Five Small Cap Rules to Live By

Published Dec. 28, 2013 in the National Post

Most investors know about the January effect, whereby small-cap stocks tend to do well on average in the first month of the year, following tax-loss selling and year-end portfolio positioning in December.

With that in mind, let’s take a look at a few small-cap guidelines before you go all willy-nilly and start buying small companies next week.

Don’t equate the stock market with the lottery

Many small-cap investors are looking for the next huge stock, the next Google or, closer to home, the next Avigilon Corp. (up 164% this year). In this search, some investors will throw money at any hot story they find. But if you buy tiny junior-gold, tech and biotech companies, you often end up just buying stories, not investments.

Small companies almost always sound great, but you do not need to be in on the ground floor in order to get rich. Wait until a company has proven itself to the world and its management has shown its chops.

Remember: If a stock is going to go from pennies to $30, getting in at $2 or $3 is still a pretty good return. Let someone else buy the lottery tickets and make sure you just buy investments.

Only buy companies with a competitive advantage

Before buying any small company, ask yourself: What makes this company different?

If a small company does not do something better (or cheaper or faster), it is likely going to be a bad investment. Larger companies simply have more pricing, financial and market power.

If you are lucky enough to own a company that has an advantage, make sure it keeps that edge. Its success is only going to attract more competition. If it doesn't keep running, it will be beaten.

Small companies need to survive before they can prosper

We need only point to the junior-gold sector right now to prove this point. This week, Jaguar Mining Inc., once touted as a million-ounce producer, filed for bankruptcy protection. But hundreds of other companies in the sector are also hanging by a financial thread.

If you have a great gold mine, yet can’t finance operations, all you have is a bad investment. Many investors need to pay close heed to this rule in 2014.

If the gold sector does not recover, small-cap companies in the sector are going to start disappearing on a regular basis. Make sure any investment you make — in any sector — at least has enough financial staying power to continue its efforts to make you money one day.

Buy experienced management teams with a large stake in the business

Small, fast-growing companies inevitably encounter numerous problems in their early years, and management’s ability to solve these problems will determine whether a company survives or flounders.

Therefore, look for an experienced management team that has grown a business before. In addition, if management has a large equity stake in the business, they’ll be more committed to enhance value for themselves (and, thus, for you by default).

Don’t stick around too long if serious problems develop

Things will often go wrong at a small company that even an experienced management team can’t fix. If there seems to be a fundamental issue at a company —  financial troubles, poor clinical trials, weak demand for products and so on — get out.

If you end up being wrong, you can always buy the company back. Even paying more when you’re proven wrong is better than holding an investment that might be on a downward spiral to zero.

These problems can be sometimes hard to confirm, but they often first show up in declining sales trends or declining profit margins. A small, growing company, in our view, should never show declining sales.