I sometimes fantasize about making fantastic stock market selections comparable to winning the lottery. The best part of the fantasy is answering questions such as, “What would I do with, oh, I don’t know, a few million dollars?” Or, in a different context, “What would I do if I ever found another Microsoft?” All kinds of plans immediately spring to mind, most of them having to do with extended vacations and shopping sprees.
I still haven’t won a lottery, although chances are literally nonexistent, considering I have yet to buy a lottery ticket. Meditating along the same lines, I have yet to convince myself that I may have found the next Microsoft, since I haven’t lived long enough.
It is a fact that many of the past decade’s greatest companies started in obscurity before rising to greatness. Microsoft, for example, traded in January of 1990 at a split-adjusted price of a measly $0.62 per share. Currently, the stock is trading at around $30.00. We’re talking about a return of over 4,700%.
Of course, hindsight vision is always 20/20. At the time, who knows what was said, if anything, about some obscure little company that started its operations from a guy’s garage. Plus, who knew that the guy would be Bill Gates? After all, how much faith can you have in a guy who left Harvard in his junior year?
Typically, famed portfolio managers and finance gurus prefer small companies that show early growth potential and earnings capabilities. They all prefer insiders to believe in their little projects and heavily own their companies’ shares. They all prefer to see tangible assets on balance sheet. And they all prefer to buy them cheap.
The story about Microsoft was that simple. There was strong vision, there were strong people behind it, and there were strong financials. Microsoft was never a penny stock. (Bear in mind that the price of $0.62 from the 1990s is split-adjusted.) Investors have yet to see a beautified press release about Microsoft. Gates never embellished or made out-of-this-world promises. Instead, Gates ran a tight ship and required from his executive team to buy the company’s shares. He wanted his employees to share in the trials and tribulations of his company, just as investors did.
The best thing about hidden gems like Microsoft is that you don’t need a crystal ball to find them. There are plenty of small-cap companies that flourish in nearly every sector, be it technology, finance, medicine, entertainment, mining, etc. Granted, investing in a small-cap company is still investing speculatively, and investors should be able to deal with a certain amount of risk. But there are ways to mitigate it.
First of all, search for companies whose insiders own large stakes of their companies’ stock. Then check out their financial statements. Many small-cap stocks are listed on the over-the- counter markets where financial reporting rules are less stringent. But if the company you’re interested in has audited and publicly available financial statements that are easy to understand, you may just have the ticket.
Also, pay attention to a company’s balance sheet. Check out its assets, and then check out how much the company owes to the bank. Debt-versus-equity ratio will tell you how much of the company’s earnings are tied into dollars owed. After checking under the hood, check out the parking lot, too. See who the competition is and how well the company positioned itself versus its peers. Don’t forget, if the field is too crowded, it usually means limited room for growth.