Don’t Be Discouraged by All the Small-Cap Horror Stories

I hope you are not listening to everything you hear on TV or read in the papers. If you read through the business sections, there is at least one horror story about a small cap “gone bad” every month. Of course, small caps cannot go bad — although the people who run them can, or they can run into other people and circumstances that are bad. In any event, the media usually focuses solely on the negatives where small caps are concerned.

True, the performance of small caps has played a role in them having, shall we say, a reputation that leaves much to be desired. Small caps are very risky investments, they’re often implicated in all kinds of manipulations, and many are certainly lacking in fundamental quality. However, the same could be said about behemoths such as Enron and WorldCom. Although those two companies were large caps, they proved to fit the mold on all three counts.

This is why editors and analysts at Lombardi Financial continue to argue that size, although it matters, is neither a sure way to lose thousands of dollars, nor a guarantee of future returns. The size of a company is only one of the factors you should use when determining where to invest. My goal in this article is to review what other factors are relevant in the bizarre world of small caps. Hopefully, it will help you decide if investing in small and micro caps is for you.

First and foremost, small caps have enormous growth potential. At some point, even the largest of the large caps started out as a small business. Apparently, Microsoft started out in a garage, while Wal- Mart was just a Mom and Pop’s convenience store, or so the story goes.

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But, we are not talking about having the foresight so clear to peg the next Microsoft. Rather, the point we are trying to make is that small companies are precisely that — small companies; but they have plenty of upside potential. A large cap, usually measured in billions of dollars, cannot double its size as easily as a small company with market cap of about $300.00 million or much, much less. If that were the case, we would have behemoths of companies bigger than the entire economy.

Another advantage of small caps is that at such early a development stage, they are on no one’s radar, except for our own and other independent analysts who are infatuated with these amazing growth opportunities. However, mutual or hedge fund managers cannot even register small caps for several reasons. First, every mutual and hedge fund has a “mission statement” of sorts, which restricts what type of securities that are allowed into a fund, at what risk level, or in which sector.

Second, portfolio managers have hundreds of millions of dollars available for a single investment. Chances are, small caps would have no way of handling that much liquidity. And, even if they had, buying that many shares would trigger certain types of heavily regulated transactions, such as a takeover bid.

Yet, with this “under-recognition” come advantages. Being out of the spotlight means that there is little or no analyst coverage. With no one paying attention from Wall Street, chances are that small caps are underpriced, which, in case of a quality small cap, could translate into “buying low and selling high” at huge profits.

Of course, not everything is rosy about small caps. As usual, there is a flip side. When you invest in small companies that are still in development stages and where money is tight, you are exposing your investment to a higher risk level.

At the end of the day, all companies are judged by their ability to generate cash. In majority of cases, large caps are smooth moneymaking machines. Small caps, on the other hand, are still at the stage when they are trying out their business models. In other words, they are very, very far from being a cash machine.

Due to their size, small caps are also less liquid and, therefore, more susceptible to market volatility. Huge price swings within days are nothing unusual for small caps. However, not every investor has the stamina to stomach them.

Regardless, there is much to be said about the kind of growth opportunities that only small caps can offer. Although with such growth opportunities comes a lot of baggage (i.e. risk), the potential for whopping returns is substantial.

Lombardi Financial’s advice has always been the same. We are huge fans of small caps, but we are also completely aware that thousands of things could go wrong with our investments. As a result, we only invest money we can afford to lose. And, we make sure all the mechanisms are in place to limit any potential loses, such as initial buy orders with stop limits built into them.