Tactics and Principles for Small-Cap Investment Success

By Paul Mladjenovic

Micro-cap and small-cap stocks are tailor-made for speculators. Whether you’re doing short-term speculating (such as trading) or long-term speculating (hoping your choice eventually becomes a major investment), you’re gambling. You may not be putting a fortune on the line, but it is your hard-earned money. Here are some small-cap guidelines to keep you sane — and hopefully profitable:

  • Know your goals. You should know as much about yourself as you know about the company and its small-cap stock potential. What is your approach? What do you aim to do with small-cap stocks?
  • Short-term speculating: There’s nothing wrong with seeking quick gains if you don’t mind the potential risks. With speculating, the fundamentals of the company aren’t that great of a concern, because you don’t plan on holding the stock for very long. As a speculator, you would use technical analysis to evaluate the stock.
  • Long-term investing: Here you approach the stock as a value investor. Think growing sales and increasing earnings. Use fundamental analysis.
  • Designate risk capital. You allocate your funds for a variety of purposes — emergency funds in the bank, investment funds in your IRA and/or 401(k) plan, and so on. For small-cap stocks, allocate a sum of money that you are comfortable losing in a worst-case scenario; this money is called risk capital.

This sum has to be high enough for you to diversify your small-cap holdings but small enough that losing the money won’t alter your life or general prosperity. Unless you’re more experienced with small-cap stocks, consider limiting your exposure to less than 10 percent (or less than 5 percent for novice investors).

  • Become proficient in the industry. When an industry does well, many of the stocks in that industry tend to do well, and the small-cap stocks tend to do very well. The more you know about an industry and the major factors that influence it, the better you’ll be as a stock picker.

  • Diversify. Yes, if you have 100,000 shares of one small-cap stock, you’ll have a fortune if you’re right. But the odds are definitely against you. Losing all or most of your money is too strong of a possibility to ignore. You’re better off having, say, 20,000 shares in each of five companies.

    In the world of small-cap stocks, you could have a situation where you end up with four losers and one winner and still come out ahead in total market value.

  • Buy some, sell some. If you bought 1,000 shares of a stock and it’s up a few hundred percent, take some money off the table and cash out enough to have (at the very least) your original investment back. Then hold the remaining stock for the long term if you’re an investor.

  • Get to know the company through a phone call (or visit). Usually, company executives like to discuss the business with investors and other interested parties, and a call or visit gives you the opportunity to pick up some valuable information. Ask about their short-term and long-term objectives.

  • Check for news and insider disclosure. Many financial websites give you the ability to receive alerts when major events happen with your stock. Many financial websites let you see what the insiders are doing. Take advantage of that.

  • Use limit orders. Choose brokerage orders that minimize risk and potential losses and maximize gains. Use limit orders rather than market orders with small-cap stocks so you can control the prices you pay or receive when you enter or exit positions.

  • Choose a batch of potential winners. When you’re investing in micro caps and/or small caps, get five to ten in your chosen industry or sector. This strategy enhances your chances of a winning total portfolio, especially if you choose a hot industry or sector.

Reading up on what history’s great investors have done is always a good idea, and one great example is John Templeton. He started his legendary multimillion-dollar fortunes investing in micro cap stocks during the Great Depression. Templeton made sure that the companies he invested in had true value (profitability, valuable assets, and so on), where the stock price was significantly below the company’s value.

Consider reading up on small caps and micro caps. A good book on the topic is Penny Stocks For Dummies by Peter Leeds (published by Wiley). The term “penny stocks” is frequently synonymous with micro cap stocks.