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Small-Cap Stocks: The Beginning Of The Journey
By: Glenn
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".
Copyright 2005. LivingTrustNetwork, LLC. All rights reserved. http://www.livingtrustnetwork.com
About the Author:
Glenn (“Chip”) Dahlke, a senior contributor to the Living Trust Network (http://www.livingtrustnetwork.com),
has 28 years in the investment business. He is a Registered Representative of
Linsco/Private Ledger and a principal with Dahlke Financial Group. If you have
any questions or comments, Chip would love to hear from you. You may contact him
by email at dahlkefinancial@sbcglobal.net |
