If you were to ask the NFL’s top 5 quarterbacks about the best way to throw a football, they would all probably have slightly different answers. Every answer would still include a few key mechanics such as setting your feet and following through on your throw. However, every quarterback would probably tweak their answer slightly to account for their own personal preferences. Picking small-cap stocks is actually fairly similar.
When it comes to picking small-cap stocks, there are a few key factors that all investors should look for. However, each investor’s strategy is likely going to vary slightly based on their own preferences. This is because, at the end of the day, each investment decision should come down to your own due diligence and investment style. With that said, let’s take a few of the key factors to look for when picking small-cap stocks.
If you’re interested in what an example of a good small-cap stock looks like, we’ve already researched a few for you here.
Pillar One – Focus On Long-Term Value Creation
It’s important to remember that behind each small-cap stock is a company. When evaluating a company’s business, you want to make sure that they are creating value for their customers. As long as this company creates value for their customers then it should help to improve financial results. Better financial results almost always result in a higher stock price.
When you look at the world’s most valuable companies, all of them provide a product or service that is immensely valuable. Google created the most efficient search engine that helps people navigate the internet (and helps advertisers target searchers). Apple creates technology that people use to achieve thousands of different goals. Netflix helps people access thousands of movies or TV shows at an incredibly affordable price.
Although a small-cap stock most likely won’t be on the same level as these three companies, they should still be providing a valuable product/service. If they are then they should ultimately be successful, even if they have not received attention from other investors. In fact, it might be a good thing that other investors have not noticed them yet.
Investing in a company before major institutional investors (hedge funds, investment banks, etc.) have noticed can be a major advantage. When institutional investors finally notice, they will probably invest millions of dollars at a higher price which will drive up the stock’s price significantly. If you can identify successful small-cap stocks before this happens then you will profit greatly when institutional investors finally take notice. This process is sometimes referred to as “robbing the train before it reaches the station”.
Now, let’s move on to pillar two of picking small-cap stocks.
Pillar Two – Invest In Large Markets
When investing in a small-cap stock, the main goal is for that company to grow significantly over the coming years. In order for that to happen, the company must have a large total addressable market. The total addressable market is just the revenue opportunity available for a product or service.
For example, the total addressable market for a product like vegan face wash is probably quite small. Even the largest company that sells vegan face wash will probably never become a $10 billion-dollar company. On the other hand, the total addressable market for electric vehicles is predicted to become massive over the coming years. Small-cap stocks that are competing in the electric vehicle market have a much better opportunity of achieving high-level growth.
In order for your small-cap stock to experience high levels of growth, it needs to be selling a product/service that is widely used.
However, even if a company has a stellar product that addresses a large market, it may still fall short if it does not have the right management team in place.
Pillar Three – Invest In Strong Management Teams
When looking at the biggest companies in the world, almost all of them have one thing in common: they are led by a visionary CEO/Founder (or they were at some point). This was true for Steve Jobs and Apple. It’s true for Reed Hastings and Netflix. It’s true for Elon Musk and Tesla. For this pillar, we will extend the circle to include the rest of the management team as well as the CEO.
Having the right management team in place is crucial because, at the end of the day, people are what drive corporations. The management team that is going to be working every day to make sure that the company is successful. When the business inevitably faces challenges, the management team will be responsible for overcoming them.
In a sense, the management team for a company is like the coaching staff for a sports program. An elite coaching staff can help a team win, even if they don’t have the best players. On the other hand, a bad coaching staff will underperform even with a team full of 5-star recruits. The same is true for companies.
We hope that this has been helping in learning what goes into picking small-cap stocks. If you’re interested in reading more, check out a few of our investment ideas.