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Small Caps: An Introduction for Value Investors

- By Robert Abbott

For value investors, small-cap stocks are something of a mystery. They often lack the history necessary for a proper job of due diligence, yet they can add growth potential to a conservative portfolio. Even finding good small caps can sometimes be a challenge, since they typically burrow away--successfully or unsuccessfully--under the radar.

Ian Wyatt, an experienced small-cap investor, set out to address those challenges in his 2009 book, "The Small-Cap Investor: Secrets to Winning Big with Small-Cap Stocks." The author described himself as a long-term investor focused on finding value. Through Wyatt Investment Research, he looks for businesses with sustainable and large cash flows at the right price.

Chapter one offered an overview and summary of the small-cap world. This included a high-level, eight-step process for finding profits among small stocks, a process he will develop as he proceeds through the book:

  1. Sectoral trends: Find market sectors poised to experience growth in coming years.
  2. Screen for potential winners: Use fundamental and/or technical analysis.
  3. Fundamentals: Know the key metrics as well as the company's business and management.
  4. Financial performance: Evaluate important markers in the company's financial statement.
  5. Earnings quality: Watch for red flags that might suggest financial manipulation or fraud.
  6. Growth outlook: Get to know the expectations for individual companies.
  7. Technical analysis: Know key indicators that help with the timing of entries and exits.
  8. Effective trading strategies: Identify the "optimal timing" for entering new positions.

Wyatt defines his small-cap universe in conventional terms: Above $500 million and below $2 billion. He adds that the smaller the capitalization, the greater the likelihood of exceptional gains.

Attributes that define favorable small caps include being a young company experiencing its fastest growth so far, that launches new produces and services, makes strategic partnerships or enters a new market without the knowledge of the big players.

He added that small caps with fewer employees and lower expenses than larger companies have "unrestrained flexibility" to chase growth and the willingness and ability to take risks that would scare away bigger players.

Among the small-cap success stories of the late 2000s was Almost Family Inc. (AFAM), a provider of home health care services. Over the five years from 2003 through 2007, its sales grew 122% while earnings popped from 2 cents to $1.40. In this case, the company caught an important trend: The aging of the population and the need for personal services that fell between independent living and comprehensive elder care.

The following GuruFocus chart shows the company's price history through the three decades from 1988 to October 2018:

Almost Family price chart

Almost Family remains a small-cap in 2018 with a capitalization of $784 million.

Since Wyatt's book was written and published in the immediate wake of the 2008 meltdown, the author was cognizant of how small-caps perform in a post-bear market. He cited Ned Davis Research as finding that "small-cap stocks tend to significantly begin outperforming large-cap stocks at about the same time and typically continue leading for at least a year after the recession has ended."

And looking at long-term results, he cited research from Duke University: Assuming $1 was invested in small caps in 1925, that dollar would have grown to $3,425, while the second-best performing class, large caps, would have grown to just $973 (assuming dividends are reinvested in both cases).

But the idea of simply investing in a small-cap index fund and then ignoring the investment until retirement would not be wise. Historically, small caps outperformed in some periods and lagged other asset classes in other periods. The relationship between small caps and large caps is not unlike the relationship between equities and bonds.

Wyatt also believed that indexes were appropriate for those who want to match the overall market. But for those who want above-average returns, it is necessary to invest in individual stocks.

The liquidity of small caps, compared to that of medium and large caps, also requires attention. Small caps are often thinly-traded, making their prices more volatile. That can be both good and bad for investors.

The key is to find small-cap stocks that can capitalize on current trends; in the recent past, such trends have included the emergence of the internet, smartphones and green energy. At the same time, small caps tend to be more nimble, allowing them to identify and exploit opportunities sooner than larger-cap stocks.

Wyatt then turned to the downsides of small caps which, include the need to be extra diligent when examining the fundamentals. Because small caps get less attention from analysts, institutional investors and the financial media, their shortcomings are less likely to be found at an early stage. As Wyatt puts it, "most small caps go unchecked, without the coverage and exposure that exposes potential problems for investors."

Additionally, the simple need to report financial results can lead to problems. The author noted that small, fast-growing companies often feel pressure to maintain earnings growth and, as a result, may be tempted to manipulate their financial statements. If such practices are exposed, then shareholders will experience double jeopardy: Their stocks were overvalued and, if they go down, are likely to crash hard.

Wyatt also discussed the issue of information, the accessibility of information and the efficient market theory. The latter refers to the idea that the market(s) is relatively efficient over time because in the modern world everyone has roughly equal access to information and data. However, small-cap investors cannot sit back and follow the financial media because that information is primarily about large-cap stocks.

In other words, the market for small caps is inefficient and investors must put in more time and energy to finding these stocks, assessing their fundamentals and identifying the trends that may drive their success or failure.

Summing up, Wyatt has introduced readers to some of the pros and cons of small-cap investing. Notable points include the need to be extra vigilant while doing analysis and to look for small caps that are capturing major growth trends.

(This article is one in a series of chapter-by-chapter digests. To read more about small-caps, 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.