More Reasons Why Small Caps Perform Better

After this week’s “show” that large-cap markets have put us through, it might be a good idea to remind our Profit Confidential readers why the editors at Lombardi Financial generally prefer small caps in the long run. For starters, one confirmation comes from the statistical source, Ibbotson Associates, which kept track of small-cap indices since 1926. The conclusion was that, in the long run, the small-cap indices outperformed their mid- and large- cap peers.

So, what gives? Is there a secret recipe? Is the secret to successful investing about small caps? Is trading small caps something that only financial gurus can do? Well, the answer is both yes and no, but mostly no. There is this cute little comparison often used to describe a typical Wall Street money manager. He or she is a person that competes in a game of darts with a blindfolded chimp. The long outstanding joke is that regardless of the blindfold, the chimp outplays the money manager eight out of ten times.

Obviously, this comparison is hardly flattering. The real question is, however, could it be true? Well, considering that most active money managers have difficulty spotting even the basic of market trends at times, it just might be.

The probability of a chimp picking better stocks than a million- dollar money manager covers the bad news. The good news is,

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“Who cares!” Who cares about abilities of an expensive money- sitter! It would certainly not be an investor who manages his own portfolio, and definitely not the investor who has a portion of it invested in small caps.

As most of us are painfully aware, particularly after the DOW dropped more than 400 points on Tuesday of this week, there are no guarantees in the 21st Century. There are also no excuses for failing to do the necessary footwork. So, what should independent investors or research services be looking for?

Well, the process is rather simple — it has been done since, well, forever, and it was the only one with proven results. The other day I talked about liquidity as a tool that gives small cap investors their edge. But, this time I am talking about an “introspection” of sorts, which consists of five self-explanatory steps, the first of which is finding out who runs a company and whether the company’s management is invested in the enterprise. Otherwise, how can you have faith in the company if its own management doesn’t, right?

The next step involves researching whether the company operates a sustainable business. If the small cap is a biotech, check if there are any collaboration agreements, because those come in handy when managing operations. Or, if the company is in the telecommunications industry, ask what is the ratio of customer base versus sales, etc.

The third step is in essence related to the second step, and that is to check whether the company operates within niche markets. This means that we are looking for something unique, either in terms of technology or a product.

The next step is plowing through the company’s financials. Balance sheets, income statements, statements of operations, etc.; everything must be examined. You want to know how much cash the company has to run the day-to-day business. You want to know how much of that cash is tied up in debt. You want to know how much cash flows from operations, and how much comes from interest or investment income.

Finally, the last step orders you, an independent investor, to follow the money, literally. It is not enough merely to have cash in your treasury. The company must also have a strong and constant influx of cash. Having a strong and free cash flow can make a difference between making it big and crashing miserably.

Of course, small caps may not make it on all five counts. Chances are, however, if the first three components are there, the other two will fall into place in the long run.