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How to Be a Small-Cap Investor [Secure eReader]
eBook by David Newton

eBook Category: Personal Finance
eBook Description: Numerous stock market experts feel that, now more than ever, the best investment bargains are in small-cap stocks. This dynamic how-to book gives readers a complete overview of small-cap stocks. The author compares small-cap to other types of stocks, offers historical performance records, highlights sample portfolios and advice directly from high profile small-cap investment leaders--everything you need to uncover the next Microsoft. In addition, small-cap experts list the bargain stocks they feel are ready to fly.

eBook Publisher: McGraw-Hill Companies, Published: 2002
Fictionwise Release Date: July 2002




PREFACE

For many individuals, there is nothing quite as exciting as rummaging through a nondescript garage sale, only to come across an item that has tremendous value hidden beneath a generic outward facade. For investors, perhaps nothing is more exciting than purchasing shares of common stock in a relatively small company at a very early stage in the development of the firm, prior to the point where its products or services experience rapid sales growth as part of a newly emerging industry trend. But the processes of mulling over secondhand yard sale items and selecting small company stocks for investment are actually quite different activities. Although they are both about being in the right place at the right time, the former depends on chance, while the latter could be the result of systematic research and hard work. With regard to small-cap investing, the question remains: Is it possible to locate and systematically invest in a portfolio of public firms that have identifiable characteristics consistent with emerging growth potential as well as smaller market capitalization?

Every investor would love to uncover the next Microsoft Corporation, Merck Pharmaceuticals, or Gateway Computer early on when the firm is small and relatively unknown. Investors could have purchased shares of Compaq Computer in 1984 for less than five dollars a share had they recognized that "portable" computers would soon become laptops, and ultimately notebooks, with speed and features that rivaled the best of the desktops, mini's, and mainframes. Just a few years earlier, shareholders in Osborne (the original "portable" computer maker) had lost everything when the company closed its doors for good. And yet at the same time that Compaq was poised for extraordinary growth, Kaypro also designed and sold "portable" computers, but through a different strategy and architecture. The rest is history. Compaq is now a household name and the worldwide leader in personal computer sales, while Kaypro, like Osborne, has long since gone out of business. The difference between these three firms was the way each was positioned for the emerging portable-laptop-notebook computer trend, as well as their financial strengths and weaknesses, and other strategic factors.

Smaller companies have several distinctions that separate their common stock from mid-capitalization and large-cap equities in the screening and selection process. There is also a good deal of unique terminology that reflects the financial structure, cash-flow patterns, and product and service introductions of smaller, emerging growth companies that may signal untapped appreciation in value. The objective for investors is to locate the hidden value that many smaller-sized firms provide to those who are actively researching the next widely successful growth industry and product or service innovation.

The Small-Cap System

"How to be a small-cap investor" is actually a multifaceted question. It might infer that there is, in fact, a particular "way" to do this type of investing. The "how" of small-cap investing opens up many issues about an individual's assessments of economic, industry, and company-specific data and analysis. It introduces decision criteria and personal preferences for stock selection into this discussion. The question also raises several issues regarding what exactly constitutes a small-capitalization stock investment. Defining and clarifying this niche within the equities arena has been the subject of much attention among professional portfolio managers and the financial press, as well as academic researchers and individual investors. Finally, the question also introduces a wide range of topics pertaining to the philosophy of managing such an investment.

This book seeks to present a concise overview of contemporary data and information related to this thought-provoking question and seeks to bring clarity and purpose to the investor who is serious about small-cap stock opportunities. These chapters try to cut through years of research studies and evidence concerning small-cap portfolio performance and to discuss an overall investment rationale and strategy geared toward this potentially profitable segment of the capital market. This specific approach to investing does not guarantee consistent double-digit annual returns, but it will clearly identify evidence and processes aimed at emerging-growth industries and the exciting small-cap companies that comprise them.

Topics and Chapter Organization

The first facet of the book addresses the processes and methodologies involved in implementing a small-cap investment strategy. It presents a systematic approach to do this type of investing, which is different in many ways from traditional common stock investment strategies. Readers will learn how to locate a large pool of small-cap stocks from existing public information that can be easily accessed through various reference materials and on-line services. Next, specific procedures and analysis will be introduced to provide a framework for narrowing the pool into a discrete group of small-cap stocks that have indicators consistent with the potential for exceptional future appreciation in price. Also, several approaches to monitoring a small-cap portfolio will be introduced with respect to risk exposure, return expectations, performance evaluations, liquidity preferences, and investment time horizons. The goal is to make small-cap investing practical and rewarding for those with an eye for emerging innovations and untapped product service industry trends.

Chapter 1 introduces the "entrepreneurial" perspective of small-cap investing. Entrepreneurs willingly assume what appear to be significant business risks, but they do so intentionally, with a plan for managing the risk through innovation and marketing ingenuity. The focus of this investment philosophy is aimed at developing a vision for what might be possible for the company's stock over time. This requires patience, even when contemporary wisdom does not, as yet, recognize the impending changes that accompany innovation and the advancing of the current knowledge base. Many smaller firms embody the distinguishing profile of entrepreneurial vision, innovation, and emerging product or service markets that are unique to small-capitalization stocks. This supports an underlying rationale and model focused on the potential for extraordinary long-term gains that might come from investing for the long term in firms that display such an entrepreneurial perspective. Chapter 2 then defines these small-cap companies as unique based upon eight characteristics that are typical of fast-growth entrepreneurial ventures. These are set apart from traditional blue-chips (large-cap) and the more mature mid-cap issues.

Chapter 3 presents clear empirical evidence from the NASDAQ, AMEX, and NYSE of how small-cap stocks have historically performed relative to large-caps, mid-caps, and the traditional market. This will help to establish the specific risk-return trade-off within this small-cap market segmentation strategy and how it affects stock selection. This chapter clearly defines companies whose market equity value represents a relatively small capitalization when compared to the range of firm values. It also summarizes some of the research questions about whether small-caps really provide a unique investment return.

They may even have different internal managerial agendas for research and development spending, cash-flow distributions, dividend policies, debt financing, and risk tolerance.

Small-cap investing is aimed at joining emerging industries and consumer market trends, in the early stages of development, by purchasing stock in the firms that will have the greatest success with products and services in these potential growth sectors. Chapter 4 discusses fundamental and technical analysis, and the basic levels of research that typically guide the small-cap investment process. Five industry characteristics are presented to help identify innovative product and service offerings that typify strong growth industries. These can be used to rank whether certain industries are well positioned to include rapidly developing product technologies as well as innovative business alliances and services.

Chapter 5 identifies three small-cap firm types and introduces eight screening factors aimed at locating the best small-cap companies in the most promising industries. Small-cap stocks are those firms that are still small enough to be flexible and focused on marketing and innovation success, allowing quicker responses to changes in industry direction and consumer behavior. The screening process is discussed, as are sample firm profiles. Chapter 6 then provides a complete overview of several key financial indicators that characterize firms as small-caps with the strongest upside potential for growth. Special attention is paid to cash flows and a growth index.

Chapter 7 develops a summary of the screening process from the earlier chapters and examines contemporary groupings of small-cap stocks from some of the best small-cap fund managers in the United States, with an emphasis on strong profiles for 1999 and beyond. Also summarized are the basic precepts and concepts that constitute successful small-cap investor perspectives. A good deal of research and well-documented tests of empirical models exists that point out several wealth-creation tenets that comprise successful investment philosophies with regard to equity portfolios, risk factors, and time horizons. Equity investors understand that changing information about the financial markets, product and service industries, and a firm's technology and financial position will likely contribute to short-term price volatility. Small-cap investors need to have an eye toward building wealth over the longer-term, and as such, they should be content to weather the interim volatility with expectations for building value over time.

Chapter 8 discusses the benefits and dynamics of diversification in general, and examines the realities of small-cap intragroup diversification strategies and how these can affect portfolio return expectations in the near term and for the long haul. Chapter 9 then presents a clear strategy for balancing individual risk tolerance and performance return expectations using a small-cap asset allocation system. It is unique from traditional asset allocation strategies and the factors that influence the small-cap trading plans. Chapter 10 provides an overview of several samples of small-cap portfolios, their risk composition, diversification and relative volatility exposure issues, asset allocation transitions over time, return expectations, and performance criteria.

The last two chapters focus on the practical implementation of small-cap investment strategies. Chapter 11 addresses some of the most common questions that individuals have about small-cap portfolio construction. It deals with the trade-offs between active and passive management in the small-cap system, as well as investment time horizons, portfolio rebalancing, industry and firm reassessment, and macroeconomic influences in the buy, sell, and hold cycles for emerging entrepreneurial companies. It also covers questions about risk and misconceptions about investing in initial public offers. Chapter 12 offers concluding remarks and areas to watch concerning the overall small-cap portfolio strategy. It provides comments and concerns that will affect the goals and objectives of contemporary small-cap portfolios.

Target Audiences

How to Be a Small-Cap Investor emphasizes a unique "entrepreneurial perspective" to formulate performance objectives for investing in high-growth, emerging businesses. The ultimate goal is to instill in portfolio managers and individual investors a sense of adventure and exploration while screening companies in search of extraordinary opportunities for capital appreciation in small-company common stock. It is anticipated that this work will become a great resource for information about key topics associated with the small-capitalization segment of applied portfolio management. As a "principles of small-cap" book, it seeks to provide a unique balance between institutional-academic rigor, empirical evidence, and practical narrative for the financial professional and the layperson alike. The book is also targeted for applications as a trade book for practitioners in the investments and portfolio management field. Fund managers, wholesale traders, and especially retail brokers will hopefully keep a copy readily available on the bookshelf as a one-stop overview of the small-cap process, concepts, and terminology. Broker-dealers could use the book as part of their in-house training programs for new financial planners and NASD registered representatives to learn how to market this strategy to retail customers and professional clients.

College and university professors can use the book within the traditional investments and portfolio management course pedagogy, as part of a recommended readings list, or as a resource for portfolio construction examples and for student research papers dealing with investment strategy. And, of course, any individual investor who wishes to learn more about his segment of the equity market will hopefully find it easy to read, informative, thought-provoking, and full of practical ideas that can be put to use right away to take advantage of the opportunities in small-cap stocks. The objective is to make it easy to locate, research, and select small-capitalization stocks for an investment portfolio, using a distinctive approach to classify emerging industries, screening prospects for innovative products and services, and performing financial analysis of small-cap profile companies.

This book introduces several new concepts, namely small-cap diversification and small-cap asset allocation, and how to make these tactics work in the practical selection and management process. The book also makes a special effort not to sacrifice any of the classic fundamentals of the institutional-academic rigor, so it should appeal to professionals in the field, offering both theoretical and conceptual principles. The journey into small-cap investing is exciting. Perhaps the next market trendsetter will wind up in your portfolio, not by accident, but because it demonstrated a small-cap profile with signals for significant returns. Remember, the small-cap investor's task is to locate emerging growth, diversify portfolio holdings toward a clearly defined level of risk and expected return, maintain the course for the long haul, reallocate stocks over time, and then enjoy the ride. This ride will probably be fast-paced and volatile, but the promising long-term rewards for those who are patient should more than make up for the short-term bumps along the way. Good investing!

David Newton
Santa Barbara, California

Copyright © 1999 by The McGraw-Hill Companies, Inc.


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