Small-Cap Stocks: The Beginning of the Journey

When an individual investor wants to roll up his sleeves and do some research in the pursuit of the next big winner in the stock market, the place many start is in the small cap sector.

As with the other capitulation sizes (capitalization is a stock's market value), no one can completely agree on a precise definition, but corporations under $2 billion are often considered small caps. It should be pointed out that there are two asset classes below small caps. Micro caps are companies between $50- 300 million and Nano caps are below $50 million. To further confuse the issue, there are also "penny stocks" that really have nothing to do with capitalization size, but are stocks that trade very cheaply.

Life begins for many small caps as an Initial Public Offering (IPO) or as a "spin off" from a larger company. Like Toddlers, these companies are often still in their developmental stage. At this point they exhibit characteristics that give them the potential for both massive growth and extreme downside volatility.

Their huge growth potential is obviously the piece that attracts most investors. Who wouldn't have wanted to get in on a Microsoft in its early days of trading? The question of course is who knew about Microsoft back then?

Often, it is individuals not institutions that first get in on the ground floor. Analysts working for major brokerage firms usually don't have the time to develop coverage on small companies and institutional investors generally have limitations of how much they can own of a single company. Although a $100 million may seem a lot to an individual, it's a drop in the bucket for the big players and equals 20% of a $500 million company. The 20% far exceeds what the SEC stipulates a mutual fund can own and often exceeds the investment policy statement of an institutional investor.

The disadvantage here to the investor is there is relatively little published research that the individual can rely on in the decision making process. But the good news is that the individual investor has the opportunity to buy the stock before the institutions get in and run the price up.

Many investors believe in the "efficiency" of the market. This means that with all the information out on a particular stock, the market can "efficiently price" any stock. In the case of small caps (where information is often lacking), an argument can be made that there is some potential to profit from inefficiencies in the market. Again, this cuts two ways. Many investors can remember that it wasn't too long ago that many small cap techs sold for vastly inflated prices only to watch a steep price slide as the market started to correct these inefficiencies.

Income investors should probably look elsewhere. Small caps generally conserve whatever cash they earn for growth potential. Any yield is usually incidental to their objective.

For mutual fund investors, small caps can be an interesting proposition. Certainly, mutual funds can help offset some volatility through diversification. However, for investors that want to follow a small cap's ascension to the large cap sector, mutual funds may disappoint. Often, to avoid what's called "style drift" a mutual fund manager sells a successful position simply because it has outgrown its capitalization value. While this may be helpful for asset allocation purposes, it's not appealing for investors wanting to watch a company "grow up".

Glenn ("Chip") Dahlke, a senior contributor to the Living Trust Network, has 28 years in the investment business. He is a Registered Representative of Linsco/Private Ledger and a principal with Dahlke Financial Group. He is licensed to transact securities with persons who are residents of the following states: CA. CT, FL, GA, IL. MA, MD. ME, MI. NC, NH, NJ, NY.OR, PA, RI, VA, VT, WY.

If you have any questions or comments, Chip would love to hear from you. You may contact him at [email protected]. You may also reach him by going to the Living Trust Network web page located at http://www.livingtrustnetwork.com.

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