008 financial crisis and drove the price down to about $11 per barrel by the end of the year.

The second half of Wyatt's screening is fundamental analysis. These are the metrics he reviewed:

  • Revenue
  • Net income
  • Diluted earnings per share
  • Gross profit
  • Sales
  • Cash balance
  • Analyst estimates of earnings per share
  • Price-earnings ratio
  • Market capitalization

Overall, at the time of the recommendation, he saw that, "The company was consistent in many of the principles I use for picking small-cap stocks, namely a strong earnings trend, growth in cash on hand, positive analysts' estimates, and an attractive price-earnings ratio."

It was the marriage of a great company and a big trend, according to Wyatt, the type of combination that can lead to big profits (but short-lived). On July 25, 2008, he recommended to his readers that they sell, with the price at $38.99 per share. He added:

"Not every small-cap stock has the growth potential that Graham exhibited within the time frame of a year--that's why you need to do your homework. But this does demonstrate that, with the proper discipline, exhaustive attention to important details, and a willingness to go the extra distance, you can find small-cap stocks with superior growth prospects. It is these stocks that are likely to provide the biggest gains."

The author offered suggestions for finding big trends and stocks, suggestions that seem to echo the advice in the title of Peter Lynch's book, "One Up On Wall Street: How To Use What You Already Know To Make Money In the Market." Wyatt's suggestions include:

  • Take a good look at the products or services that "you buy and love."
  • Watch television news, programs and commercials.
  • Keep up with the print media, newspapers and magazines.
  • Engage in conversations with teenagers and people in their 20s.

He pointed out that anyone who read heavily in 2008 would have been reluctant to invest in the financial sector or anything connected to real estate.

This kind of monitoring isn't something Wyatt stops once he has located a small-cap or a trend. After developing a short list, he continues to watch the news in hopes of learning more or finding corroborating evidence for a case he has made. His resources include:

  • Yahoo! Finance
  • Investor's Business Daily
  • The Wall Street Journal
  • The Economist
  • Reuters
  • Nasdaq
  • EDGAR (financial filings with the Securities and Exchange Commission)
  • Stockcharts.com
  • Russell Investments.

When watching, or watching for, trends and companies, he asks questions such as these:

  • Does this idea have long-term potential, or is it likely to be here today and gone tomorrow?
  • Is this idea focused, or does it go in several different directions?
  • Do you have personal experience of an idea that would give you an edge?
  • Can you see any inherent flaws in the trend?
  • Will effects of the idea manifest immediately or in the distant future?
  • Is there relative unanimity about the prospects for this trend?
  • If it is a small cap, is it providing a "genuinely new" approach?
  • Does the company have enough history to show progress?
  • Has there been a lot of coverage of it?
  • Who is managing, and did they enjoy success in previous operations?

In summary, if you put together all the pieces in chapter three of "The Small-Cap Investor: Secrets to Winning Big with Small-Cap Stocks," you have a process for analyzing promising small caps and the trends that may propel them to new heights (or not).

(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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This article first appeared on GuruFocus.